Substantiation of economic efficiency of strategic investment project in hospitality: achieving balance of the interests between investor and the city of st. Petersburg

3. Changed traveler expectations and preferences: it is very likely that preferences of those who travel will change, e.g. with a much stronger emphasis on safety standards. This might pose challenges to hotels to adjust their offer to meet those changed expectations and might have an effect on room design, housekeeping, public areas like lobby, restaurant, spa and will present a market advantage to those hotels that can adjust more quickly and effectively. Additionally, travelers might become more cautious with hotels overall and prefer private apartments, AirBnB etc. These trends will need to be considered and hotel will need to react effectively if they don't want to lose market share to competitors.

Q. What is your forecast on the development of Russia's hotel industry in Russia, in particular in St. Petersburg, in the period of 2020 to 2025?

Q. Which perspectives and possibilities for recovery from the effects of the COVID-19 pandemic do you see for the Russian hotel industry?

Answer. The exact development of the industry depends on too many uncertain factors right now and cannot be predicted accurately. However, let us take a step-by-step approach to answer this question.

1. Overall economy recovery: there are different methods to model the recovery process but most of them have in common that they see different scenarios, mostly the so-called “U-curve”, “V-curve” and “L-curve” scenarios. The letters describe the shape of the curve of economic activity and output with the V-curve seeing the quickest recovery and the L-curve seeing a sustained downfall. Most think tanks agree that two key variables for those scenarios are 1) the spread of the virus itself and 2) the effectiveness of economic policy, e.g. via government interventions and stimuli. The development of the hotel industry in Russia and the pace and nature of its recovery will depend on the overall economic development, not only in Russia itself but in the entire world. The amount of travel, the money that is spent on hotels on private and business trips and the possibility to travel itself will strongly depend on those factors. As Russia is still in an early stage of the pandemic, it is right now impossible to say which scenario is likely, but the situation should be monitored closely within the next few weeks and months.

2. Hotel industry recovery: although related to the overall economic recovery, the development of the hotel industry in Russia will depend on multiple more factors. Overall, the hotel industry will most certainly recover more slowly and “painfully” than other sectors. Let us explore the most important reasons for that:

Travel restrictions: as of now, most travel is restricted and will remain so for a longer period of time. Most European countries have already indicated that travel will remain very limited over summer 2020 and Russia is likely to follow. It is also likely that travel and especially long-haul travel will be allowed and common again after all other sectors of the economy have like production, retail, food & drinks have opened again. This might mean a slow opening in the end of 2020 or even in 2021 and then a very slow increase in travel over time. Travel will probably only reach its pre-crisis levels in 2023 or even later, depending on how quickly a vaccine will become available.

Private consumption: travel is considered discretionary spend, i.e. non-essential for survival and typically one of the categories that falls most sharply in times of economic hardship. There will be a global recession in most scenarios and most certainly the perception of economic stability around the globe will be damaged, which mean that consumers will cut down significantly on non-essential spendings. Travelers from Europe, who might have visited St. Petersburg to see the white nights in June and would have spent ~ €200 per night for hotel rooms for their entire family, might now decide to stay at home and travel to a nearby holiday destination. This will affect not only Russian tourists but also tourists from all other major source markets for Russian hotels (e.g. China, Japan, Germany and Western Europe).

Major industry disruption: a third effect that will hit the industry very hard is more of a supply-side effect. Many hotels will be in big financial trouble due to the missing revenue streams and the missed out summer season in 2020. Many of those hotels will need to dismiss personnel, stop operations, cut down on costs etc. Many hotels will be out of business. When the recovery of the market wills start, many hotels will need to re-adjust to increasing business again, e.g. by hiring and training new personnel, negotiate new contracts with suppliers, rent new property etc. which will take time and might additionally slow down the recovery process.

Q. How do you assess the current investment climate in the hotel industry?

Answer. Generally, there are two big opposing trends in investment decisions and processes right now that will also apply to the hotel industry.

Low prices: many assets are currently sold for much lower prices than before the crisis. This will likely also apply to the hotel industry, because many owners will be happy to sell their assets to increase their liquidity (i.e. swapping real estate, equity, debt etc. against cash). This will lead to a lot of attractive investment opportunities and will attract many investors who are looking for solid investments right now.

Uncertainty: people's sentiment right now is characterized by uncertainty and partially pessimism about the future and especially their economic future. This obviously has an implication on the financial markets. Banks are extremely hesitant right now to give out any loans the whole piece around debt financing will pose big problems. But also investors themselves will be less confident about the project's financial future. Any business case that you present will have so many uncertain factors related to COVID-19-related regulation and demand recovery that it will be very difficult for the investor to assess the prospects of the investment.

Summarizing these two opposing effects, the overall investment climate is probably rather strained. Although there is potential to make use of lower prices and discounted assets, the uncertainty around the current market environment will make most investment very difficult.

