Title

The Case of the Disappearing Hotel, The Hong Kong HILTON

Author

William Hsu, Ph.D., is a professor at the HK Ploytechnic University
Robert O
Halloran, Ph.D., is a professor at the University of Denver

Source

Cornnell Quarterly, Aug. 97, Volume 38, no. 4

 

 

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The Hong Kong Hilton was worth more dead than alive, even though it did well from day one. Here's why.

On January 22, 1994, Hutchison Whampoa, the company that owned the Hong Kong Hilton Hotel, announced that it had bought out the remaining 20 years of the management contract with Hilton Hotels Group for US$125 million (about HK$965 million). The landmark hotel subsequently closed its doors on May 1, 1995, to be torn down and rebuilt as a multi-story commercial office complex. The 26-storey, 750-room Hilton Hotel was the oldest “grand dame” hotel on the Hong Kong island. It opened its doors in 1961 and had since been the favourite hotel for tourists and dignitaries alike.

The announcement also included plans of Cheung Kong Holdings (like Hutchison Whampoa, owned by Li Ka Sing) to jointly develop Hilton's neighbouring sites-a private car park and the Beaconsfield House, a crown property belonging to the Hong Kong government. If any hotel deserves the title of institution, the Hong Kong Hilton was that hotel. Its staff of 850 was long-term and loyal. Hilton Hotel employees were given an average of nine months of salary as part of the “retirement fund.” Moreover, Hutchison Whampoa was able to place over 60 percent of the Hilton’s employees in the new Harbour Plaza Hotel, located in Hung Hum, Kowloon.

James Smith, the Hilton’s last general manager, said the buy-out was an unfortunate, but logical business decision: “As a hotel, it’s worth $500 million; as an office block, it’s [worth] $1 billion.” Most hoteliers we contacted agreed that it is unlikely that another top hotel such as the Hilton will be built in central Hong Kong, because land values there are among the world’s highest. Moreover, the Hilton was not the first hotel to be bulldozed in favor of commercial space. In October 1991 the 194-room Grand Hotel closed its doors in Tsimshatsui, Kowloon, in favor of a multi-storey office tower. In 1993 the 20-year-old Lee Gardens Hotel in Causeway Bay was also knocked down to make way for a commercial office project. The same fate took the Ambassador Hotel and the China Harbour View Hotel. Exhibit 1 shows which Hong Kong hotels have checked in and checked out.

Those hotels' removal is made even more peculiar by the fact that tourist arrivals to Hong Kong continue to increase. Arrivals in 1994 grew by 11.6 percent over 1993, to 8.9 million visitors. That number is estimated to double by 2004. With the new Click Lap Kok Airport under development and further expansion of the Hong Kong Convention Center, tourism and convention activities should achieve new records. The $64.3 billion generated in 1994 made tourism Hong Kong’s second-largest earner of foreign exchange .

Hotels are traditionally among the most lucrative and glamorous of real-estate projects, even though they are complicated to operate. Hong Kong's annual city-wide occupancy usually exceeds 80 percent--a rare performance among international markets. Yet many hotels have been removed even in the face of excellent returns.

The case of the vanished Hilton should not be viewed as the story of this hotel alone, because the decision to remove such a hotel affects not only the hotel itself, but also the nature of Hong Kong as a tourist destination. This article explains some of the rationales for the decision to close the Hilton. The reader will see that any hotel owner, developer, or investor must contemplate these issues in determining the best use of a given real-estate parcel.

The Hotel Ordinance

On August 8, 1988, an electrical fault sparked a blaze in the lower floors of the 16-story Mirador Mansion in Tsimshatsui. As dense smoke enveloped the building, 327 residents and hostel guests were evacuated. The fire drew 320 firemen and 27 fire engines. Twenty-three people, including a baby girl, four elderly men, two elderly women, and two firemen were treated for smoke inhalation at the Queen Elizabeth Hospital.

