Hotels Under the Hammer

Many new hotel investments in a post-war boom are turning sour

Since the end of the 25-year civil war, the tourism industry has been a poster child for Sri Lanka’s growth prospects, attracting both first-time and veteran investors alike.

“In the 1990s, everyone got into the garment business. Since 2010, everyone has been opening hotels,” said Jetwing Group Chairman Hiran Cooray.

With a boom in both hotels constructed and tourist arrivals, the situation may appear to be well in hand. However, whispers of trouble among some hotel owners are growing louder. The market is likely to experience a flurry of acquisitions and mergers, as disappointed hotel owners seek to rid themselves of failed investments.

“Some investors who entered the market after 2010 may look to divest after witnessing lower-than-expected room rates and occupancy,” said John Keells Holdings Deputy Chairman Krishan Balendra.

The cracks in the industry started to widen this August, when Anilana Hotels and Properties Plc was snapped up by a Singaporean investor. It has run in the red since commencing operations in 2013. Accumulated losses topped Rs2 billion in 6 years.

Graph of return on capital employed

Anilana isn’t alone among public companies that have burnt their fingers entering into hospitality.

The leisure arm of Laugfs Gas PLC, which has two properties, has reported Rs1 billion in losses since inception in 2014. Citrus Leisure PLC reported Rs474 million profit in 2018 following five consecutive years of losses. However, Rs561 million in income from a real estate associate propped up profits.

Citrus planned to construct a third hotel in Kalpitiya. Initial designs included a high-end resort and a theme park. Now, it is pursuing a low-cost ayurvedic spa and resort.

Return on capital employed (ROCE) of these three new entrants, when pitted against the established Serendib Hotels PLC, contrasts their operational performances. Anilana, Citrus and Laugfs Leisure have generated negative ROCE compared to Serendib’s positive ROCE. While newcomers suffer, Jetwing Yala, which opened in 2014, moved into the black within 18 months of launching, a testament to Jetwing Group’s scale and experience.

Larger companies are not alone in feeling the pinch, with market buzz of dozens of smaller hotels available for sale. Many are depending on banks for help in matchmaking investors. Others are looking towards established giants for support.

“Jetwing gets at least three business calls every week from hotels in trouble. They want our help,” Cooray said.

Amid death throes, these hotels are hoping that a final spurt in room rates and occupancy would attract more palatable deals.

Post-war, established hotel companies experienced a windfall. Previously, occupancy had averaged below 50 percent. Hotels filled up, with average occupancy rising to 70% in 2010 and peaking at 77% in 2011. More tourists were attracted by low prices and the mystique of a relatively undiscovered destination. In 2010, tourist arrivals grew 46%, and 31% the following year.

Net profits at the Sri Lankan resorts of John Keells Holdings nearly tripled in the 2011/12 financial year.

Government mandarins highlighted how the industry will play a pivotal role in Sri Lanka’s economic progression. Tourism revenue grew from $576 million in 2010 to $3.9 billion in 2017, a 577% increase, overtaking Sri Lanka’s traditional exports and closing in on the biggest source of foreign exchange. In comparison, earnings from tea, Sri Lanka’s second-largest export, grew just 15% in the same seven years to $1.5 billion. Sri Lanka’s leading export, apparel, increased 43% to $5 billion in the same period. This soon caused an expectation that industry earnings can eclipse the top foreign exchange source, remittances from Sri Lankans overseas. Anyone with resources to spare wanted an early foothold.

From the outset, many novice investors made fundamental errors.

“Those with cash started buying land and building hotels. Those owning land borrowed to build. They just hired an architect and started building,” Cooray said.

Many approached hospitality as an extension of a real estate investment, oblivious to nuances. They were unaware that designing and constructing a hotel is best achieved with input from experts in food & beverage, engineering & operations, and housekeeping.

Some hotels were well located, but many were not. Banks lent enthusiastically because there were assets to hold as collateral. The government egged the unwary with optimistic projections of 2.5 million tourists annually in 2016 and 4.5 million in 2020. Arrivals are well short of the early target, at just 2.1 million in 2017.

Most of these hotels commenced bookings from 2012 onwards. It didn’t take long for investors to realise that running a hotel was more complex than building one.