Q. Which types of hotels fit the hotel market in a city like St. Petersburg?

Answer. Historically, St. Petersburg has been a city of hotels for the types of tourists that come to the city the most - families and tourism groups. This was obviously split in the typical categories but these were the main target audiences. This might change because of a few trends that are happening right now:

1. Global Tourism Trends.

Millennialism: Travelers all over the world are becoming more IT- and mobile-phone savvy and therefore preferences change significantly. Even older generations get used to using digital technologies to book their travel themselves, which leads to major changes in the sales channels of the industry, e.g. in the role of online travel agencies and changes the profile of the typical traveler coming to the industry significantly. Hotels in St. Petersburg need to adapt to the changing profile to provide a superior experience to those travelers by making stays more of an experience than “just a stay”.

Digitization: there are significant innovations happening in the hospitality industry. This is not about only the already well-known competitor AirBnb but also relates to other trends like increased usage of Google Hotels or rising importance of Online Travel Agencies. Big chains like Marriott are already partnering with online travel agencies to negotiate better clauses and additional competitive advantages. Hotels in St. Petersburg should adjust to the new, digital ecosystem and invest in digital technologies to sustain their competitiveness.

2. Trends specific to St. Petersburg.

Business activity: historically, St. Petersburg has been predominantly a leisure tourism destination related to its historical sites. With more and more business moving to St. Petersburg and the economy growing there might be increased need for business accommodation. These hotel types are completely different than your typical 18^th-century palace type of hotel and require a target a different audience with another go-to-market approach. One example of this trend is the planned shift of the Gazprom HQ to Lakhta Center. Moves like this one will required a completely new infrastructure of business hotels and will significantly change the hotel landscape of St. Petersburg.

E-Visa introduction: the introduction of a free and online e-visa for St. Petersburg is also likely to change the tourist profile of the city, as it allows young, single travelers to come to the city for short-term trips. These travelers are usually digital natives and prefer experiences and therefore often go for AirBnBs or even hostels. To capture this additional business, hotel will need to adjust their offering, e.g. by opening newly branded properties that value design and a special guest experience.

Appendix 2

Descpition of interview with the representative of Investment Committee of St. Petersburg, Deputy Head of the Directorate for Large-Scale Projects.

Q. What kinds of hotel were trending to construct from 2015 to 2020?

Answer. There was a traditional trend for 3 stars comfort level hotels in different areas of St.Petersburg. In addition, obtaining municipal real estate for hotels was common. The central location (Moika river embankment, 27 (5 stars) and Voznesenskiy, 36 (4 stars)) was the most interested to build new objects of hospitality industry. However, due to their complexity in terms of implementation, because of a conflict between the Investment Committee of St. Petersburg and the Committee to Protect the Monuments of St. Petersburg, there is no real construction progress.

Many objects were concentrated around Saint Isaac's Cathedral (e.g. Luceo Spa at Four Seasons Hotel Lion Palace St. Petersburg, SO Sofitel St. Petersburg).

Q. What of the objects have the status of “strategic projects”?

Answer. No one.

Q. What were the budgets of the hotels built?

Answer. It is confidential information, hence exact numbers cannot be told. For the familiarization, the budget of Luceo Spa at Four Seasons Hotel Lion Palace St. Petersburg exceeded $270 million.

Q. What changes in the infrastructure of St. Petersburg have occurred after these hotels were constructed?

Answer. Recent major changes are the building of the ExpoForum in the Pushkin area, also the creation of socially significant facilities such as the stadium “Gazprom Arena” (Football alley, 1) and other facilities for the 2018 World Cup, the completion of the WHSD (Western Highway Speed Diameter). Moreover, construction of these hotels increased the tourist image and prestige of the city.

Q. What hotels by the level of service, features, location and room fund are required by St. Petersburg nowadays?

Answer. Since St. Petersburg claims to be the new business capital city of Russia (Gazprom headquarter is transferred to Lakhta Center, the Constitutional Court and other facilities are shifting to St. Petersburg as well), therefore, there is a need in hotels with business infrastructure that will meet the requirements of the new flow. Previously, the city was purely tourist, but now the Federal Government has changed the concept for St. Petersburg. It is expected that St. Petersburg will be even more business concentrated than Moscow, the capital city of Russia.

Consequently, business hotel facilities are required such as conference and meeting rooms, different kinds of business centers.

The location is determined by the commercial prospects of the land plot. For example, hotels around the “golden triangle” (Saint Isaac's Cathedral, Fontanka river embankment, Church on spilled blood) will be always in demand. Closeness of streets or highways within walking or auto access (several minutes), key transport hubs (Moscow railway station, Ligovskiy prospect, Nevsky prospect, Staro-Nevsky prospect and others), airport “Pulkovo” are usually essential for guests of three stars segment.