The Mirador is just two blocks away from Chungking Mansion, a building that is home to some 170 guest-houses and businesses, where a Danish tourist fell to his death trying to escape a fire. In this mansion, there are about 150 hostels ranging from a single room to multi-storey accommodations. Those hostels provide inexpensive and affordable accommodation for hundreds and thousands of budget travellers each year. Many of those tourists are from mainland China visiting Hong Kong on a special permit and demanding cheap, short-term accommodations. That in turn encouraged rapid growth of hostels and guest-houses.

Like the Mirador Mansion, the Chungking Mansion was originally built as a residential property. As the number of visitors from the main-land increased, entrepreneurial owners have renovated their individual premises into guest-houses. Those owners, however, employed unlicensed electricians and failed to install transformers that would have handled the electrical load created by the appliances installed for hostel guests, particularly in-room cooking facilities. The shoddy and improper wiring allowed fires in the over-loaded cables. Between August 1988 and January 1995 the Chungking Mansion experienced a total of 28 fires, most due to electrical short circuits and malfunctions of cookers.

As a consequence of the many fires, the Hong Kong government in September 1988 approved the Hotel and Guest-house Accommodation Ordinance, which required hotels and guest-houses alike to hold a license to be renewed yearly. The ordinance changed license fees from their former flat rate to a scaled scheme based on a property’s total number of rooms. Many hotels faced a fee increase of as much as 13 times over the original annual fixed rate of HK$24,000 per property. The authorities also required all hotel operators to carry out remedial work to meet new safety requirements before September 1993.

The ordinance drew immediate criticism from the powerful Federation of Hong Kong Hotel Owners, whose members (including Li Ka Sing) owned many of the finest hotels in the territory, such as the Hong Kong Hilton, the Peninsula, and the Mandarin Oriental.

A federation spokesman claimed that “almost all the recognized hotels in Hong Kong would fail to meet the new, tougher regulations, and remedial work would cost rnillions.” The federation gave the example of a new 3-star property that had to spend almost HK$7 million replacing fire-exit doors with the more fire-resistant models.

Federation executive director Michael Li claimed that the Licensing Authority's list (of facilities included in the license law) had unfairly included some guest-houses and hostels considered by many operators unqualified to claim the title of a hotel. He suggested that the licensing ordinance should focus only on those guest-houses and hostels located in buildings never intended for public accommodation exempting purpose-built hotels. Li also contended that the tourism industry of Hong Kong, which earned HK$63.4 billion in 1993, would be endangered by the licensing conditions because those rules are inflexible and inappropriate for the hotel industry.

The Licensing Authority also refused to offer any grandfather clause that would exempt those hotels that were already built and that complied with the building codes and fire regulations in force when they were constructed. The authority felt it could not exclude existing hotels from an ordinance that was intended to license all hotels and bring them in line with existing codes.

A particularly stringent regulation required all hotels to have sprinklers. Old hotels had not been required to have a built-in sprinkler system, and installation of sprinklers would necessitate demolishing upper floors to accommodate the necessary water tanks. Needless to say, such construction would seriously disrupt daily operations and entail great expense.

Importing Labor

One of Hong Kong’s historic competitive advantages was its abundance of skilled labor and the resulting low wages that meant inexpensive goods and services. Some hotels operated economically with a ratio of two employees for each guest room. After nine years of annual inflation hovering around 9 to 10 percent per year, however, Hong Kong's labor rates in the mid 1990s were high, compared with neighbouring countries such as China, Vietnam, and Cambodia. Many industries (especially manufacturing) consequently have moved to mainland China or elsewhere seeking lower-wage workers. The result was that Hong Kong's economy turned flat in the 1990s. Unemployment reached new highs in 1995, and the cost of living soared (see Exhibit 2).

Responding to employers' pleas regarding rising labour costs, the Hong Kong government developed a labour-importation scheme that allows 25,000 "skilled" expatriates annually to come to Hong Kong to work in various industries. The scheme has created contention between employers and employees in virtually all industries, particularly hotels. The hotel sector's quota supplied only about 10 percent of its annual labour demand.

