HEARTBREAK HOTELOpportunities and challenges posed by the sharing economy NOVEMBER 2016

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In September of 2016, Airbnb raised US$850 million in new equity, valuing the company at US$30 billion dollars and subsequently crowning it the most valuable lodging provider in the world without owning a single room. It is a particularly 21st century phenomenon that a company that started eight years ago, with no tangible product of its own, can overtake some of the most storied and well-known brands in the lodging industry.

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SHARING ECONOMY

The accommodation sharing economy refers to the growing number of property owners who are making their dwellings available for short-term rentals. These short-term rentals compete with traditional lodging providers by offering an alternative, often cost-effective, form of accommodation in major markets. The accommodation sharing economy is facilitated via a number of internet platforms, most notably Airbnb, which have greatly boosted the viability of short-term rentals as an alternative to traditional hotels. These new platforms increase the ease of marketing properties, managing bookings and facilitating payment, and have led to an explosion in the use of short term rentals.

Since its inception in 2008, Airbnb has grown to have more than two million listings in more than 191 countries2 on its website. This compares to the 1.1million rooms in more than 100 countries of the world’s largest lodging company, the newly combined Starwood-Marriott entity3.

The table below shows the top ten markets as ranked by active Airbnb listings. The average number of active listings as a percentage of existing supply is close to 10 per cent in the top ten markets where the sharing economy has gained traction. This suggests that recent supply growth in these markets, as measured by traditional lodging data sources, underestimates the true degree of available accommodation supply that has come online in recent years. Indeed in many instances, the supply added by Airbnb and the broader sharing economy is often multiples of what is added via traditional construction in an average year. Of particular note is San Francisco, Airbnb’s home market, where it appears that the success of Airbnb has largely been in response to a chronic lack of new supply.

MARKETACTIVE AIRBNB

ROOMSHOTEL ROOMS

AIRBNB / HOTEL ROOMS

FY16 SUPPLY GROWTH

MULTIPLE OF AIRBNB TO NEW

SUPPLY

3YR REVPAR CAGR^

AVERAGE REIT EXPOSURE TO

MARKET*

New York 27,965 117,367 19.50% 6.6% 3.0x 1.2% 11.3%

Los Angeles 17,967 98,166 13.30% 2.7% 4.9x 8.7% 4.8%

San Francisco 8,790 51,561 12.50% 1.2% 10.4x 10.9% 11.2%

Miami 7,368 51,498 10.10% 3.6% 2.8x 7.2% 3.3%

Chicago 6,153 111,408 4.20% 1.1% 3.8x 6.2% 5.7%

Washington DC 5,784 107,776 4.10% 2.1% 2.0x 2.9% 7.5%

Boston 5,566 52,119 8.00% 4.4% 1.8x 8.1% 9.4%

Seattle 5,601 42,455 9.50% 3.1% 3.1x 9.7% 1.4%

San Diego 6,290 60,754 6.60% 3.8% 1.7x 7.3% 7.2%

Austin 6,024 33,877 9.90% 8.0% 1.2x 8.8% 1.4%

Top 10 U.S 97,508 726,981 9.90% - - - 63.2%

Overall U.S. 277,256 5,031,645 3.40% 2.50% - 6.5% -

Table sources: Airdna, STR Inc., Bloomberg, CBRE Hotels’ Americas Research, Q4 2015, Company reports *Average of CHSP,DRH, LHO, HST, HT, INN, PEB, RLJ, SHO ^ to year end FY15 ^ to year end FY15

DISRUPTION

During the last 12 months alone, Airbnb grew its US listings by almost 70 per cent and nights booked increased a staggering 125 per cent to almost 40 million room nights1. On these numbers, Airbnb has captured more than 3 per cent of US lodging demand within the last eight years, and is gaining share rapidly.

With each month that passes, the impact of Airbnb becomes more pervasive, and its effects on lodging occupancy and pricing power will become more visible. In the listed space, this will manifest in slower revenue growth, and weaker profitability. Fortunately, the competition from providers such as Airbnb will not be felt equally across the industry. Investors can benefit by finding the names that are insulated from the sharing economy. This piece seeks to highlight the opportunities and challenges posed by the sharing economy for real estate investors.

Figure 1. The top ten markets as ranked by active Airbnb listings

Since its inception in 2008, Airbnb has grown to have more than two million listings in more than 191 countries2

1 “Airbnb update from AirDNA; Growth Ahead of Expectations” BofAML Research, September 2016 2 www.airbnb.com, May 2016 3 “Marriott International to Acquire Starwood Hotels & Resorts Worldwide, Creating The World’s Largest Hotel Company”, Marriott International merger press release, 16th November, 2015. www.marriott.com

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While it is equally true that services like those provided through Airbnb may have enticed more people to travel, thus adding to incremental demand, it is a stretch to claim that the new supply from the sharing economy is having no impact on occupancy levels and pricing power of the traditional hotel sector.

