ANTON GILLIS: Hotel investors learn the hard way: experience counts

Drive through Cape Town’s tourist hot spots and you’ll see dozens of hotels and “aparthotels” (buildings comprising serviced apartments) that weren’t there just a few years ago. The same is true in other touristy areas countrywide.

Many of these new hotels were built by developers using the Section 12J tax incentive.

While there was initially much hype about their development, things are unravelling fast. Many hotels and aparthotels built using the incentive are struggling to stay afloat, never mind deliver the sort of returns investors demand. We’ve seen the effects of this first-hand, with several funds and investors calling us in to consult on their options. 

Where did it all go wrong and what, if any, solutions are there? The answer to the first question is simple: experience. As for the second, there are no easy answers, or no answers investors will like. But there are lessons to be learnt, particularly for investors looking to ensure they don’t get burned again.

Before looking at how lack of experience contributed to the downfall of hotels built with 12J backing, it’s worth understanding a little more about the incentive and how the hospitality sector used it.

The 12J incentive was introduced in 2009 to stimulate job creation by allowing investors to claim a 100% tax deduction on investment in qualifying venture capital companies such as the hospitality sector.

Initially, it helped drive a flurry of investment in hospitality. Of the R12bn raised by various funds using the incentive before it ended in 2021, more than R2bn was invested in hospitality. Those investments provided a vital lifeline at the peak of the Covid-19 pandemic, allowing developments to continue and hotels to stay open.

More recently though, cracks have begun to emerge, partly because many 12J investments in general did not deliver returns  anything like what investors were promised. Investors had to pay performance fees based on their tax savings.

Big losses

One thing hospitality taught us repeatedly is that guaranteed returns aren’t predictable. Hotel occupancies and average daily rates are fluctuating and nuanced. Anyone promising high returns with a strong sense of conviction is playing a dangerous game. Those who  achieved high returns on their investments face hefty capital gains tax bills.

We are witnessing a snowball effect, with some hotels facing big losses, even closure. Almost all of them were built by developers seeking quick returns on the section 12J initiative, most of whom had no clue what they were doing.

With no experience in hospitality development, developers entered the space putting up the wrong buildings in the wrong places. They then tried to hack the daily operations themselves before learning the hard way that you can’t succeed with a “lick-and-stick” approach to hospitality.

Some of the ways they got things badly wrong are astonishing. An investor who leant heavily into section 12J approached us recently with a view to firing the present management company and putting in a new operator. When we took a closer look we found that the developers hadn’t included something as basic as a housekeeping storeroom. Housekeeping had been keeping their trolleys in fire escapes, a serious safety concern. They also forgot basics such as a staff canteen.

From the start there were signs that things would go badly.  When section 12J started, someone raising capital approached us to see if we would be interested. When I asked about food and beverage, their answer was that they would install a vending machine as that met 12J requirements, and guests could always order UberEats. Imagine the headache of trying to convert that into a functional hotel. 

Nearly all of these developments also fall short of big brand fire and life safety requirements. They wouldn’t meet feasibility requirements, and to retrofit them would be a nightmare. Satisfying these requirements is critical for large national and international companies that so many hotels rely on for mass bookings, particularly in winter.   

Jumped ship

We also saw the emergence of many start-up management companies in which developers poached experienced individuals. When these individuals asked holding companies for funding or resources, they’d be told to take a lean start-up mentality and learn to go without.

As the tide washed out, many of those experienced hands jumped ship as they knew the business didn’t have what it took  to make it. Several I know returned to mainstream hotels as tourism soared after Covid. Their time in these 12J developments also taught them the value of large teams. To think you can go it alone is idiocy.       

Hospitality requires attention to detail. Rising through the ranks is like mastering the ability to juggle several balls while riding a unicycle. Only after many years of experience should you consider going into hospitality development.

Just because you know something about property development doesn’t mean you know how to run a hotel. Filling up a hotel every night to anything like sustainable levels requires a sophisticated sales and marketing plan. One cannot simply list the business on an online travel portal and wait for guests to arrive.

Revenue management and digital distribution are both art and science. The same is true for any hospitality business that requires high levels of service, including aparthotels and co-living spaces.

Confronted with this reality, some developers have tried to convince investors that the building could be converted into a sectional title investment in a worst-case scenario. That’s nonsense. We have yet to see this done successfully. Investment principles applied to the hotel industry are typically for long-term investments. We never invest in a hotel to make a return within five years.

No liquidity

Eventually, what may happen is that you’ll have lots of segmented investors. Some will disinvest from a rental pool and try to go it alone. Then you’ll have a building filled with mixed tenants and mixed market segments, with zero control by anyone and everyone fighting for their own returns on investment with no cohesiveness on a collective sales and marketing strategy.

It shouldn’t be surprising then that five years after opening the doors of their hotels, developers have no returns and no liquidity. That’s bad news for them and their investors. Worse,  there’s very little chance of things turning around.

No matter how good these hotels may look from the outside, there’s little chance of converting the shell to an independent or flagged hotel. That’s because no sane hotelier would touch a building built off script. Hotel development guidelines and hotel operator specifications are derived from extensive market research and guest expectations. At your peril do you deviate or not consider this.

Industry norms exist for a reason: they were proved to work over decades. Sure, there’ll occasionally be maverick hoteliers who shake things up and change the game for everyone, but they’ll usually do so from a place of deep industry experience. Those  thinking to do otherwise are like tennis players believing they can do well in volleyball because the courts look kind of similar.

So, where does that leave investors? Given that the most 12J investors were high-net-worth individuals, it’s unlikely that the financial hit would be particularly devastating. Hopefully, though, they’ve learnt that experience matters when investing. 

• Gillis is cofounder of the specialised hotel asset management company Hamac.