In recent years, the serviced apartment sub-sector of the hospitality industry has grown faster than any other class of temporary accommodation in Europe. Consumers now travel more widely and frequently, both for business and pleasure purposes. As a result, accommodation requirements are changing: customers are looking for more flexibility, more space and a "home away from home" experience.

In theory, for operators, this means an increased risk to profitability, as revenue from the asset is generated almost entirely from the guest rooms themselves rather than a significant proportion being derived from an on-site food and beverage offering. However staffing costs are likely to be lower than that of a traditional hotel, not only due to savings made by the absence of a restaurant but also through reduced housekeeping costs (room cleaning is unlikely to be offered more often than weekly unless a premium is paid for a more frequent service).

The combination of lower fixed costs and thus a higher proportion of revenue being converted to profit makes for a business model which is, commentators argue, potentially more attractive than a traditional hotel.

Who is investing and why?

The quality and location of the real estate involved in the best serviced apartment operations is particularly attractive. To meet consumer demands, serviced apartments must be positioned in prime locations, close to transport links and business and shopping districts in key cities. The value arises from the perceived flexibility of the assets which can be put to alternative uses, subject to the necessary planning/zoning consents.

A number of private equity investors have entered the market energetically, injecting capital into their chosen independent brands directly. This has allowed some of the newer independent brands to own and operate their own assets, expanding their brand profile through site acquisitions in key cities across the UK and Europe.

Institutional investors have also taken notice of the sector but are perhaps more conscious of its relative infancy, taking a comparatively cautious approach to investment as compared with the more opportunistic private equity houses. Barriers to institutional investment have included a lack of brand awareness and/or a proven operator track record, as well as a lack of understanding on the part of the investor of the sector as a whole, with some operators commenting that investors have in the recent past been uncertain as to whether the assets are classed as residential or commercial perhaps since, in the UK, sites acquired for development as serviced apartments were often apartment blocks authorized for planning/zoning purposes for residential use, although serviced apartments are now recognized as hotels. This has led to many institutional investments being structured in a more risk adverse manner, with sale and leaseback arrangements proving to be popular.

Sale and leaseback structures

Through a sale and leaseback structure the investor will acquire the freehold/long leasehold title to the asset, and will then grant a fixed term lease (eg 25/30 years) back to the operator. Subject of course to the terms of the lease, the operator may opt to charge its lease to a third party lender for the provision of additional operating finance.

This provides the investor with reliable security as legal title to the asset is acquired at the outset, and a regular stable income over a fixed period with no exposure to the risk of an operating loss. If the operator is unable to meet the rent payments, the investor can terminate the lease and take back the asset.

For the operator, working under the remit of a lease rather than a management or franchise agreement allows it to have full control over the day to day operation of the asset. However it will also assume full risk for any operating losses and at the same time will remain liable for the rent payments throughout the term irrespective of the success of the business. That said, if the business proves to be successful the operator will retain the whole of any surplus.

Who are the operators?

While the serviced apartment market has been well established in territories such as the United States and Australia for many years, with recognised branding and established operators, it is still a relatively new concept within Europe and particularly so in the UK.

The operators who are active in the market vary from a selection of established "big brands", eg Accor/Adagio, IHG/Staybridge Suites, to smaller independent brands, often having an emphasis on design, who are looking to offer something new to the consumer.

Whilst it would appear that the big brands prefer to remain asset light, tending to adopt the management or franchise agreement operating model, smaller independent brands without the same level of financial backing and recognisable covenant strength may have to consider alternative options depending on investor requirements.

Conclusions

While serviced apartments remain a developing sector of the market, with a lack of local comparables for benchmarking and untested brands, it seems likely that the institutions will continue to remain interested but cautious, structuring their investments accordingly. However as more product is brought to market (such as the owner/operated brands which have been backed by private equity investment) and the success theories of the market's supporters are tested, there may be a movement away from sale and leaseback structuring towards management and/or franchising agreements, as has been the case in recent years for more traditional hotel operating models.