Recent research by commercial real estate company CBRE shows that Airbnb hosts respond to incentives in a similar way to the traditional lodging market just with greater speed and flexibility. Firstly, when demand is strong and pricing can be set at attractive levels, additional supply is brought online. The higher the rate that a host can achieve, the more pronounced the supply response. This highlights one of the key features of the sharing economy; that of an increased elasticity of supply where accommodation capacity can be added and withdrawn rapidly in response to changes in available pricing.

The same CBRE report confirms the fluidity of this shadow supply. It illustrates how shadow supply waxes and wanes during the course of the year in line with peak travel times. While it is difficult to separate the structural growth from the more seasonal patterns,

the path of the data suggests peaks around December, most likely due to Christmas and New Year’s Eve, and the warmer Northern Hemisphere months, which coincide with the summer school holiday period and peak travelling season.

Quantifying the exact impacts of Airbnb is a difficult task because there are so many moving pieces, and demand in the lodging sector is cyclical and sensitive to changes in the broader economy. However, anecdotal evidence from lodging REIT management teams, such as Mike Barnello, CEO at LaSalle Hotel Properties4, suggests that shadow supply from the sharing economy is reducing pricing power by acting as a release in times of extreme demand. This is confirmed by a recent Morgan Stanley report5, which showed that the number of compression nights (nights where occupancy is greater than 95 per cent) has declined in the year to May 2016 versus the same period a year ago. This has occurred at a time when average occupancy is close to all-time highs across the market, and supply and demand growth is in balance. This suggests that there has been an increase in the amount of leakage from the traditional lodging sector at times of extreme demand.

$0

$50

$100

$150

0 1,000 6,0005,0004,0003,0002,000

12 M

onth

Ave

rage

Hot

el R

evPA

R

Active Airbnb Units

West Palm Beach

Fort Lauderdale

Oahu

San Josey Santa Cruz

Anaheim

DenverNashville

BaltimoreDallas

Albuquerque

Philadelphia

Austin

San Diego

Chicago

Boston

Miami

Washington DC

San Francisco

Atlanta

CharlestonLong Island

Source: “The Sharing Economy Checks In: An Analysis of Airbnb in the United States”, CBRE Hotels’ Americas Research, January 2016

Figure 2. An Analysis of AirBnb in the United States

SepAugJulJunMayAprMarFebJan2015

Dem

and

: Air

bn

b/H

otel

DecNovOct2014

0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

1.8%

2.0%

Sources: Airdna, STR, Inc., CBRE Hotels’ Americas Research, Q4 2015. “The Sharing Economy Checks In: An Analysis of Airbnb in the United States”, CBRE Hotels’ Americas Research, January 2016

Figure 3. Analysis of AirBnb in the United States

4 LaSalle Hotel Properties, 4Q15 Quarterly earnings call, 22nd April 2016. www.lasallehotels.com 5 “Are Alternative Accommodations Starting to have a Material Impact on Hotels’ Compression Nights?” Morgan Stanley Research, June 3rd 2016

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350

300

250

200

150

100

50

0

2006

108118

4226

59

124

169

232

299

332

8464

2007 2008 2009 2010 2011 2012 2013 2014 2015 2015YTD

2016YTD

Source: Morgan Stanley Research; Smith Travel Research (STR)

Figure 4. Number of compression nights in top 25 US lodging markets (to May 2016)

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MARKET DEEP DIVE: TEXAS

A study6 by Georgios Zervas of the Questrom School of Business at Boston University supported the suggestion that the sharing economy reduces pricing power for traditional lodging companies. Zervas came to his conclusions by monitoring the evolution of nightly hotel rates in Austin between 2010 and 2015, with a particular focus on the period that coincides with the annual SXSW Festival. After controlling for external factors such as hotel supply, the economic environment and differences in quality between available rooms, Zervas and his associates found that hotel pricing power in Austin weakened as the number of rooms available via Airbnb increased.

The study showed that growth in average daily rate (ADR) during the period when SXSW is held relatively underperformed market ADR growth during the rest of the year. Furthermore, this phenomenon was witnessed during a period where the SXSW attendance tripled from 10,000 to more than 30,000, and average occupancy had increased across the hotel market. So in essence, during a period where SXSW attendance tripled, where one would expect meaningful pricing power on behalf of the lodging operators,

the opposite actually occurred with price growth decelerating versus prior years. This effect was most noticeable at the lower end of the lodging spectrum, suggesting that Airbnb competes most aggressively at the budget conscious end of the market.

To confirm their analysis, Zervas and his team did a similar study around the Dallas State Fair. Dallas was chosen as their control due to the limited penetration of Airbnb in that market. The analysis again confirmed their hypothesis that in the absence of a release valve in times of heightened demand, price growth should relatively outperform during periods of peak demand.

While the jury is out on just how much of an impact Airbnb will have during the long-term, it is erroneous to conclude that it is not leaving any impression on the lodging sector. Over the long- term, if Airbnb is left to grow without appropriate regulation, it is reasonable to conclude that this additional supply will negatively impact both the occupancy and pricing power of traditional lodging owners, ultimately putting downward pressure on the revenues and profitability of lodging companies.

