Plenty of value at the Hotel California

Disruption is the buzz word of the modern era and San Francisco as the home of Uber, Twitter and Salesforce.com should know a thing or two about it. To that point, disruption of a very different kind has literally been tearing up the San Francisco skyline, but this is a very different real estate disruption and one that is only short term in nature, with opportunity knocking on the other side.

On our analysis, San Francisco will see a rapid recovery in visitor numbers over the next few years as the city’s newly renovated and enlarged Moscone Convention Center re-opens. The new 1.5 million square feet facility in the Market District of Downtown is a boon for business, especially hotel landlords. Cautious investors are normally well advised to be wary about investing in the hotel market at this point in the business cycle. However, we believe that investors should be considering the inflexion point approaching in this particular market cycle, presenting an opportunity to invest in high quality companies exposed to a world city with accelerating fundamentals.

Hotels are the most cyclical listed real estate sector and are characterised by rapid share price movement when investor sentiment turns. Over the last few years, hotel supply has been constantly added to the US skyline, including the explosion of disruptors such as Airbnb, which tends to act as a release valve on demand. Nevertheless, we have still seen nearly a decade of earnings growth in US hotels with occupancy and nightly rates (that we view as rent) reaching new highs.

However, it has not been an easy ride for hotels in recent years, as sentiment impacted the market in 2014 over global concerns about the potential spread of the Ebola pandemic and then again in 2015 as demand for corporate travel weakened. In 2017 however, speculation about possible US tax reform has seen companies that are sensitive to growth in the economy react positively. Hotel valuations have rebounded towards the top of their historical range through multiple expansion (an increase in the price to earnings ratio at which companies or a property are valued) as the market prices in potential growth. Looking ahead, the San Francisco market is one market we think worth exploring for opportunities.

The city attracted 25.2 million visitors last year, many from groups associated with events at the Moscone Convention Center. These delegates spend close to US$500 per day, much of it on hotels. The San Francisco hotel market has been significantly impacted by the Moscone’s major US$500m+ four-year refurbishment project. This has caused disruption and obviously less convention-related visits to the city. This project will increase convention centre space by 21 per cent upon completion in the second half of 2018. Very simply, more convention space in a globally relevant city means more visitors and more upwards demand pressure on services, especially hotels.

Bookings data indicates that the second half of 2018 will see an 8 per cent increase in convention room nights compared to the same period in 2016. This suggests strong demand in subsequent years, which is expected to lead to RevPar (revenue per available room) growth in the city centre hotels. This increase in RevPar is likely to be driven initially by higher room occupancy rates as conference delegates return. Subsequently in a self-perpetuating cycle, we expect the Moscone Center to host larger and higher-rated conventions, which will lead to high occupancy levels and also stronger pricing power for hotel companies.

However in real estate it’s not all about demand; you also need to consider supply. The San Francisco hotel market is forecast to grow supply by only 2.7 per cent in 2018, and just 1.1 per cent in 2019. This compares very favourably to the US national average, especially against other gateway markets such as New York, which has forecast supply growth of 12.4 per cent over the next two years. That sets San Francisco apart as an attractive market with a demand/supply imbalance and strong fundamentals skewed to the landlord, which allows investors focused on this market to add significant value.

Identifying high quality hotels that derive a high proportion of their earnings from this market enables the astute global listed real estate investor to participate in the growth of a strong market with an idiosyncratic demand driver, even while the US national hotel market is late in its cycle.

Not all markets are made equally and that always creates opportunity.