Hotel employers contended that the quality and productivity of Hong Kong employees was low, particularly in front-line positions. Employers said they were unable to develop a qualified labour pool that could keep pace with increases in demand. They urged the government to increase the labour-import quota to the hotel sector. Moreover, employers indicated that their exhaustive efforts to attract qualified local workers were in vain. Although many local workers attempted to switch to the hotel sector when their manufacturing jobs moved out of Hong Kong, employers said many didn’t measure up even after on-the-job training.

The Association of Hotel and Restaurant Employees vehemently opposed the labour-importation scheme. The association claimed that as hotels closed down for redevelopment into commercial space, employees who were laid off found it difficult to find jobs in the same industry. The association deemed employers' request for more imported labour to be a move to hire cheaper labour and reduce their payrolls and benefit expenses while claiming to upgrade quality. The employees also charged the employers with blatant age discrimination when they allegedly recruited young expatriates, rather than retaining local, laid-off workers (in their late 30s and 40s) and thereby saved money on the company retirement and pension plans.

Both sides have sought help and political influence from the Legislative Council, the statutory lawmaking body in Hong Kong. The election campaign for the sole seat in the council's hotel and restaurant service sector, held in 1995, pitted candidates supported by the contending groups. Chan Wing Chan was nominated by the Association of Hotel & Restaurant Employees with heavy union support, while Michael Li is the same person who is executive director of the Federation of Hong Kong Hotel Owners.

Chan won the seat by a relatively small margin. Shortly after, on October 12, 1995, Governor Chris Patten announced an amendment to the labour-importation scheme that would reduce the hotel allocation from 25,000 to 5,000 workers annually.

Operating Costs

A hotel is a complicated and expensive business to run. Horwath Asia Pacific compiled figures showing that payroll expenses for Hong Kong hotels reached 37 percent of revenue. Hotel operation is also a cyclical business. Even considering Hong Kong’s high average occupancy, its hotels squandered its owners' capital with unsold rooms. Comparing hotels' expense percentages with those of a commercial office complex, one sees that management fees, utility bills, security-management charges, HVAC, and other costs are generally being borne by the tenants of a commercial building. Payroll is not a factor. As a result, owners of commercial properties can often anticipate a strong return on their capital investment. Exhibit 5 compares developing a hotel with developing a commercial building, with figures compiled by Pannell Kerr Forster.

Would statistics like those in Exhibit 5 convince a hotel owner to make the drastic decision to demolish a hotel and build a commercial building? Not alone, but they add another factor to those already discussed. Perhaps most fatal is the astonishing rise in land values and the demand for commercial space.

The Plot Ratio Thickens

Since mid-1992, Hong Kong’s office-rental market has strengthened rapidly. Rentals hit a low of HK$16 per square foot during the 1991 recession, and stood at $38 a square foot just after Tiananmen Square in 1989. By 1995, however, rents in central Exchange Square were hitting $100 per square foot.

The Jones Lang Wootton index recorded that office rents increased 40 percent during 1993 alone, and climbed another 10 percent in the first two months of 1994. Given the demand, grade-A office space is drastically in short supply, especially in Central, where the vacancy rate is a mere 2 percent. Average monthly rents in Central are now around $90 per square foot-one of the highest rates in the world. Most real-estate analysts expect commercial rents to continue their rise and believe office space will be in great demand, especially at prominent locations in Central.

On a commercial site in Central, the market value of a grade--A office space is 4.5 times that of a tariff--A hotel such as Hilton. Exhibit 6 gives a simple comparison of the return available in Hong Kong for a commercial office building and that of a hotel. The office building gives greater cash flow and offers a higher residual value than the hotel under the assumptions existing at the time of the Hilton decision. That higher expected return from commercial development placed hotels in a disadvantageous position.

