Hail Mary underwriting and other tales of hotel acquisitions in the post-recession era

Hail Mary underwriting and other tales of hotel acquisitions in the post-recession era

The post-recession period has been a somewhat mystifying time when it comes to hotel transaction prices — especially for those of us who were around in the early to mid 1990s. For the most part, the drop in prices never reached the level of our expectations (especially considering the severity and breadth of the downturn). And the rebound in prices happened with blistering speed. For anyone but the REITs, which are buying long-term yields with artificially low-cost public capital, the prices being paid are hard to justify. After all, non-REIT buyers are still expecting over 20% IRRs on an average five-year hold period. So, what is driving this great disparity in values? I have a few ideas: 

A reason to believe: The skeptic in me says that money raised is money that has to be spent. That’s not to say that the spenders are foolhardy, indifferent to their investors or any other of a dozen not-so-flattering explanations. To the contrary, I’m pretty sure they are well-intended. The issue is simply that they want to believe in the upside. This world view means they are more likely to give the benefit of the doubt to the positive. This predisposition to the positive is a phenomenon fairly common in people and impacts us across a wide range of human activities.  

The pro forma — a study in (to be polite) self-administered satisfaction: If one wants to justify buying an asset (see prior point), it is all too easy to do so with an overly aggressive pro forma. The great thing about pro formas is that they’re never wrong at the time they are created and, at the day of reckoning, there are lots of plausible reasons why they were not achieved.  

Discount to replacement cost: One of the justifications I hear most often is that there is inherent value in an asset that can be bought at a discount to replacement cost. The implication is, of course, that replacement cost is an indicator of actual value; in other words, at some point in the future, the asset will sell at a value close to or even above replacement cost if the location is special. That logic worked beautifully in the early 1990s. At least three things were different then: 

  1. At an equivalent point in the recovery, assets were trading at US$0.20 to US$0.50 on the dollar — not US$0.70 to US$0.90 cents on the dollar, which is what we are seeing today. 
  2. Economic troubles through that downturn were limited to certain sectors, not the entire economy, and the path forward was clearer and more certain.  
  3. Factors affecting real estate investment at that time were generally less complex.
The biggest problem with the discount to replacement cost theory, though, is that it presumes that a hotel of the type and location being purchased is — or will be at some future date — economically viable at that price. There are simply too many instances where that is not the case. Take luxury hotels. Reproduction costs range from US$750,000 to US$1 million per key (rarely less and significantly more in some locations). How many places support the ADRs necessary to justify that kind of investment? Would anyone build such a facility without the subsidy of associated residential? What does replacement cost even mean in such situations? The bottom line is that an attractive discount to replacement cost should be nothing more than a starting point to warrant a closer look. 

Inflation bets: This is likely an influencer on why someone wants to be in the lodging sector rather than a justification for a particular transaction. To wit, if it’s true that we are not far from a period of hyper-inflation, real estate has proven to be a pretty good hedge. And, among real estate types, hotels stand out for their ability to raise prices daily. The ability to raise prices with inflation will always be trumped by supply-and-demand factors, but it’s a pretty safe bet that new supply will be constrained for the foreseeable future, and demand increases, though tepid, are a pretty good bet.  

Cycle bets: Perhaps the most compelling argument for justifying aggressive purchase prices lies in a comparison of current price to the demonstrable prior high. But here’s where it gets tricky. In the immediately preceding cycle, the high was driven by plentiful cheap debt and high leverage. Therefore, the only rational way to evaluate this for an income-producing property is to look at the prior high point in EBITDA — not sales price. If one believes that level of EBITDA can be repeated based on current market conditions and operating cost factors, then a future value can be underwritten using capital cost and leverage assumptions more likely to be available throughout the hold period.  

Off-market transactions: Insider knowledge is a beautiful thing — when it’s legal. If a buyer can find a deal that has not been shopped and will not be shopped, a real bargain may indeed be possible. Most buyers would love to tout they acquired a hotel in an off-market transaction. Indeed, many fund equity-raising documents claim they have access to off-market deals. The question is, why would a seller not ask several parties to bid on a hotel unless they are desperate, naive or believe the single-source, negotiated price is higher than the net proceeds they would achieve through broader exposure? How many of these actually occur? Not many, I suspect.

Adaptive reuse and deep turnarounds: There are scattered good deals out there – diamonds in the rough and broken projects that require deep, but very believable, turnarounds. For those that have the stomach for this type of purchase and the skill set and time to execute, this is where the greatest opportunities reside.

The greater fool theory: I don’t think anyone actually underwrites this — but I believe all bottom-cycle buyers inherently believe it will be a dumb money buyer that turns a planned double into a home run — an unstated insurance policy against mediocre returns. And, quite frankly, they’re often right. 

I have no doubt that the industry will fully recover. It always does. The only question is whether it does so fast enough to deliver the high-octane yields required by anyone other than REITs — and whether the prices being paid already represent a big part of the upside.