Internet hotels are haunted by spectre of bankruptcy

Only a year ago, Internet hotels were seen as the most exciting business opportunity in the property industry.

Also called data centres, co-location facilities and web-hosting facilities, they house and service the networks that allow users of Internet and data services and their providers to connect with each other.

But this month, CityReach International, owner of eight facilities around Europe, was placed into administration, while TeleCity, a competitor, announced what amounted to a "rescue" rights offering, saying that it risked bankruptcy if new funding could not be found.

What has gone wrong? Barry Gilbertson, partner in the real estate advisory group at management consultants PricewaterhouseCoopers, says: "The real problem is that these companies could never decide whether they were in the property business or the telecoms services business."

As a result, the web-hosting companies that entered the business failed to understand the property implications, while property entrepreneurs - the handful whose businesses did get off the ground - may not have grasped the service elements.

Why should property developers even be interested in this area? After all, their business is to provide the space within which commercial activities can take place.

Carrying out those activities is the task of occupiers. In the case of Internet hotels, the property requirements appeared so unique that they justified investment.

Supply of space was forecast low and customer demand high. Last year, telecoms analysts at JP Morgan, in a research note about tele-hotelier Exodus Communications, forecast the industry to be worth $18 billion by 2002.

To place that forecast into context, consultancy Forrester Group now expects the sector to be worth $1.5 billion by the end of this year, and $6.5 billion by the end of 2004, with demand rising by 75 per cent annually.

Although Forrester's latest forecasts still suggest a sector with strong growth, last year's forecasts of demand and supply now appear woefully optimistic.

This month, TeleCity's rescue rights offering was priced at 12p per share, against a high of £23.07p last year and a flotation price of 775p. Others in the business saw the writing on the wall.

By the end of 2000, Global Switch, the Internet hotels company one-third owned by Chelsfield and Toronto-based TrizecHahn, had trimmed expansion plans.

According to Charles Homs, senior analyst of e-business trade at Forrester Research, one problem was that forecasters failed to take into account how long it would take for users to adopt the new technology. The two-year time frame expected by most was unrealistically short, he says. In addition, the suppliers of capital to the telecoms industry finally became suspicious of forecasts.

Instead of growth, they wanted to see revenues. When these failed to materialise, the supply of capital to the tenants of Internet hotels was turned off, leading to lower demand.

But the problem, according to Nigel Hugill, managing director at Chelsfield, was not simply falling demand but one well-known to the real estate industry - indiscriminate capital investment.

"Nobody ever expected the role of private equity in Internet hotels," Mr Hugill says. Indeed, the vast majority of capital fuelling the expansion of the sector came not from the banking market - the source of real estate excesses - but from private equity investors.Many of the companies facing tough times were carrying hardly any debt.

Thus, the brake applied by the lending market in order to block excessive property development during the past decade was ineffective here. Equity capital, not debt finance, was the culprit.

Mr Hugill says this anomaly shows why the Global Switch business model, in which the company owns the property rather than leases it, is a more defensive strategy than that of most Internet hoteliers. The firm has been able to raise capital by arranging secured borrowings against its property assets. If it leased properties, capital markets would be closed to it.

However, Susen Sarkar, telecoms analyst at consultants the Yankee Group, argues that it makes little difference whether the premises are leased or owned. Both can be sold off. What matters is strategy.

Too many providers, he says, invested heavily in infrastructure to offer higher-margin and more complex services - only to find that this is where demand has fallen most.

Others, such as Global Switch, have built to shell and core, leaving customers to invest in infrastructure.

However, once a tenant occupied an "anchor" spot within a building, Global Switch used this to entice other smaller operators, who wanted the more profitable services.

Managing an Internet hotel may not be so different from managing a shopping centre. Secure the right anchor tenant at a low rent and you are likely to rent the remainder at a good price.

Internet hotels may fundamentally be telecoms businesses, but it will be interesting to see which survive without some property skills as well.