Drive through some of Cape Town’s tourist hot spots and you’ll see dozens of hotels and so-called aparthotels (buildings comprising serviced apartments) that weren’t there just a few years ago. The same is true in other touristy areas around the country. Many of these new hotels were built by developers using the SARS Section 12J tax incentive.
And while there was initially plenty of hype around their development, things are unravelling rapidly. Many hotels and aparthotels built using the incentive, are struggling to stay afloat, never mind delivering the kinds of returns that investors demand. We’ve seen the effects of this first-hand, with several funds and investors calling us in to consult on what their options are.
So, where did it all go wrong and what, if any, solutions are there?
The answer to the first question is fairly simple: lack of experience. As for the second, there are no easy answers. Or, more accurately, there are no answers that investors will like. But, there are lessons to be learned, particularly for investors looking to ensure they don’t get burned again.
How 12J backfired in hospitality
Before looking at how a lack of experience has contributed to the downfall of hotels built with 12J backing, it’s worth understanding a little more about the incentive and how it was used in the hospitality sector.
Introduced in 2009, the 12J incentive was designed to stimulate job creation by allowing investors to claim a 100% tax deduction on investments into qualifying venture-capital companies. The hospitality sector was among those in which those companies could invest.
Initially, it helped drive a flurry of investment in hospitality. Of the R12 billion (€613m) raised by various funds using the incentive before its 2021 sunsetting, more than R2bn was invested in hospitality. Those investments provided a vital lifeline during the peak of the Covid-19 pandemic, allowing developments to continue and hotels to stay open.
More recently, however, cracks have begun to emerge. In part, that’s because many 12J investments in general haven’t deliveredanything like the returns investors were promised. Additionally, investors have had to pay performance fees based on their tax savings. And one thing hospitality has taught us time and time again is that guaranteed returns aren’t predictable.
Hotel occupancies and average daily rates are constantly fluctuating and are incredibly nuanced. Anyone promising high returns with a strong sense of conviction is playing a dangerous game. Those who have achieved high returns on their investments, meanwhile, face hefty capital gains tax bills. That won’t, however, be a problem for large numbers of investors who put their money into 12J-backed hotel developments.
Experience matters
That’s because we are currently witnessing a massive snowball effect, with hotel after hotel facing significant revenue losses and even closure. Almost all of these hotels were built by developers wanting to make quick returns on the Section 12J initiative. The problem? Most of them didn’t have a clue what they were doing.
With no experience in hospitality development, developers entered the space building the completely wrong buildings, in the wrong locations. They then tried to hack the daily operations themselves before learning the hard way that you can’t take a “lick-and-stick” approach to hospitality and expect to succeed.
Some of the examples of how badly they’ve got things wrong are truly astonishing.
An investor who leant heavily on Section 12J recently approached us with a view to firing the current 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, which is a massive safety concern. Other basics that had been forgotten included a staff canteen.
Then again, there have been signs that things would go badly from the start. When Section 12J started, we were approached by someone raising capital to see if we would be interested. When I asked them about food and beverage, their answer to me was that they’d install a vending machine, because that fulfilled the 12J requirements and the guests could order UberEats. Imagine the headache of trying to convert that development into a functional hotel.
Almost all of these developments also fall short of big-brand fire and life safety requirements. They would never meet feasibility requirements and to retrofit them would be a nightmare. Meeting these requirements is critical for the large national and international companies that so many hotels rely on for mass bookings, particularly during winter.
We also saw the emergence of many start-up management companies where, when you dug a little deeper, you’d find that the developers went out and poached one or two experienced individuals. When these individuals would ask the holding company 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 have jumped ship because they know the business doesn’t have what it takes to make it.
Several that I know personally have returned to mainstream hotels as tourism’s soared post-Covid. They’re all working for long-term incentives and they’re all back in the hotel industry with a vengeance. Their time in these 12J developments also taught them the value of a large team. Serious hotels all have large teams working all day, every day to make them a success. To think that you can go it alone is pure idiocy.
Hospitality is an industry which requires incredible attention to detail and, once you’ve risen up the ranks, mastering the ability to metaphorically juggle several balls while riding a unicycle. Only once you have many years of experience under your belt should you consider going into hospitality development.
Just because you have some knowledge of property development, doesn’t mean you know how to run a hotel. Filling up a hotel every night of the week 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 the guests to arrive. Revenue management and digital distribution are both arts and sciences. The same is true for any hospitality business that requires high levels of servicing, 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. The 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.
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 situation where the building is filled with mixed tenants and mixed market segments, with zero control from anyone and everyone fighting for their own return 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 to their hotels, developers cannot show returns and have zero liquidity. That’s bad news for them and their investors. Even worse news is that there’s very little chance of things turning around.
Follow the norms
No matter how good these hotels might look from the outside, there’s very 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 largely derived from extensive market research and guest expectations. If you deviate or do not consider this then it is at your own peril.
Industry norms exist for a reason: they’ve been proven to work over decades and decades. Sure, there’ll occasionally be a maverick hotelier who shakes things up and changes the game for everyone, but they’ll usually do so from a place of deep industry experience. Anyone thinking they could do otherwise is like a tennis player believing they could do well in volleyball because the courts look kind of similar.
So, where does that leave investors? Given that the vast majority of 12J investors were high-net-worth individuals, it’s unlikely that the financial hit would be particularly devastating. Hopefully, however, they’ve learned that experience matters when investing.
