What doesn’t kill the bull market only makes it stronger

Life with COVID continues to be quite challenging and has included some unexpected or ironic twists for the hospitality industry.

Contributed by Stephen O’Connor, principal and managing director, RobertDouglas

For instance, the recurring waves of COVID variants and attendant restrictions on quarantine, masking and gathering that makes international air travel so difficult continues to support peak levels of demand for domestic resorts and other drive-to locations, resulting in bumper profit levels and record-breaking transactions.

Similarly, the COVID adjustments to hotel operating standards and procedures, some mandated by the brands or regional authorities, others borne out of necessity, have had a dramatic impact on utilization of labor, the guest experience and, ultimately, profitability. This is most notably seen in reduced housekeeping services, something that operators had already been experimenting with or considering pre-COVID.

Thus, the overall fewer full-time equivalent man-hours for properties of all classes are hastening a transition that was already underway. Clearly, this will reshape the hospitality sector into a more automated, streamlined and more profitable business, albeit one that employs fewer people. Most operators are reluctant to give up some of these painfully gained advantages or insights, especially with so many cost escalations coming at them in other ways, including for basic supplies, utility costs, any construction expense or wage rates for the staff they do hire.

Strong investment interest

Seasoned hospitality investors recognized the threat (and future opportunity) that the pandemic represented to the sector and rushed to raise funds to provide “rescue capital” and make “opportunistic” investments but have been largely frustrated in deploying this capital. What is more interesting are the many new entrants into the hospitality sector, including entrepreneurial spin-offs from larger investor groups. It seems that for every closed-end private equity fund that mistimed their investment and is going to get stung on an exit, there are two multifamily investors that are being attracted to the hotel sector by the comparatively high yields.

This continuing attraction to the hospitality sector is a function of the fact that the “four major food groups” for real estate investment are relatively unattractive. Multifamily and industrial values are bid up and yields are razor thin, whereas retail and office markets are facing more profound, existential challenges. Multifamily investors in particular should “play well” with hospitality, as it is a natural steppingstone from apartments and the lines between the sectors are rapidly blurring. Witness the rise of Airbnb and newer hybrid concepts such as Bode or Sonder that marry the hotel and apartment experiences.

Of course, let’s not forget that some hospitality property types are currently very much out of favor, including “big box” full-service properties in major urban markets that rely heavily on meeting, group and convention business. The hurt is real and it will take some time to right that ship. We know that the sector will attract creative and ambitious developers that understand how to right-size capacity with some properties being converted to other uses – anything from apartments, student and senior living to gaming or club concepts. Stay tuned on that front.

Financing outlook

Despite the many global challenges right now, in epidemiology and politically, as well as those endemic to hotel investing, the U.S. remains one of the most desirable real estate marketplaces. Factors include the relative stability of our government, legal system and capital markets; the reasonable liquidity of investments and the attendant protections provided to individual civil liberties and property rights, all combined with the size and buying power of our market.

Yes, the risk-free interest rates are likely to rise, but they will be doing so from historically low levels. However, hospitality credit risk financing spreads that widened dramatically in the teeth of the COVID crisis have room to compress to offset some of the pain.

Similarly, leverage levels are rising as we get deeper into a resumption of trading activity and “floor values” are being re-established. However, if you believe that inflation is not transitory but rather is here to stay, then, of commercial property classes, hotel operators with their 24-hour leases have the greatest ability to re-price their product and pass on additional costs to end-users.

Many hotel owners are also facing serious deliberations on whether to continue to carry hospitality investments that aren’t able to cover debt service, as well as whether to reinvest in properties through the resumption of deferred customary capex expenditures or formal property improvement plans. The current thought is that the major brands are anxious to complete PIPs that are necessary to maintain property competitiveness. In that case, owners must evaluate whether it is prudent to seek a refinancing to fund the necessary investments or “sell the dream” and leave it for the next owner to undertake.

Ultimately, the repayment of debts can only be deferred for so long and for so many properties that require major infusions of equity capital that may trigger a sale. As a result, 2022 should see a material increase in both refinancing and sales activity. Fortunately there is no shortage of ready and willing buyers with equity raised and ready to be deployed.