Room fund depends on the hotel location mainly, the average range for number of rooms is from 100-120 and up to 400.

Q. What are the main socio-economic indicators of the effectiveness of a strategic investment project in the hotel business?

Answer. Total net discounted income and discounted lost income of St. Petersburg budget and their ratio. If the first indicator is greater than the second one, the project is potentially beneficial and should be considered for the further implementation.

Q. What are the legislative mechanisms for the interaction of a private investor with the city when implementing socially and economically significant projects in the hotel business? What are their advantages and disadvantages?

Answer. There are two main legal mechanisms: Conclusion of a concession agreement, Agreement on the joint implementation and appropriation of a status of a strategic investor.

It is hard to say which one is better, which one is worse. Each mechanism has its own advantages as well as disadvantages for each particular situation.

Q. What capitalization rate is optimal to use in financial calculations for the potential strategic investment project?

Answer. The range varies from 9 to 11%, it depends on the discount rate of the marginal growth factor, the discount rate depends on the WACC.

Appendix 3

Descpition of interview with the investor Vyacheslav Ivanov, former director of VIY Management investment office.

Q. What objects in hotel business are the most attractive for possible investments?

Answer. The most attractive and interesting objects are projects with a maximum rate of return on invested money (ROI). Implementation of hotel projects in the 5 stars category requires enormous amount of money, therefore an economy class and the middle segment objects in beneficial locations are preferred.

Q. How do you assess the current situation (the spread of the coronavirus) regarding investments in the hotel business?

Answer. We consider it as devastating. The spread of coronavirus and introduction of preventive measures connected to it reduced the tourist flow by almost 100%. Hence, the investments in hospitality are uncertain nowadays.

Q. What information do you take into account when making a decision on investing?

Answer. Usually a prepared business plan and a comprehensive assessment of commercial promising facilities are used.

Q. What are the criteria for evaluating an investment project in the hotel lodging industry?

Answer. Criteria might be devided into two groups: for operational efficiency (ARR, OCC) and for invest efficiency (NPV, IRR).

Q. What is the optimal planning horizon for future financial calculations?

Answer. It depends on a point when a business reaches a maximum index of capitalized value. For hotel business it varies from 8-9 to 20 years.

Q. What conracts with the city are the most effective and beneficial for you as investor (Conclusion of a concession agreement, Agreement on the joint implementation and appropriation of a status of a strategic investor)?

Answer. Actually, both of them. The main thing is that the city offers a beneficial project according to location and conditions.

Q. What capitalization rate is optimal to use in financial calculations for the potential strategic investment project?

Answer. Usually it is from 9 to 11%, depending on the particular project.

Q. What contracts are the bases for the agreement between an investor and a hotel operator on the implementation of the project? Which one is the most common?

Answer. There are several kinds of conracts such as franchise, IMA and SDA. The most common is franchise, the rarest one is SDA, there were just a few cases in modern Russia.

Q. What operators are the most attractive to work with?

Answer. International ones such as Accor Hotels, Hilton Worldwide, Marriott International, Radisson Hotel Group and InterContinental Hotels Group are the most attractive.They have an experience needed to work in such tourist city as St. Petersburg.

Appendix 4

Descpition of interview with the hotel operator's representative Mihail Kolesnik, development president of Marriott International in Russia in 2011-2017.

Q. How do you assess the current situation (the spread of the coronavirus) regarding the hotel business?

Answer. The hospitality sphere never had such big issues. There are no tourists, hence there is no profit. Some hotels are even closed for indefinite term, because their operational costs are too high.

Q. Do hotels have enough own funds to survive in this situation?

Answer. No, they do not, except the large chains. The only option to survive in this situation is to reduce different expenditures.

Q. What can be done to minimize hotel maintenance costs in a crisis situation today?

Answer. The reduction in any possible expenditure will be a wise decision. For instance, cutting labour, service and other costs might help. All the measures applied should be based on the federal and local legislative framework.

Q. Will the operation of hotels change after the end of pandemic? What changes might happen?

Answer. It is not clear yet, but the potential changes can be divided into two big groups:

1. Changes in structure. Part of the hotel capacity or even the whole one will have to be sold. For sure, not everyone will be able to save the business.

2. Changes in working way. It is unknown how the political and economic spheres will change, also international borders close has its impact.

Q. What contracts, the bases for the agreement between an investor and a hotel operator on the implementation of the project, are the most common?

Answer. Investors more often choose franshise and IMA contracts due to their convenience.

Appendix 5

Room fund budget

Appendix 6

F&B budget

Appendix 7

Business infrastructure and hotel territories to rent budget

Appendix 8

Services for telecommunication budget

Appendix 9

Project consolidated budget

Appendix 10

Staffing table

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