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The Best Hotels To Buy

Have you ever thought about what a hotel really is? Is it just somewhere we stay for a few days when we go on holiday? Or are they those big-red counters that we use to represent the most valuable assets in Monopoly?

Thing is, a hotel is nothing more than an asset that is rented out to people, like us, on a daily basis. It might make some money from food and beverage, doing our laundry, charge guests for telephone calls and maybe even levy a fee for watching in-house movies. But its main source of revenue is room rentals.

Buffett’s insights

That is something we should remember. Hotels are just income-generating property assets. And Warren Buffett has provided us with some useful insights on investing in real estate….

…. As unlikely as it might seem, the Sage of Omaha, is not averse to putting money into bricks and mortar. He once said that property investors should focus on the prospective yield and ignore the daily price fluctuations.

He also said that games are won by players who focus on the playing field rather than by those whose eyes are glued to the scoreboard. So, hotel investors should think in terms of income and not price appreciation, though the latter could play a part in the long term.

Revenue generator?

In the main, hotels are not particularly efficient at generating revenues from their assets. The median asset turnover for hotels last year was a disappointing 0.2. In other words, hotels, on average, generated about $2 for every $100 of asset employed.

The reason for the low asset turnover is, perhaps, not entirely surprising. Hotels can be expensive buildings, with some considerably pricier than others. Those chandeliers in the hotel lobby can cost a packet. So, they need to achieve high occupancy rates, most of the time, to extract as much revenue as possible from their rooms.

Lend me some money

Those expensive assets are generally paid for through borrowings, which is something we need to be mindful of. The median leverage ratio for hotels is a not insignificant 2.0. In other words, many hotels could owe as much to creditors as they own in assets.

That said, hotels can be quite profitable, provided they can rent out their rooms. In 2017, hotels made around $10 of bottom-line profit on every $100 of sales. Consequently, it is important that hotels squeeze as much revenue as possible from every available room.

So, hotels are not great at generating revenue from their hefty assets. But they can produce decent profits when their available rooms are rented out. Some may also borrow heavily.

When we put those three things together, we find that hotels are not too bad at generating profits for investors. The median return on equity is a low, but still respectable, 5%. In other words, hotels, on average, can generated around $5 for every $100 invested by shareholders.

Cheap rooms

By and large, hotels are not expensive. But that would depend on how we choose to value them. The traditional way of valuing businesses by using the price-to-earnings ratio can be misleading. That is because these are very capital-intensive businesses.

Between 2006 and 2017, the median price-to-earnings ratio was between a low of 12 to a high of 33. Put another way, we could be paying $33 for every dollar of profit that hotels make. That is nearly three times more than the market average.

Enterprise value

However, the enterprise multiple or EV/EBITDA paints a different picture. The enterprise multiple can be a better way to assess the value of hotels because it includes assets, debt and equity, whilst ignoring hefty non-cash items such as depreciation.

In 2017, the median EV/EBITDA for hotels was 19, which is lower than the price-to-earnings ratio of 30. So, someone looking to buy over an entire hotel would be paying $19 for every dollar of operating profit.

Another way of looking at hotels is to determine how much we are paying for every dollar of free cash flow. The free cash flow yield has varied from a low of 0.8% to a high 5% over the last decade. Currently it is around 3.3%, which means that investors are paying $100 for around $3.30 of free cash flow.

Investors would ideally expect more. But here’s the thing….

….. Valuable assets….

….. Hotels are generally sitting on land have generally risen over time. So, investing in hotels can be as much an income play as a bet on rising property prices.

Currently, the price-to-book ratio for hotels is around 1.4, which is just below the long-term average, and significantly lower than the peak of 2.6 before the financial crisis of 2007.

Meanwhile, the average yield on hotel shares are around 1.2%. That may, admittedly, not be particularly attractive. But it could still be an acceptable compensation, whilst waiting for property prices to appreciate.

A version of this article first appeared in The Business Times.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned. Mandarin Oriental is a PIP recommendation.