Capital gains

The name suggests a unification of sorts, but the UK, it's often said, suffers from a kind of geographical apartheid. In the south, in between a cluster of well-heeled home counties, lies London, the UK's capital and de facto city-state. North, east, south and west of the capital lies everywhere else - and the less said about them the better.

This picture of civic and economic segregation is no caricature. Real physical and psychological divisions exist between London and the rest of the UK, stretching back hundreds of years and helped along by the transformation of its industrial base.

Like many other industries, the UK's hotel sector has become a microcosm for this unhealthy geographical disjunction. London, the gateway city, remains in its own stratosphere, barely touched by the financial crisis, with deal volumes down, but hotel performance as a measure of revPAR well above its pre-recession peak.

"Demand has been fairly insatiable in London," says Jeremy Hill, director and head of hotels at Christie and Co. "It's a non-volatile safe haven and it can offer very liquid investments for investors from all parts of the globe. Of course, trading has tailed off during the recession but the capital remains very strong nonetheless."

Regional downturn

Outside of London, it's a different story entirely. A few of the country's secondary destinations like York, Edinburgh and Cambridge remain popular, but for the most part life is difficult. According to a recent survey by Deloitte, 60% of the hospitality sector expects the UK's regions to take five years or more to recover pre-2008 levels of profitability.

This isn't just happening in the UK. Provincial hotel markets in most countries are more likely to follow wider macroeconomic patterns than the major gateway cities, which are less aligned to GDP and generally more resistant to exogenous shocks.

It may seem surprising that the UK's regions are struggling, given that analysis. As far as Europe is concerned, the general economic picture in the UK isn't too bad; bond yields remain relatively low and the latest GDP figures were unexpectedly positive.

But being better than Spain or Greece is hardly a good yardstick for economic performance. General output across the UK remains down. Real wages are falling and the labour market faces long-term stagnation. Unless the government wants to sustain demand by returning to private debt, then consumer spending is likely to remain suppressed for the foreseeable future.

Alongside cuts to the welfare budget and the wider public sector, these changes are having a direct impact on the hotel market. According to PricewaterhouseCoopers, public sector-related bookings account for "somewhere between 20% and 30%" of UK hotels' customer base - and it's the regional areas that are hurting the most.

Data by TRI Hospitality Consulting points to the fact that the sector is facing its fifth consecutive year of decline as revenues fall and costs grow.

"If the economy is suffering, then so are the provinces," says Huw Zachariah, senior corporate banking manager for hotels at HSBC. "There are fewer drivers on the motorway looking for a place to stay, corporate budgets for training and entertainment are being slashed, and general business activity is down. It will be hard for them to sustain business levels, let alone grow."

Dependence on corporate budgets has become extremely problematic for the provincial market. Many of the UK's unbranded hotels invested large sums in new infrastructure for the meetings sector, leaving huge outstanding costs when the market crashed in 2008.

Research by Deloitte suggests the total debt volume in the provinces stands at £16 billion. Josh Wyatt, an investment director at Patron Capital, has called this a "capex time-bomb".

Room for improvement

The other problem the UK regions face is the amount of rooms being added to the market. This might seem like a strange statement - how can the provinces be struggling if the market is growing? But the answer is obvious. Without steady demand, increases in supply are creating even less occupancy per available room.

In the last 18 months, seven different hotels have opened in Newcastle and Gateshead, adding over 1,000 rooms to the market. A thousand more are expected to follow in a similar time-frame. According to STR global, Manchester will go through the "largest expected room growth" in Europe if its pipeline projections come to fruition. Birmingham is the second-fastest-growing market according to the same figures, with 1,702 rooms set to open.

"Over 17,000 new hotel rooms opened in the UK in 2012," says Andrew Taylor, head of leisure at NatWest. "That growth is set to continue with 15,000 new rooms expected to open in 2013, highly driven by the branded and budget space."

It does seem strange to talk about expansion and investment as a bad thing but, with competition already stiff, new openings and new rooms are creating a hotel environment that Ken Ellington, managing director at Cophthorne referred to as a "bedroom factory".

Aside from Liverpool, which has seen some increase in profitability, none of the other major provincial cities undergoing "expansion" are actually experiencing growth in profit per available room. Newcastle has experienced the greatest declines at 10.4%, but Manchester (1.9%) and Leeds (3.8%) are also falling according to STR Global.

"In certain places, supply has grown far too much," Zachariah says. "The full-service hotels are reducing their pricing to a level where the difference between themselves and budget hotels is almost non-existent. It makes it difficult for everyone. Once hotels are in this vicious cycle of having to reduce average room rates to maintain turnover, it can work to everyone's detriment."

In areas where there isn't a clear oversupply, the UK's budget sector has been squeezing the mid-market across the country; for example, 2011 and 2012 were brutal years, with hotels from Principal Hayley and Von Essen economic casualties, and Malmaison Group sold to a private equity firm earlier this year.

But in areas of significant overproduction, both budget and mid-market are doing poorly. People may have expected the former to do well as falling wages and job cuts create a trading down scenario, but that hasn't happened. Not only are prices falling in the mid-market, as Zachariah says, but those people who do still travel are unwilling to lose out on quality.

"People don't tend to compromise on quality," Hill says. "What they want is a better price, it's about what value brands contribute."

Investment opportunities

Private equity has been naturally active under these circumstances. Though some single asset purchases have been made in London, the prices required remain prohibitive to those funds targeting a high internal rate of return (IRR) and a reasonably quick exit. Many have turned to the regions for distressed sales like the Belfry in Warwickshire, the Hyatt Regency in Birmingham and the Glasgow Radisson Blu.

"Some people are optimistic," Zachariah says. "They can see we've been bobbing along at the bottom for a while and there's got to be some opportunities out there. You very rarely hear of a distressed asset in London. That's not the case with the regions. Some very high profile groups have traded and others will be struggling to keep their head above water."

Not every region is affected by these trends. Performance is generally much harder to gauge in the UK's regions, where assets and geographies vary widely. As a rule, it's far easier to get debt and find interest in a provisional market that has generated success and proved its profitability. In Aberdeen, for example, demand for oil and constraints on supply have created an extremely successful environment for the hotel sector. And Edinburgh, Cambridge, Oxford and York all continue to attract visitors and generate interest in hotels as an asset class.

"From a trading perspective I don't think you can look at the regional UK as one market that behaves in one single way," Hill says. "It has to be addressed on an asset-by-asset basis, submarket by submarket. If a hotel is focused on corporate and leisure then things are better than the conference sector."

Only in more select regions does investor appetite remain and, even there, debt finance is difficult to secure. Perhaps that's no great shame. In 2007 and 2008, the UK's financial sector was lending far too aggressively to the hotel market, producing loose deal structures entirely devoid of financial covenants.

"In the crazy days, there was too much debt too readily given," Zachariah says. "Now, debt is scarcer but the deals that are being done are more sensibly leveraged - deals that the market genuinely needs."