European Hotel Real Estate Time to Check In

European Hotel Real Estate Time to Check In This document is for Professional Clients only in Austria, Belgium, Denmark, Dubai, Finland, France, Germany, Italy, Luxembourg, The Netherlands, Spain, Sweden and The UK as well as Qualified Investors in Switzerland, for Institutional Investors only in the United States, for Institutional Investors only in Australia and Singapore, for Professional Investors only in Hong Kong and for Professional Investors in Japan as defined under the Financial Instruments and Exchange Law of Japan. In Canada, the document is intended only for accredited investors as defined under National Instrument 45 106. It is not intended for and should not be distributed to, or relied upon by, the public or retail investors. Please do not redistribute this document. Today, many institutional investors are adding hotel real estate to their portfolios to achieve diversification, to help boost income in their multiasset portfolios and for liability matching requirements given the longer dated income. Marc Socker Invesco Real Estate, Managing Director Hotel Fund Management, Europe Chris Brassington Invesco Real Estate, Director Fund Management, Europe Whilst 10 years ago hotels were considered alternative real estate investments outside of the more traditional universe of office, retail and industrial uses and data available on the sector were not readily available or transparent, the sector has now become mainstream. This is due to the sector s strong income component, relative resilience compared to commercial real estate during the global financial crisis and the increased depth of hotel performance data. Hotel real estate is an established sector and since 2008 has comprised an average of 7% of the total European investment volumes in real estate, with 8.5bn of assets trading last year 1. Since 2010 hotel yields have maintained a premium over comparable quality commercial office or retail assets despite typically offering longer dated income streams and potentially more stable investment performance. A core holding in the hotel sector can be compelling because of the historically relatively stable value profile offering attractive long-term income potential. It is also a growing sector, which should add support to values over time. Adina Apartment Hotel, Nuremberg, Germany

Relatively stable income return potential Underlying assets are cash flow generative; a good match for lease liabilities with explicit oversight of affordability of rent through the asset s operating performance. Daily pricing of the underlying rooms can provide inflation protection, with long-term real terms growth in revenues. Turnover has grown in real terms over 5, 10 and 20 year periods. There are transparent trading data for the occupier of the asset and rent affordability, and refurbishment and repositioning can take place on a phased basis: very rarely are hotels empty or non-income producing. In the mid-market segment hybrid leases are common, providing a minimum income with potential turnover performance in addition. A growing sector The hotel sector across Europe has shown above inflation growth over the last 20 years 2. We believe this is set to continue in the prime markets across Europe for the following key reasons: Underlying demand expected to continue: 3.8% p.a. (45% compound) growth in European tourist arrivals into Europe forecast between 2010 and 2020 3. Supply response has been muted: 2.8% of stock under construction across EMEA region 4. Less than 30% of hotel stock is branded, suggesting room for new supply from the main hotel groups which can provide higher quality assets to capture existing market share 4. 15 quarters of positive revenue growth experienced since last negative quarter; only two negative quarters in last eight years 5. In many cases directly feeding through to rental income. Evolving tourism industry and varying consumer preferences are facilitating the emergence of hotel sub-sectors, thus providing further opportunities to access market growth. Historically relative value stability MSCI data highlights that over the 15 years of the available history of the European Hotel Total Return Index, its volatility has been significantly lower than that of European real estate. Furthermore, during the worst year of the financial crisis, 2008, hotel total returns remained positive while commercial real estate experienced a negative return. This relative return stability has been partly due to the higher income yield, but values may also be relatively protected due to: The long-term nature of hotel leases, derived from a cash flow generating underlying asset. High quality real estate: typically hotels are in core Central Business District (CBD) locations by virtue of serving tourism and business demand. Lower asset depreciation: ongoing tenant investment into the asset as part of their business maintains quality of real estate. In addition hotel real estate adds sector diversification to a core real estate portfolio given the different underlying industry exposure which is otherwise hard to access. Figure 1 MSCI European Hotels vs. MSCI All Property Total Returns (%) Hotels All Property 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 15 10 5 0-5 Source: MSCI, 31 December 2015. Latest data available. Returns are calculated in Euros. Past performance is not a guide to future returns.

