Luxury Hotels - Cost model, April 1996

Introduction

Luxury hotels form a small proportion of the UK hotel industry. Out of a total stock of 239,000 rooms, in Group & Consortia managed hotels, only 5,755 five-star bedrooms were available in 31 hotels, 75% of these rooms being located in London (source: Hotel and Catering Research Centre, University of Huddersfield).

Luxury hotels serve a predominantly business market which is relatively insensitive to price but subject to considerable variability in patterns of demand. Over the past decade the sector has endured a cycle of boom and bust closely linked to the general health of the economy.

Opportunities for hotel development were limited during the 1990s by the recession and by the effects of the Gulf War upon tourism and air travel. The sector’s heavy reliance on corporate and overseas guests (45% and 87% of total guest numbers respectively) made it especially vulnerable. A glut of hotel completions in London during 1991/1992 coincided with a decline in occupancy levels to 66.4%, the lowest level recorded since 1977. Following the reduction in operator profit that resulted from falling demand, no high quality hotel of significance has been completed in London since the Regent London, now the Landmark Hotel, in Marylebone during 1993.

Since 1992, occupancy levels have recovered. Research by Pannell Kerr Forster Associates (PKFA) shows that occupancy levels in London have increased from 66.4% in 1991 to 82.2% in 1995. Average rate per room and operating profits have also recovered since 1993 (see table, left)

According to BDO Hospitality Consulting, occupancy levels in luxury hotels charging £140 a night and over, increased by 11% from 2% in 1993 to 13% in 1994. Gross profits increased by up to 30% to between 33% and 42% of annual turnover (£22,000-£45,000/room) over the same period.

The recent takeover of Forte hotels by Granada is evidence of renewed investor confidence. Long-term prospects for hotel performance are good, as the supply of new bed capacity is likely to remain restricted. It remains to be seen what effect the resumption of terrorist activity in London will have on hotel performance. But conditions for development are good. Constraints on availability of suitable sites will limit supply and ensure occupancy levels are maintained. Refurbishment of existing premises will continue as operators endeavour to maintian quality standards, hold on to market share, and increased room rates. Conversion of existing buildings, such as offices, is also becoming a more popular option.

Design considerations

Four and five star hotels are targeted at a predominantly corporate market. The characteristics of demand are for short stays, single occupancy, non-seasonal patterns of use and insensitivity to price. The key features that are important to regular corporate users are: standard of service, location, general housekeeping, car parking and the standard of bedrooms. Private guest facilities are of greater importance than public areas and the quality of management and service is most important of all. The following design factors are particularly significant:

Bedrooms - quality and individuality/brand identity of guest room and bathroom design; size and layout; lighting; quality and control of environmental services; space for working/provision of desk; provision for business IT; efficiency and quality of room service

Common Areas - size and flexibility of meeting and conference rooms; availability of business IT and support facilities

Service areas - layout of relationship to guest areas; efficient use of staff and fixed equipment (chambermaids per floor etc.); minimisation of travel distances; segregation of staff and guest circulation routes

Location is more important than any other attribute of a potential hotel development site. Site constraints are likely to determine the layour and spatial efficiency of the hotel development. Constraints will be most significant on conversions or developments behind existing facades where, for example, window openings may not correspond with guest-room size standards. Guest room sizes, corridor layouts and escape cores will have an effect on the overall efficiency of the hotel. Grossing factors (the proportion of circulation and services areas to net bedroom areas) could exceed the five-star development norm of 40% to 45%. In determining guest room configuration, a number of factors need to be addressed:

Corridor layout Double loaded corridors reduce grossing factors but only suit relatively deep floor plans (20m + is required). Single loading increases corridor lengths, travel distances, escape stair requirements and will reduce cost efficiency.

Aspect Rooms that face into light wells, have restricted views or that are overlooked from guest or public accommodation are less desirable and may attract substantially lower room rates, which will in turn affect scheme profitability.

Vertical services distribution through continuous risers is desirable for each pair of rooms. The layout of risers restricts the extent of variation in room size and plan that can be made from floor to floor.

Horizontal services distribution will be located in ceiling voids. The accommodation of bulky ducted services may affect the interior design by reducing available floor to ceiling heights. The location of access points should be designed to minimise the impact and disruption of maintenance operations upon guest floors.

Columns should ideally be incorporated into partitions or voids. Their grid spacing will restrict room size and layout. Efficient column grids found in office buildings such as 6m x 9m and 9m x 9m do not correspond to efficient guest room and corridor size standards (commonly 8m x 4.5m).

