As a sector-agnostic investment manager, Altera focuses its efforts on identifying off-the-beaten-path opportunities. Inherent in this approach is a desire to identify resilient strategies whose return characteristics are less dependent on macro factors and more on micro-level execution. In this series of articles on Unconventional Assets, we examine some of these sectors and explore what makes them both potentially attractive financially and effective diversifiers in an investment portfolio.
UNCONVENTIONAL HOSPITALITY: EXTENDED STAY (ES)
Extended stay (ES) hotels generally serve a different market than “nightly stay” hotels. Price points are typically lower, and stays are longer. With fewer check-ins and check-outs, extended stay properties are usually able to operate with reduced housekeeping and front-desk staff. On average, the reduced need for amenities and services in extended stay properties results in profit margins 10-15% higher than nightly stay hotels.
With these “stickier” characteristics, ES hotels have been proven to be far more resilient in difficult economic environments, continuing to generate positive free cash flow while maintaining occupancy rates in the 70%+ range. As the graphic below indicates, the Economy sector of extended stay shows particular stability versus other, higher price-point segments during the COVID-19 pandemic. Some estimates place the breakeven point for Economy ES hotels at less than 35% occupancy.
Despite these characteristics, extended stay hotels have yet to be understood or appreciated by institutional investors, and transaction multiples remain low versus other segments. In fact, capitalization rates among ES properties tend to be in the 10% range, which is a rare valuation benchmark that sees few comparables among other real estate sectors. As this sector matures and investors are drawn to its resilient characteristics, we expect these valuations to become more aligned with other sectors, giving investors a financial tailwind over time.
Cash flows from extended stay hotels can be substantial, and many investment vehicles provide
investors with well covered distributions in the mid-high single digits annually. These cash flows have largely persisted during the COVID-19 environment. These characteristics have attracted a variety of competitors to the segment. The current pipeline of extended stay hotels shows a more than 30% increase in room count by year-end 2022. Such an expansion of lodging options will likely keep pressure on pricing while the segment potentially steals share from higher priced offerings.
Many recent transactions in the extended stay segment appear to be driven by overall weakness in the lodging industry (not by particular issues with ES.) Many hoteliers are diversified across a range of brands and concepts. ES hotels, being among the few in their portfolios still operating with positive cash flows, present the easiest option for accessing liquidity. These facilities are hitting the market at a time when traditional operators are cash constrained. Discounted valuations reflect this mismatch.
While some of the the ES industry is operated by large entities, the industry still remains fragmented,with a wide dispersion of profitability characteristics among operators. Weaker competitors, especially those at the higher-priced end of the sector, are having difficulties under current economic conditions. The ability to acquire and improve such under-managed properties provides investors with one more avenue to generate returns from strategy execution, not from macro factors.
In summary, ES is a maturing sector that could increasingly gain investor attention for its characteristics of strong cash flow generation, resilient operating fundamentals, and modest valuations. Total returns would be driven by cash distributions, valuation upgrades, operational improvements, and long-term growth of units. We would argue that these drivers are, to a large degree, independent of macro factors, potentially making extended stay hotels an attractive portfolio addition for their return potential and diversification benefits.
For more information Altera’s vehicles that access opportunities in this sector, please contact Altera Investments at firstname.lastname@example.org or by calling 404-537-2759.