A core investment strategy for hotel real estate There are multiple strategic opportunities for investors into hotel real estate, depending on the risk/return preference. Hotels comprise both an operating business and an underlying real estate asset. These can be separated and considered as two distinct components. Splitting the ownership of the asset from the operator requires an equitable and co-dependent relationship between investor and operator. If done correctly the result can be more certain long-term cash flows. Risk/return balance in hotels Hotel real estate investors can then consciously take on management agreements with higher operational risk with a view to accessing growth potential, or transfer much of that risk to the tenant and settle for a more stable or fixed lease income. There is also the opportunity to invest into different market positioning, and through branded hotel chains or local hotel operators. For example, luxury hotels usually have more trading volatility but typically offer more real estate value potential, while for budget hotels it is usually the opposite and the brand is key to selling the rooms. Each also provides a different exposure through an economic cycle. Sheraton Grand, Krakow, Poland Figure 2 Risk/return balance by investment profile Trading risk Management contracts Focus on growth Variable leases Hybrid leases Fixed guaranteed leases Focus on income Returns Source: Invesco Real Estate. For illustrative purposes only.

Leased hotels We prefer the hybrid lease structure: a minimum guaranteed rent, usually indexed against inflation, with a turnover rent above this, seeking to provide downside protection with some access to upside. The great advantage of the link between the asset and the occupier is that hotels are suited to rental liabilities and longer-term agreements: 1. Tenants typically build their business around the asset and stay for a long time, with very few voids seen in the sector and long-term lease commitments common. 2. The operating nature of the asset means the underlying business tends to generate ongoing cash flow to service the rent liability. 3. It is clear therefore at what level of rent the business can operate and what the appropriate long-term sustainable rent level would be. Hotels leased to major operators can offer strong covenants, limiting exposure to the individual asset performance, and leases provide a fixed or minimum rental liability supported by that wider covenant. However an understanding of the asset and its operating forecast, and the rent affordability can offer further comfort and potential upside. There are a range of occupiers for most hotel assets and rents can be set at an appropriate level of affordability for the asset, not just for one specific tenant: the business can be replicated and therefore the rent replaced. Not all hotels are bespoke to their user beyond the furnishing: there are now a broad range of operators and business models that can operate the same hotel asset. When determining rent, a margin for error or unexpected events is built in: typically a minimum 1.25x rent cover (EBITDA over rent ratio) is used. This in turn means at least a 20% fall in profitability can occur before the tenant is no longer making money after covering rent liabilities. Strong asset performance can add more to the investment value than just the variable income addition: the future potential can be capitalised into the value while there is also potential for a lower risk premium to be applied to the base rent given more certainty with a higher rent cover. Asset depreciation, a usual feature of commercial real estate, is mitigated in leased hotel investments as the ongoing cash flow also covers investment into the asset. Under a lease the tenant typically covers the FF&E all the internal fit out and operating equipment. Management of this investment is controlled in the lease by defined reserves the tenant must build up annually (usually as a percentage of turnover). This is not a common requirement in the wider commercial sector (usual for repairing responsibilities rather than minimum levels of investment). As well as affordability, the analysis of the operating business and insight on trading data mitigates risks of voids seen in commercial real estate by offering immediate feedback for the operator and owner to react and manage any downturn. If there is a more significant issue with management or positioning, a hand over between operators, brands or tenants is possible without a break in the cash flow, while the smaller pool of available tenants helps identify demand and requirements for occupiers. An indexed rent (typical in most European markets) can be met because the underlying business is re-pricing every day and should follow market trends in inflation. Long-term RevPar growth has been above inflation, so an indexed baseline set at the right level should be consistently affordable. Figure 3 Long-term RevPAR growth and inflation (%) Index (Base 100 = 1996) Eurozone Inflation Index RevPAR Index 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 180 160 140 120 100 Source: STR Global, Oxford Economics; based on a strategy developed by Invesco Real Estate, September 2016.

