Asian vacation

Massive sporting events on the horizon in Beijing and Delhi are shining a spotlight on the underserved hospitality sector in Asia. Private equity real estate GPs are already checking in to this opportunity. By Dave Keating

It's safe to say that the biggest private equity dealmakers spend a lot of time in hotel rooms. Whether they're jetting across the world on road shows for their latest fund or checking out acquisition opportunities, travel is an inherent part of the job for this type of investing.

In other words, who but GPs know better the crucial role that hotels play in the economy? For a number of reasons, hospitality has become a major focus for private equity over the past two years. Motivated by the robust operating fundamentals and the anticipated appreciation of these assets, the big firms have been grabbing hospitality assets across the globe. Blackstone's $25.6 billion buyout of Hilton Hotels in June, for instance, continued that firm's major activity in the hotels sector. The transaction added almost half a million hotel rooms to the firm's already massive global hospitality empire. This year also saw a $160 million joint venture between Warburg Pincus and Triyar Hospitality to invest in niche hospitality assets, not to mention Aetos Capital's $50 million commitment to develop Super 8 hotels in China. And 2007's deals came hot on the heels of a mammoth deal at the end of 2006, the $27.4 billion buyout of hotel and casino company Harrah's Entertainment by Apollo and Texas Pacific Group. According to financial information provider Dealogic, the total value of hotel M&A deals increased from $60.7 billion in 2005 to $105.8 billion in 2006, a 74 percent increase.

“Between 2006 and 2010 Delhi is going to have to build 20,000 hotel rooms. That's a massive management project.”

But as US and European lodging assets become more and more expensive based on the rising interest, US and European investors are turning their attentions to Asia, where the fundamentals of the market are quite alluring.

“The hospitality indicators are very positive in Asia,” says Cameron Cartmell, who focuses on real estate, hospitality and construction for Ernst & Young. “There's been a large growth within the local economies, and at the same time there's also been an increase in inbound leisure visitation. Baby boomers are retiring at the same time as there is greater wealth generally in the developed countries, which means these people have a higher propensity to spend and to travel, because they've grown up with the concept of travelling around the world.”

With the influx of both leisure and business travelers looking for lodging in these countries, demand has far outstripped supply. This has been reflected in the rapid rise in hotel prices across Asia. According to Ernst & Young, the average daily rate across Asia Pacific was $137 in the first half of 2007, an increase of 13 percent from the previous year.

So far, China and India have received the lion's share of hospitality investment in Asia, driven by anticipated GDP growth of 9.5 percent and eight percent, respectively, in 2007. Virtually all of the major lodging companies have aggressive expansion strategies in these locations through joint ventures with local partners. But Southeast Asia, particularly Vietnam, is quickly becoming a third major area of interest for international investors.

Going for the gold
China and India have become a particular focus not only because of their size and growth trajectory, but also because they both have massive sporting events coming up shortly. In Beijing, the 2008 summer Olympics are prompting a construction boom. The Beijing Tourism Administration estimates that during the 2008 Games, Beijing will receive 500,000 to 550,000 overseas tourists and spectators, while the number of domestic visitors will reach 2.58 million. This expectation has been reflected in pricing. In 2001, when Beijing won the bid to host the games, real estate prices rose 40 percent almost immediately.

Xiang Ping, vice-director of the Games Services Department, which is organizing the event, says that so far they have signed services contracts with 112 hotels in Beijing including 38 five-star, 40 four-star and 34 three-star hotels.

Similarly, the Commonwealth Games, a multi-sport event in which former members of the British Empire compete every four years, are scheduled to be held in Delhi in 2010. This will be the biggest multi-sport event ever held in Delhi, which previously hosted the Asian Games in 1951 and 1982, and India will be only the second Asian country to host the Commonwealth Games.

“Between 2006 and 2010 Delhi is going to have to build 20,000 hotel rooms,” says Cartmell. “That's a massive management project. To do that successfully comes with great risk. So it will be interesting to watch how the Delhi market develops over the next two years.”

Though there are usually case studies to consult when it comes to real estate projects in cities hosting major events, the concurrent rapid growth of India and China make these two games a bit of a wild card in terms of predicting the effect they will have on the hospitality sector in the long run.

“The expectation is normally you're likely to get some form of oversupply, so afterwards there's a rebalancing of the offering,” says Cartmell. “Generally it's good because you end up replacing the poorer stock with higher quality stock, it has the dynamic of upgrading the facilities. It has the potential to be a problem if it's not well managed, but in China and India, both are so lacking in their existing hotel stock, [the oversupply] can only be positive.”