These factors combine to make it difficult to plan well proportioned and consistently sized guest rooms. Given that rooms make the greatest contributions to income and profitability, poor grossing factors and a sub-optimal room mix will have the greatest potential effect upon the viability of the hotel investment. The effect of room mix and size upon projected income should be fully assessed as part of the development appraisal.

Other common hotel design faults include:

• inadequate administration space leading to the take-up of guest rooms as offices
• inadequate maid service areas
• inadequate bulk storage facilities
• inadequate conference/function room furniture storage
• poor relationship of leisure facilities and guest rooms
• restrictions upon external services access for deliveries.

Refurbishment of existing hotels

The key objectives of refurbishment are:

Maintain standards and market position. This will require updating of services and the re-configuration of rooms to match current space and service standards. The key constraints upon refurbishment are restricted service voids and the layout of load bearing structure.

Incorporation of business IT facilities into guest room. Faxes, modems and other IT equipment are now expected in guest rooms by Business users.

Upgrading to current building standards. Means of escape requirements and provision for the disabled (1 in 20 hotel rooms must be suitable in terms of layout, size and facilities for wheelchair access) will require substantial alterations to existing layouts. Additional costs associated with the fitting out of bathrooms for the disabled will also result.

Maintenance of decorative standards. Older established hotels can rely on ambience, style and quality of service to compensate for smaller room size and less effective building services. The Fixtures, Fittings and Equipment (FF&E) costs associated with the refurbishment of quality historic hotels will be considerably in excess of those for a modern 5 star chain hotel. (Chain hotel standards are £7,000 - £9,000/for FF&E in each guest room, whereas comparable FF&E costs for top quality historic hotels can exceed £30,000 - £35,000 per room).

Hotel development standards

Most hotel are constructed for management by chains and consortia. Minimum space standards are applied by chains as a part of brand identity. Standard room rates are an important aspect of marketing in most sectors of the market, but luxury hotels are more flexible. Room sizes and rates can vary considerably within individual luxury hotels, particularly in older hotels where historic patterns of room and corridor layout dictate less than ideal room sizes and layouts. The following table gives development standards that are appropriate to modern four- and five-star hotels in the UK or Europe. Space standards for American hotel chains in markets such as the Middle and Far East tend to be more generous.

Hotel investment and project appraisal

Hotels are a hybrid sector of the property investment market. Institutional investment is limited by high risks associated with the sector and the illiquidity of the hotel property market. Institutional investors prefer the steady income and upward rent reviews associated with office and industrial development. In contrast, income to the developer from hotels is seasonal, subject to economic cycles and often directly linked to operating profits.

Investment in hotels involves stakes in both built space and in the management of the hotel operations. The value of the property is underpinned by the trading performance of the business. The dependence on management performance results in risks being at a level comparable to equities. The risks involved in hotel investment and the difficulties associated with valuation were clearly illustrated by valuations of The Queens Moat Hotel portfolio in 1992, which differed by £1 billion (£1.86 billion - £861 million). Higher risks require higher returns, and the greater risk associated with hotel development is reflected in requirements for higher annual rates of return than in other property sectors.

During the years 1979-1993, annualised rates of return from hotel investments have reached 15.9% compared to a UK wide property return of 10.7%. (Source, Pannell Kerr Forster Associates). Rates of return from equities (16-19% for UK pension funds on UK and overseas equities, 1979-1993) do however exceed those achieved by hotels and consequently most institutional investment into the sector is made through the shares of operators.

The hybrid character of hotel investment and in particular the different rates of return required on loan and equity capital need to be accounted for in any hotel feasibility study. The key factors in any appraisal will be forecasts of income and expenditure and expectations of rates of return.

Feasibility studies are of particular importance for hotel developments as the target market and forecast financial performance will determine the grade, specification and facilities offered by the new scheme. An industry rule of thumb is that the capital cost per room should not exceed 1000 times the target achieved room rate. Although it is a useful guide, this simple approach accounts for neither the costs and revenues of non-residential facilities nor does it reflect potential changes in income, costs or inflation over time. A more detailed approach based upon discounted forecasts of cashflow and expenditure should be adopted.

Discounted cashflow approaches require a detailed projection of the operating performance of the hotel over a study period of at least 10 years. If sufficient detail (i.e. variations in annual income and expenditure) cannot be built into an investment appraisal then a simpler approach based upon an estimate of steady annual earnings should be adopted.