2010 2015

Budget

2010 2015

Economy

2010 2015

Midprice

2010 2015

Upscale

2010 2015

Luxury

20%

10%

0%

-10%YoY

chan

ge in

pri

ces

SXSW Rest of the year

Source: “ The Rise of the Sharing Economy: Estimating the Impact of Airbnb on the Hotel Industry”; Zervas et al, Boston University, June 9th 2016

Figure 5. Year-over-year changes in Austin hotel prices broken down by hotel price level.

6 “ The Rise of the Sharing Economy: Estimating the Impact of Airbnb on the Hotel Industry”; Zervas et al, Boston University, June 9th 2016

2010 2015

Budget

2010 2015

Economy

2010 2015

Midprice

2010 2015

Upscale

2010 2015

Luxury

20%

10%

0%

-10%YoY

chan

ge in

pri

ces

SXSW Rest of the year

Source: The Rise of the Sharing Economy: Estimating the Impact of Airbnb on the Hotel Industry”; Zervas et al, Boston University, June 9th 2016

Figure 6. Year-over-year changes in Dallas hotel prices broken down by hotel price level.

The solid line displays changes during SXSW (March) while the dashed line displays changes for the rest of the year.

The solid line displays changes during the State Fair of Texas (October) while the dashed line displays changes for the rest of the year.

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IMPLICATIONS FOR REAL ESTATE

Globally, the lodging sector accounts for 3.4 per cent of the FTSE EPRA NAREIT Developed Global Index of which almost 3 per cent comes from US companies. Additionally, the Lodging C-Corps are not included in the benchmark, but are valued in the same way as REITs and can be considered an acceptable substitute given exposure to the same fundamental drivers. With a modest weighting in the global index, and the ability to substitute between REITs and C-Corps, an opportunity exists to generate meaningful relative performance for investors who can identify companies with the most attractive business characteristics that account for the risks created by new technologies.

Taking into consideration the motivations for technology – ie to maximise utility from fixed travel budgets – and the resultant increase in the elasticity of supply and demand, investors should identify desirable characteristics for potential lodging investments and seek to appropriately reflect this in the relative attractiveness of investment options.

DIVERSIFICATION

Companies with concentrated portfolios that are exposed to markets with a high degree of sharing economy penetration should be penalised so as to reflect the potential reduction in pricing power and impacts on occupancy.

LOWER OPERATING LEVERAGE

Given potentially lower pricing power and the downward pressure on revenues resulting from an increasingly cost conscious customer set, companies with lower operating leverage should trade at a premium through cycle to reflect more attractive risk/return characteristics. On this basis, the C-corps are seen as relatively more attractive than the lodging REITs.

PRODUCT DIFFERENTIATION

Commodity-like lodging offerings with lower levels of amenities and reduced service will face the most intense competition from the sharing economy and are most at risk of price competition, loss of market share and the resultant impacts on profitability. The REITs are well placed to control the physical quality of their properties but this may manifest in a higher capex load going forward.

ABILITY TO CONTROL THEIR OWN DESTINY

The ability to react and respond to the threats posed by technology should command a premium. This slightly favours the lodging C-Corps over the REITs as they can adjust many aspects of the lodging experience including booking terms and conditions, branding and marketing, loyalty program benefits, and brand standards/product offering.

LOW FINANCIAL LEVERAGE

In an environment of variable supply and lower pricing power, it is not unreasonable to expect a higher level of volatility in occupancy and rate growth. Consequently, revenue growth will also be more variable, and companies which maintain a lower level of financial leverage should command a valuation premium.

The ability to react and respond to the threats posed by technology should command a premium

Important notice: While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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CONCLUSION

In an environment where corporate profitability has been under pressure and consumers have become more cost conscious, it is evident that technology will play an increasingly important role in helping customers stretch their travel budgets. On the supply side, technologies like those that facilitate the sharing economy have given rise to cost-effective alternatives to traditional lodging and will put downward pressure on pricing power in the lodging sector.

Going forward, it will be important for hotel owners to be proactive and nimble in order to stay ahead of technological progress. Companies that are slow to react may be shocked at how quickly they can lose market share either to new alternatives or to their competitors. Technology has helped increase elasticity on both the supply side and the demand side, suggesting it will be imperative for hotel owners to differentiate their offering and to be able to demonstrate the value in hospitality. Similarly, hotel owners will have to be aware of the impacts of higher price elasticity, and take that into consideration when assessing their outlook for the marketplace, and what that means for their ability to bear financial risk at this late point in the cycle.

As a cyclical sector, lodging will always have a role in a global real estate portfolio. The ability to reprice rents daily means that lodging names can take advantage of changing economic conditions immediately. As portfolio managers, the ability to take active positions in names with exposure to specific geographies or market segments can lead to opportunities to generate significant alpha through the cycle. Combining a local presence with a global vantage can help identify the best opportunities as regions are never perfectly in synch from an economic perspective. In times like the present, where growth in the lodging sector is anaemic but still positive, one must be mindful of the multitude of factors that can impact lodging company profitability, whether they be macroeconomic in nature or longer term changes in industry structure, and position accordingly.

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