Both countries are hoping that the tail effect of the games will spread to other cities, and they are putting massive amounts of money into marketing themselves as attractive vacation destinations.

Incredible India
Readers in major Western cities will be familiar with the “Incredible India” campaign that's been hard at work for the past year. It is the first major public/private global campaign showcasing India as a tourist destination, and has coincided with a number of other initiatives including the announcement of an open-skies policy for the peak travel season, removal of foreign and domestic airline tax, reduction of taxes on the hotel industry, and the proliferation of budget domestic airlines. All of this, along with the extension of “infrastructure status” to the hospitality sector, has resulted in a marked increase in tourism. In 2006, international tourist arrivals in India were at 4.43 million, a growth of 14.2 percent over the previous year, according to Ernst & Young. Domestic tourists in 2006 numbered 430 million.

However, supply is not keeping up with the increasing demand. The current room shortage in the country is 27,000 rooms, according to Ernst & Young, and the biggest need is in the mid-range category. Any business traveler who's stayed in India can tell you there are basically two options – a five-star international-brand hotel, or a two-star local guesthouse. There is little in between. Virtually all of the hotel construction in India has been in 5-star resorts, and given that there's still not nearly enough rooms to cover the need, rates can be exorbitant. This has left a wide opening for budget hotels, which are being increasingly demanded particularly by Indian business travelers who would like to decrease their travel budget.

“In India, there's a lot of pressure on each industry to cut cost on business travel,” says Sunil Rohokale, head of real estate investment for ICICI Bank. “So developers have just started thinking about budget hotels. There are also not enough serviced apartments, and this area has huge potential.”

Given that 80 percent of travel within India is business travel, divided equally between foreign and domestic travelers, it's virtually guaranteed that budget business hotels would see a high demand far into the future, whereas the massive crop of five-star hotels, fully booked for the moment, are likely to see a drop-off if travelers have the option to stay in cheaper, mid-range lodging. Slowly developers are starting to address the need, and investors are looking at such developments. For instance Kotak Realty Fund, a domestic Indian fund focused on real estate, has invested in Lemon Tree Hotels, an Indian chain of business budget hotels. Such budget hotels aren't just good for business travelers, they also service the needs of religious pilgrims and have been situated near pilgrimage sites to capture this business.

Searching for budget in China
The lack of mid-range hotel options in India today is similar to the situation in China five years ago. But today, China has advanced into the development of traditional mid-range hotels.

“Generally the dynamic is, the five-star properties develop first,” says Cartmell. “But the more Western visitation you get, the more the demand appears for a budget offering. That's what you're now seeing in China. Look at Accor, for instance. They're opening 50 properties over the next three years. India's two or three years behind that, and clearly the Olympic games in China was a big driver.”

At the same time as these traditional budget hotels have begun to pop up in China, for the first time the country has started to see some oversupply. This year China saw its first reduction in occupancy levels, according to Cartmell. What is likely to happen after the Olympics, he says, is that the traditional hoteliers as well as the unsuccessful five-star developments will get pushed out of the market, which will be left with a more even range of hotel offerings similar to what one would find in the West.

“Generally the dynamic is, the five-star properties develop first. But the more Western visitation you get, the more the demand appears for a budget offering. That's what you're now seeing in China.”

Investments in the mid-range area include Aetos Capital's $50 million commitment in August to invest in Tian Rui Hotel Corporation, the main franchiser of Super 8 hotels in China. That brand was introduced in China in 2004 and Tian has since opened 49 hotels in the country, totaling more than 4,700 rooms – with plans to develop an additional 67 hotels. In October, the Lotus Hotel Fund, a Hong Kong-based $1 billion private equity fund targeting hotel development across Asia, partnered with Carlson Hotels Worldwide, which manages the Regent, Radisson, Park Plaza, Country Inns and Park Inn brands. Marriott and Courtyard also have plans to roll out in India.

The real estate arm of private equity firm Warburg Pincus has had success in China building out the operations of a “two-star” hotel franchise called 7 Days Inn. The group plans to open 100 hotels per year through 2010.

The gaming sector in China has attracted attention as well. In October, Permira, one of the world's largest private equity firms, made its first investment in the country when it bought an approximate 20 percent equity stake in Galaxy, a casino and hotel operator in Chinese special administrative region Macau, for a total consideration of $840 million. The deal provides the foundations for the future development of a 2,500 room resort, which will feature the world's largest casino once complete.