The Hong Kong Hilton was located at 2 Queen's Road, the center of Central District and a premier location with a relatively unobstructed harbour view. But the hotel’s mere location was not the only real-estate factor that hastened its demise. Zoning restrictions also became a problem. At the time of the decision to demolish the Hilton, Hong Kong’s building and planning regulations contained no zone especially for hotels. For that matter, the government offered no special tax incentives for hotel developers.

A particular aspect of the zoning code, the plot ratio, worked against hotels. The plot ratio specifies the relationship of the square footage of a building to the square footage of the land on which that building rests. The higher the plot ratio, therefore, the less restrictive the zoning. Domestic properties, for instance, have a plot ratio of 8 to 10, while non-domestic and commercial ones have a plot ratio of 15.

Hotels were generally treated as domestic rather than non-domestic or commercial properties. Hotel developers were generally assigned a plot ratio of 10, which would generally include the basement and the engineering rooms. At that, they had to obtain the concessions from the government to get that high a ratio.

The plot ratio was calculated at the time the government auctioned the land. Factors bearing on the ratio are density of population, sewage availability, and transportation services.

Considering land values, potential return, and fire and zoning codes, it is little wonder that the owners of hotel properties have been doing their sums. “You cannot blame the hotel investors,” said Manuel Woo, executive director of the Hong Kong Hotels Association, “but we are seeing an epidemic of hotels turning into commercial buildings, and I am very concerned.” The situation in Hong Kong is unusual in that office space is extremely valuable, while the incentives to own a hotel are few. Even more peculiar is the fact that the hotels being demolished were profitable enterprises, in contrast to, say, hotels in New York City in the mid-1960s, when many unprofitable properties were leveled.

Hilton Aftermath

The demolition of hotels seems to have abated in recent months. Perhaps the real-estate market has reached some sort of balance between office space and hotels. Nevertheless, two of the major hotels in Central, the 605-room J.W Marriott Hotel and the 513-room Conrad Hotel, were unexpectedly put on the block to be sold. Both owners gave their reason for the sale as getting rid of non-core business. The owning group of the Conrad, the Taiwan-backed Pacific Electric Wire & Cable conglomerate, wants to sell its 30-percent stake in the Conrad for HK$600 million, while the British Swire Group put a price tag of about HK$2.8 billion on its wholly owned J.W Marriott Hotel. Both hotels are located in Central and both hotel-management companies are expected to continue their management of the hotels after the sale.

Existing hotels are in a strong position to charge high room rates. Because of high occupancy throughout the year, remaining hotels have been able to increase room rates substantially beyond the annual 9-percent inflation rate, jumping rates by 15 to 20 percent annually and by 25 percent in some cases.

While those room-rate increases are keeping the hotels alive, they also may be driving some price sensitive tourists elsewhere in Pacific Asia. Until the new hotel rooms are opened, room rates will almost certainly continue to escalate. That puts even more pressure on the Hong Kong tourism industry.

Prospects

Many of the factors that contributed to the downfall of the Hilton and other hotels remain unresolved. The recently completed changeover of administration of Hong Kong makes matters even more uncertain.

Fire ordinances.

The Hotel Ordinance (fire code) went to the newly elected Legislative Council (Legco) for consideration, but China authorities insisted that the election of that council constituted a violation of the agreement between China and Britain. Dissolved as of June 30, 1997, the former Legislative Council will be replaced by new officials to be selected out of 400 current members. The fire ordinance remains in limbo.

Plot ratio.

The government of Hong Kong has set aside about nine sites for hotel development in Hong Kong and Kowloon. Most of these sites are in suburban rather than central areas. In a move to encourage development of these hotel sites, the government announced on September 2, 1995, a relaxation of plot ratios for hotel developments to a maximum of 15, similar to that of other commercial developments. At the same time, however, the government also decided to remove any concession regarding the basement and the engineering plant rooms for the purpose of calculating the plot ratio for new hotels. This concession was regularly made to hotels for the past 30 years.

