The current state of global macroeconomics is volatile and despite enormous liquidity in the marketplace the cost of capital to transact on hotel assets needs to become more efficient. With volatility comes opportunity. So, the big question for 2023 is when will that dislocation abate and how quickly will transaction volume come roaring back?
Bill Grice, president of CBRE in the U.S., expects the second half of 2023 to be the moment when the cost of capital aligns with sustained consumer demand to help facilitate more transactions.
“Once we have more clarity on all the existential things that are going on abroad; once financial markets have a better understanding of the trajectory of the Fed and have more data points on how the Feds actions are working to tame inflation; once we have a clear path, I think you will see more lenders reengage and credit spreads will start to compress,” Grice said. “That will facilitate more transaction volume, but it will take it will take some time.”
For now, Grice said it’s a little bit of an ice bucket challenge for a lot of owners and operators that have to adjust to a higher interest rate environment. “It changes the calculus on what you can invest in a property,” he said. “You have to deal with a lot of different factors and, of course, inflation is kind of front and center.”
At the same time, in fall 2022 the dislocation between strong industry performance fundamentals is juxtaposed with where the debt capital markets sat. “There’s an immense amount of liquidity on the equity side of the equation,” Grice continued. “You’ve also had a number of lenders recently that have tapped the brakes on financing opportunities.”
Pair that with higher interest rates, it makes it more challenging for hotel owner-operators to identify the most efficient capital structures.
Grice suggested hotels that will struggle to meet the financing extension tests, those that are maturing, are going to have to source capital that is sometimes twice as expensive. “With assets that might still be ramping up, that haven’t really achieved peak, it’s going to be challenging to deal with the increase in debt service and other inflationary pressures. So, we’re likely to see a period of distress in certain parts of the hospitality market.”
With this as a backdrop, HOTELS reached out to a number of lenders, brokers and consultancies to get their takes on the 2023 merger and acquisition climate. Here is Part 1 of a three-part series on what they had to say in response to a number of timely and topical questions:
HOTELS: What is the expected impact of higher rates on hotel distress and sales volume? What segments will see the most volatility?
Denny Meikleham, Berkadia, Boston: From the seller’s and owner’s perspective, most had a record summer and fall and will even end 2022 with record profits. Unless they’re facing a debt maturity issue, most will hold their asset rather than accept a price reduction below what they feel their asset was worth back in June or July.
From the buyer or investor’s perspective, the 200+/1 basis point increase in interest rates (and climbing to 7%-plus) is a real cost and therefore factored into pricing and thus cap rates. Unless the asset is unique and in a “target” market, they believe values are off 10% to 15%. Many with cash have decided to just take a “pause,” hoping that the opportunities in the next two to three years will be to acquire distressed assets or bank loan sales.
Regardless, transaction activity will slow down in all segments as buyers take a pause to determine what the new normal is and how to make money.
Robert Hecker, Horwath HTL, Singapore: I’m not so sure higher interest rates will add to any distress already out there. More likely, it adds more to the buyers’ costs and thus to the buyer-seller price gap. The sales that are occurring are generally not associated with distress as pricing is rather robust (more like pre-COVID levels). The driver seems to be positive attitudes/outlooks about travel and hotel performance recovery and plenty of equity-seeking investment. Assets being sold/bought tend to be full-service hotels, good locations, prime assets.
Charles Human, HVS, London: It’s looking inevitable that there will be stress in the market, which will lead to some degree of distress. In Europe, there is usually a lag between the onset of this and any distressed selling that may result. So, for the time being (at least the remainder of this year and probably Q1 next year), we expect to see relatively low levels of activity as investors take a wait-and-see approach. Right now, it’s the uncertainty combined with the high cost/low availability of debt that are stalling activity.
J. Pedro Petiz, Avington Financial, London: Higher rates have quickly arrived and become the new normal for the foreseeable future as part of central banks’ fight against inflation in the aftermath of a decade of highly dovish monetary policy. Historically, the hospitality industry has been resilient to inflation. However, higher interest rates over an extended time typically results in increased capitalization rates and pressure on real estate asset prices.
Andrew Broad, RobertDouglas, San Francisco: It is inevitable that rising interest rates will lead to rising cap rates. The question becomes whether hotel net revenues can at least keep pace with inflationary pressures, including the cost of capital, as opposed to falling behind.
For example, consider that a hotel that had US$1 million NOI in 2021 might have sold for a 7 cap, or roughly US$14.3 million. Now, let’s say this same hotel produces US$1.3 million NOI in 2022, but cap rates widen to 9. Since the hotel value is around US$14.3 million, this means that NOI has to increase by 30% to maintain January 1, 2021, value.
But if this hotel only increases NOI to US$1.1 million, with cap rates having widened to 9, its value is now only US$12.25 million, which represents a 15% loss in value. So, in an inflationary climate, treading water is not good enough in terms of maintaining valuations.
Leisure, drive-to markets and extended-stay properties continue to perform well and have the greatest likelihood of pacing to inflation. However, markets and assets are different. Valuations can’t be simply derived from NOIs and cap rate calculations. More general factors like current cost of capital, anticipated market growth, barriers to entry, diversity and prospects of demand drivers, as well as property-specific factors like needed capital for CapEx, preventive maintenance or brand-mandated property improvement plans, all factor into valuations.
Overall, we expect new construction and development activity to be tempered with caution, although even in challenging times the brands may vigorously enforce scheduled property improvements. Many completed projects most likely will feature mixed-use components, and look for brand conversions to create new value for well-positioned properties.
On the other hand, the conversion of older or distressed assets to other uses, including in mature suburban markets, will help relieve capacity issues in some markets.
H: Was is the expected level of CMBS distress?
Broad: CoStar (in November) reported US$6.8 billion in CMBS maturities over the remainder of 2022 and an additional US$15.3 billion on deck in 2023. A large portion of those loans is probably going to be renegotiated. Unless the hotels have grown revenues enough to keep up with the rise in interest rates, their new decreased coverage ratio will limit proceeds on a new loan and the borrower’s ability to pay back the maturing loan.