Jobs were plentiful and low unemployment meant that there were few new people to entice, resulting in a challenging environment for retaining staff. Overheads increased as employees moved frequently for better pay. Staff turnover in 2017 at Laugfs Leisure was 60%. High employee turnover constrains the delivery of goods and consistent service, which is required for a premium price. It increases recruitment and training costs as well.

According to the Sri Lanka Tourism and Hospitality Workforce Competitiveness Roadmap 2018-2023, the industry will create 25,000-30,000 new jobs every year, but only 10,000 workers can be trained given the current capacity.

Meanwhile, as more hotels commenced operations between 2012 and 2017, competition increased.

In the southern coast, international brands such as RIU, Shangri-La, Anantara and Marriott launched with clearly positioned hotels. Global balance sheets, international experience and loyal customer bases made it possible for these brands to quickly emerge as leaders in their segments. Many global players here don’t own the real estate, but only brand and manage the hotels.

With greater competition, room occupancy, which peaked in 2011, declined and plateaued at 70% despite arrivals rising.

The daily spend of a tourist grew from $98 in 2011 to $170 in 2017, but many millennial travellers are opting for informal sector accommodation with lower prices and authentic experiences, compared to expensive and uniform offerings at hotels. Room aggregators have allowed informal businesses with low overheads to grab market share away from hotels. The number of tourists staying in hotels fell from 69% in 2009 to 51% in 2016.

“It is estimated that the number of units in the informal sector, which continues to be unregulated, is almost equal to the number of units in the formal sector,” Citrus Leisure Chairman Prema Cooray said in 2017. By June 2018, there were 36,381 rooms in the formal sector, of which 23,338 were in hotels.

Many hoteliers feeling the pressure of competition are requesting regulations of online aggregators to stem the tide. Online booking companies opened the hospitality industry to market forces, with peer reviews giving greater credibility than traditional star ratings.

However, many hoteliers are averse to competition, with most in Colombo requesting the now lapsed minimum room rates to be reintroduced.

Graph of FX earnings from key exports for Sri Lanka

Classical economics suggests that price controls stifle innovation, which many hotels seem to be in great need of, evidenced in online reviews. Price controls in Colombo also prevent hotels from competing with the informal economy and regional destinations.

Tourist arrivals have fallen short of projections over the past three years. Arrivals growth trickled to 3.2% in 2017 due to a partial airport closure, floods and a dengue epidemic. As new hotels launched during 2017, the slowdown in arrivals caused occupancy to slip.

Despite Rs2 billion collected for destination marketing, delays in launching promotional campaigns did not help to fill vacant rooms.

“Promotional campaign delays have pressured the entire hotel industry,” says Tourist Hotels Association President Sanath Ukwatte. He says planned promotional campaigns will boost arrivals closer to the now forecast 4 million mark in a couple of years.

“If tourist arrivals grow, the current room supply will be absorbed. But it will take some time,” Balendra said.

Even during the war, hoteliers recovered an investment in less than 10 years. However, with the peace dividend, many greenhorns have yet to even post profits for a quarter, let alone get a whiff of breaking even, 6 years after opening.

“In fact, feasibility studies show return on investments now extending from 10 to 12 years, as against six to eight years in the early 2000 period,” Prema Cooray admitted. Who is most likely to acquire ailing hotels? Ukwatte believes both foreigners and locals are interested in acquisitions.

“There is renewed interest in the hotel industry, especially from local companies. They’re testing the market and prices,” he said.

According to Hiran Cooray, hotels with bad fundamentals would not interest foreign investors, as they lack the patience to invest further to renovate and market properties.

“Owners of better designed hotels in prime locations would be able to recover most of their capital, as land prices have appreciated. Poorly designed hotels will be sold at a bargain,” he said.

A section of hoteliers heading for trouble are demanding that the government restrict the new development pipeline. In 2017, the Tourism Minister said that he was considering such a policy. The informal sector has also become a piñata. Competition is expected to intensify before easing in the future. Compared to 171 hotels where $1.6 billion was invested between November 2010 and June 2018, another 115 are under construction, with investments topping $1 billion.

 

[A version of this story first appeared in Echelon magazine]

Hospitality Insider Issue 4