Hotel income is generated from five principal sources. Fig. 1. details the proportion of income generated by rooms, food, beverages, minor operated services and rental/other sources. Guest rooms are the most significant revenue generator. Rooms also tend to generate the highest profits before deduction of fixed operating costs, emphasising the significance of the initial capital investment in hotel fabric. The high proportion of income that can be generated by services with low operating costs (e.g. rooms, where operating costs equate to 22% - 25% of total revenue) means that hotels gain substantial benefits from room rate increases in excess of inflation.

Capital allowances are particularly generous for hotel developments and should be considered as part of a feasibility study. In addition to building services, carpets, furniture, and decor items which create ambience all qualify for allowances as part of machinery and plant. Consequently the value of capital investment qualifying for machinery and plant allowances can equate to 45%-70% of the total construction cost. Machinery and plant qualifies for 25% reducing balance writing-down allowances. In addition to these allowances, most hotels qualify to be treated as ‘industrial buildings’ which permits all remaining capital expenditure (excluding land costs) to be written down over 25 years at 4% per annum. To qualify for these additional allowances, the hotel must have at least ten bedrooms, be open for four months between April and October and also offer basic services to guests such as room cleaning and meals.

The factors which affect the feasibility of hotel developments are more complex than those which are commonly considered for other forms of property investment such as offices, where assumptions of long term rental income streams can be incorporated into feasibility studies. Hotel developments are highly sensitive to market conditions and need to be targeted and appraised in considerable detail. This is best achieved through a professionally prepared feasibility study and development appraisal.

The feasibility appraisal detailed in this cost model uses a discounted cashflow method which applies different yield requirements to the loan and equity components of the investment. This approach more accurately reflects the higher rates of return required by equity investors from their portion of the total capital investment. The appraisal is based on techniques developed by hotel specialists HVS International. In the model, income and expenditure are forecast over a 10 year period, with the residual value of the hotel and outstanding debt balances being capitalised at the end of the period and included in the cashflow at year 10. The appraisal model is relatively simple and excludes the effects of Capital Allowances and other factors.

In practice, income and expenditure forecasts would be based upon detailed studies of demand for hotel occupation. Annual debt service costs are deducted from net income and are discounted at a lower rate, reflecting the greater security attached to loan finance. In the example, debt service costs are discounted at 9½% (base rate +3%) and returns on the equity investment are discounted at 16%. The total value of the loan (£27,500,000) is determined by the Loan to Value Ratio (0.65) and by the interaction of the two discount rates. The total Net Present Value of the hotel development is the sum of the loan and equity streams. In this case, the total NPV exceeds development costs by £1,709,000 and it is demonstrated that the development can produce the required economic return.

This form of appraisal includes the effects of the appreciation of the capital value of the hotel due to increasing property values. This element of appreciation is determined by the capitalisation of the residual value of the hotel at year 10.

Furniture, fittings and equipment

Interior design and finishes elements are usually procured as part of the main building or refurbishment contract. FF&E elements are normally outside the scope of the main contract and are under the direct control of the operator. There is considerable potential for uncertainty in the definition of the scope of interior design and FF&E elements which can, in turn, be a source of risk within the overall development budget.

The definition depends on the target market and varies from operator to operator. Establishment of a clear client brief and a full understanding of the target market are essential if FF&E costs are to be accurately budgeted. In many cases, FF&E are procured on a supply-only basis for fixing as part of the main contract works.

Analysis of the building in the model

The hotel development featured in this cost model is a notional 106-bedroom, five-star hotel in central London. It is constructed over seven floors, partly behind a retained facade, and includes a basement. The gross floor area of the hotel - 10,594 m2 - includes both a provision for banqueting, meeting rooms and leisure facilities (1050 m2) and large suites on each guest floor.

The floor plate is determined by the layout of adjacent buildings and the retained facades. It is deeper than is optimal for a hotel configuration, but is not sufficiently deep to allow for a central atrium. This has resulted in a single-loaded corridor layout and an extensive central core that can only be used for vertical circulation or staff areas. Because of the inclusion of suites, guest floors are not as tightly planned as is possible and there is potential for a total of 115-120 rooms. Bedrooms account for 44% of gfa and the grossing factor is 53%.

International hotel costs

While luxury hotel development has been static in the UK, construction in other regions, particularly the Far East, has been very active. Hotel space standards in the Middle and Far East are generally dictated by US operators’ requirements, which are more generous, particularly in grades four-star and below, where room sizes can be up to 30% larger than their European counterparts (35 m2 minimum for four star). New-build hotels in these markets tend to be large (300-plus modules) and benefit from the efficient floor plans that are characteristic of slab block developments. Costs in the table (below) are provided by Davis Langdon & Everest’s offices n the Arabian Gulf and Davis Langdon & Seah in the Far East.