Southeast Asia
Traditionally Southeast Asia's tourist dollars have flocked to Thailand. With its pristine beaches, relative isolation from the region's turbulent wars of the 1960's and notoriously debauched attractions, hospitality has been Thailand's most outstanding sector for some time. Yet having recently suffered from a major natural disaster, terrorist attacks and a military coup, this pre-eminence is going to be seriously challenged by its neighbour – Vietnam. By contrast, that country now has a stable government, no history of terrorism, and the fastest-growing economy in Asia after China. Current GDP growth in Vietnam is at 8.2 percent, a number that is viewed as sustainable over the medium term. Given that the country has a desirable climate and a 3,000 km coastline, and that the government is slowly deregulating foreign ownership of property, it is no wonder investors are taking notice.

Still, so far there are only two private equity funds exclusively targeting Vietnamese real estate. Hanoi-based Indochina Capital has two dedicated Vietnam property vehicles totaling $300 million, and the Pacific Alliance Group, a Hong Kong-based hedge fund and private equity manager with $3.5 billion in assets, has launched a $633 million dedicated Vietnam real estate fund through its subsidiary, VinaCapital. Steven Murphy, managing director of VinaCapital's hospitality division, says this is exactly the right time to be focusing on the country's growing tourism.

“It used to be that when you went to a travel agent you'd find Vietnam as an added page on a Thailand brochure,” he says. “Now it has its own brochure. It's a destination recognized by the wholesale market.”

Launched in March 2006 and listed on London's Alternative Investment Market in 2007, so far VinaLand's acquisitions have included the Hilton and Goldman hotels in Hanoi and the Omni Hotel in Ho Chi Minh City. The genesis of the fund came when the firm found that so many of the investments from its Vietnam Opportunity Fund were in real estate that the area deserved its own targeted vehicle.

But there are two main problems with investing in this sector in Vietnam. First, despite the fact that the country has such a vast and beautiful coastline, almost all of the hotel development is taking place in the two main cities of Hanoi and Ho Chi Minh City, which are not on the coast. This has resulted from several factors including the fact that almost all business is conducted in these two cities, dealing with local province governments for land acquisitions can be difficult and infrastructure along the coasts is still underdeveloped. But for the investors that can navigate these difficulties, some very desirable tourist destinations could be developed.

The second difficulty is that land acquisitions are very challenging. In the rest of Asia, Greenfield development is the main way to go for hospitality investment. Yet in Vietnam, foreign investors are unable to completely buy land.

“The fundamentals of the country are communist, the land is the property of the country,” says Murphy. “Nobody owns the land, whenever you take land you're leasing it from the state, at the moment for 49 years, though the government has recently implemented an extension to 70 years.”

This leaves acquisitions as the main route for investment, but even these opportunities can be hard to come by. “This country's come through the past nine years with no development whatsoever of international hotels,” notes Murpy. “Hotels had a very rough ride, and a lot of them were really running in the red.”

Murphy says the difficulties involved in land acquisition are so high that, as a fund, VinaLand would prefer to do almost all acquisitions. However the limited hotel stock in the country means this just isn't an option, and they have to find ways to make development opportunities happen. “There's only a certain amount of acquisitions available, due to limited availability,” he says. “As a fund, we don't really go into development, we like to invest in developers. But we've created a highly experienced development team who are addressing this issue so we can invest in assets.”

The road less travelled
Though India, China and Vietnam are receiving the bulk of investors' interest, there are other hospitality opportunities in Asia as well. In Japan, the continued economic recovery means hotel activity will pick up and prices are likely to rise. Malaysia has seen a significant rise in tourist numbers recently, with that sector being the second largest exchange earner since the year 2000, receiving 17.5 million international tourists in 2006 according to Cushman & Wakefield. That translated into a six percent growth in tourist arrivals to that country last year, with a 13 percent increase in receipts generated. The hospitality sector has seen significant gain in the Philippines as well, with foreign and local investors in the final stages of building several hotels and resorts in the country, including the $70 million Imperial Waterpark Resort and Spa in Mactan. Carlson Hotels Asia Pacific are set to develop and manage a 350-room property in SM Bay City, and Ayala Land is building three major hotels in Makati.

But Taiwan may present the most unpredictable opportunity in the coming years. Starting in 2008, mainland Chinese tourists will be allowed to visit the island, and many developers and investors are constructing new hotels for the expected influx. Some office buildings have been converted into hotels, and many hotels are expanding their capacity. But this expectation is tempered by the fact that restriction on tourism generally will have to be tightened once the new rule takes effect, and Taiwan's tourism outlook has generally been in decline. According to Cushman & Wakefield, the island has dropped in the global rankings for tourist growth from 35 to 48. Much like the rest of Asia, these peripheral opportunities can come with a fair degree of risk as well.