The plot-ratio changes failed to stimulate a major rush to develop or expand hotels, probably because of the confusion with the simultaneous change in the ratio and elimination of the basement concession. The relaxation of the plot ratio has little effect on the 16 districts in Kowloon where most hotels are located. The chart in Exhibit 9 shows the distribution of Kowloon hotels.

The Conrad Hotel announced expansion plans, but the effect of the sale of Pacific Electric Wire & Cable's stake in the property is as yet unknown. One other hotel that plans to increase its floor space and room count by as much as 32,000 square feet is the 392-room Eaton Hotel, in Kowloon. 17 Its owning company, Great Eagle Holdings, has been in the construction business for many years. Actual construction of the extra hotel floors will be done by Great Eagle’s real-estate arm.

Financial Decision

The decision to demolish the Hong Kong Hilton and replace it with commercial space was one of economics. For a real-estate-business conglomerate like Hutchison Whampoa, the commercial office building offers far greater appeal than did the hotel. For a publicly traded company, moreover, the board of directors'responsibility is to ensure that the stockholders earnings are being maximized. In this case, the owner had what could be characterized as a fiduciary duty to investigate and compare the two types of real-estate investment and calculate the best return. The prestige value of owning a world-class hotel does not offset the simple calculation of financial return on an office building.

Does this mean that hotels will disappear entirely from Hong Kong (or any other destination)? The answer is that some companies are specifically in the hotel business, rather than in the business of managing a real-estate portfolio. Such publicly listed hotel companies as Shangri-La Hotels and Resorts and Regal Hotels International, which will construct its fifth Hong Kong hotel at the new Chek Lap Kok Airport, are unlikely to face the kind of decision that Hutchison made. Companies like Shangri-La and Regal will generally not be affected by short-term deterrents involved in government regulations. They will continue to develop hotels, work with the government (old and new), and continue to operate hotels.

Moreover, with the new convention center being completed just before the 1997 Handover and the new Chek Lap Kok Airport to be completed by August 1998, Hong Kong is expecting a greater influx of tourists. With the shortage of rooms, developers are rushing in to capitalize on the strength of the tourist market. Thus, there will always be room in the inn.

 

 

Handover Headaches

With the shortage of rooms and good results from 1996 and early 1997 hoteliers raised room rates in anticipation of Handover, when they expected people to come in droves. Some are coming: there were, for example, 400-plus television stations and well over 7,300 journalists in Hong Kong for the event. But others stayed away due to high prices or were kept away by government action.

Hong Kong hotels faced a particular challenge during the remainder of July after Handover. Many tourists were scared off by the Handover prices, and to make matters worse many hotels asked tourists to book the rooms in a package deal, such as the five days before or after Handover (with little discount). Such sales tactics discouraged many tourists, not to mention business travelers. As a result, the true challenge was to fill rooms the rest of the month of July-when tourists were being lured away by favorable prices in Singapore, Malaysia, and Thailand.

Hotels catering primarily to travelers from the Chinese mainland also suffered because the government stopped issuing visas for the month of July to forestall an expected flood of people to Hong Kong. Thus, Handover has disrupted the hotel trade at all levels. Hong Kong Tourist Association Chief Executive Amy Chan said: Hotels that are near the Convention Center or on either side of the Hong Kong harbor are full, as they are near the action, but those farther away have had trouble.

Handover in Hong Kong

Hotel

Typical Rate

Handover Rate

H/O room occp

Peninsula

3,100

5,000

100%

Mandarin Oriental

3,000

4,830

98%

Conrad

2,850

2,850

100%

Imperial

950

2,600

40%

Holiday Inn Golden Mile

1,300

3,500

70%

Kimberly

1,550

1,997

50%

Royal Park

1,780

1,980

70%

Island Shangri-la

2,700

3,850

100%

Warwick, Cheung Chau

990

990

95%

Marco Polo

1,850

2,380

70%

Metropole

1,330

2,409

94%

Hyatt Regency

1,680

3,960

94%

Note : All figures in HK$, Handover was June 28, 29, 30 and July 1 & 2, 1997

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