In these challengingtimes,it is easy for hotel investors to overlook the most important cornerstone of the capital markets: that expected returns are (and should be) greater for more risky assets.
Hotel investors commonly believe, implicitly if not explicitly, that they are getting a higher expected return without assuming greater risk. If a hotel investor wants a higher return, the investor must generally accept more risk.
The extra return for a given level of risk is the ‘risk premium’ that is necessary to induce investors to invest their money in a hotel whose cash flows are less certain.
The investor who understands the intersection between risk and return relies on the concept of a risk-adjusted return, ameasure of an investment’s return after taking into account the degree of risk that was taken to achieve it. The purpose of risk-adjusted return is to help investors determine whether the risk taken was worth the expected reward. Too often, the quantification of risk is left to hunch, intuition and gut feel or at best a “sensitivity analysis” or a “best-case. worst-case” analysis. Without a probabilistic estimate of risk, the estimate of a risk-adjusted return is problematic.
The graph below illustrates the IRR distribution for three hotels,derived from a simulation model. The expected mean return for each hotel is 15%, however, the distribution of IRR’s varies widely.Measures of dispersion, such as the standard deviation, indicate the spread of the distributions and the risk associated with the prospective return.
Apart from the standard deviation we use the:
- Coefficient of Variation– the ratio of the standard deviation to the mean and
- Semi Standard Deviation– returns the standard deviation of the data values below the mean. This is useful for measuring down-side risk when the distribution is highly skewed as illustrated in the graph.
The graph illustrates that there is a 68% probability Hotel 1 will achieve an IRR between 10% and 20%. Hotel 3 has a 22% probability of achieving an IRR above 20% and a 19% probability of achieving less than 10%.
The use of probabilistic simulation models can overcome many of the shortfalls of the outdated hotel feasibility analysis, designed to estimate the potential return of a hotel investment and its accompanying risks (the prospective risk-adjusted return). These analyses generate a range of possible returns rather than a single value and also calculate the probability of receiving different rates of return, depending on how the future unfolds. The use of risk simulation models by stakeholders in hotels can have a significant impacton their investment decisions.
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