Core hotel investment criteria A core real estate investment provides the potential for capital protection through a combination of asset location and quality which is expected to generate income consistently over a long term. In our opinion this translates into the following criteria: Recognised and proven hotel markets Proven leisure and/or business demand drivers High quality real estate, location and infrastructure Limited immediate supply pipeline Leased assets with a fixed base rent Well aligned management team and affordable lease (appropriate sharing of the asset generated cash flow) Trading history or clear stabilisation path Active asset management opportunities: to create and protect value. Invesco Real Estate s track record in hotels A pioneer in investing institutional capital into the sector Invesco Real Estate (IRE) was one of the first investment managers to devise a dedicated hotel strategy for the European real estate industry. Key strategic sector for IRE with a long track record we have invested c. 1.6bn into hotels since 2008. Dedicated team of hotel specialists with wellrounded expertise in the hotel market - covering first-hand hotel and real estate investment management experience. As part of our market selection the proven leisure and/or business demand drivers are important and we prefer to see a strong mix of both, as well as understanding the range of visitor source (national vs international) and mix of existing and potential offering in the market. Hotel location is naturally important and we would be cautious of secondary city locations or out of town business parks where underwriting relies on the development of a single demand driver. This would lead to the conclusion not to chase yield into secondary markets in this case, especially as we expect income (yield) growth to develop in established locations. International brands and the associated distribution platforms are important but the selection of asset and operator is now as important: hotel companies (the brand owners) are more specialised and have pursued expansion through franchising brands to specialist operators and managers, and selling the underlying real estate creating a broader hotel investment product. The branded standard mid-market hotel, which sells on being reliable, clean, functional, is still valuable but probably more suited to expansion in regional markets, while in international cities with more competition the differentiation is coming from the positioning as lifestyle/affordable luxury or extended stay (apart-hotels). The lifestyle approach focuses on creating a destination or driver of demand in the restaurant, bar or common areas. There is general acknowledgement that the traditional brands have not utilised their common and public areas well in the past, and restaurants are perceived as expensive and poor value for money. Brands such as Hoxton, 25 hours, and Generator (hostels) are leading the way in focusing more on their surroundings and positioning of the social areas or F&B offering. The extended stay concept offers extended room size (with kitchen or kitchenette), and the operating model is more efficient than the traditional hotels due to limited turnover of rooms and more efficient staffing. Technology and changing consumer tastes will influence the sector over the next decade. AirBnB is a hot topic of discussion at the moment and the industry is watching to see if this will be a disruptor. So far this appears not to be impacting the core operators as much as advertised, which may be explained by the overall demand supply imbalance, but also the positioning of the product. A recent STR report notes that AirBnB room supply has been growing (as often quoted) but shows that take up has not grown as quickly, and generally achieve a lower rate level than hotels 6. Older stock and peripheral assets are more at risk from this at present, and this is mainly leisure rather than business travel. A further example is the potential use as part of the distribution channel and an alternative to online travel agents, who can charge high fees. This is hard to challenge as a smaller operator and can have a significant impact on profitability. There is evidence some of the longer stay aparthotels are using AirBnB as a distribution platform to overcome this. Overall AirBnB have impacted the sector but our opinion is that they have fulfilled a need and are making operators think about their offering a positive impact on the industry. Together this adds up to higher quality offerings and a higher expectation at a mid-market price point while both for tourist and business travel the demand is for a differentiated product. This is a good reason that the absorption of current levels of new supply is expected to have limited top-line impact: there will be competition for some assets, but overall new supply is raising quality, and market growth in room rates will be driven from this.

Important Information This document is for Professional Clients only in Austria, Belgium, Denmark, Dubai, Finland, France, Germany, Italy, Luxembourg, The Netherlands, Spain, Sweden and The UK as well as Qualified Investors in Switzerland, for Institutional Investors only in the United States, for Institutional Investors only in Australia and Singapore, for Professional Investors only in Hong Kong and for Professional Investors in Japan as defined under the Financial Instruments and Exchange Law of Japan. In Canada, the document is intended only for accredited investors as defined under National Instrument 45 106. It is not intended for and should not be distributed to, or relied upon by, the public or retail investors. Please do not redistribute this document. Sources 1 RCA to 31 December 2016. 2 STR/MKG/Oxford Economics to 2016. 3 UNTWO forecasts. 4 STR data to December 2016. 5 STR/MKG to December 2016. Negative quarters = Q1 2013 and Q4 2011. 6 AirBNB Hotel Performance, Jan 2017, STR December 2016. Source: Invesco Real Estate, all data as at 10 March 2017 unless otherwise stated. This document does not form part of any prospectus. It contains general information only and does not take into account individual objectives, taxation position or individual financial needs. It does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Nor does it constitute an offer or solicitation by anyone in any jurisdiction in which such an offer is not authorised or to any person to whom it is unlawful to make such an offer or solicitation. Where Invesco Real Estate has expressed views and opinions, these may change. Forecasts are not reliable indicators of future performance. The value of property is generally a matter of an independent valuer s opinion. Property and land can be difficult to sell, so investors may not be able to sell such investments when they want to. Past performance is not a guide to future returns. The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. 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