Owners of hotel assets might be headed for a reckoning. Operating performance continues to be outwardly healthy, but for how much longer? And, as loan maturities and property improvements begin to stack up, owners are left having to decide what to do: sell or hold? The latter could be costly and as the pain mounts, some prospective buyers are in the market eyeing discounted real estate that could be repurposed into other asset classes, including residential.
According to CoStar Risk Analytics, $23 billion of lodging CMBS loans scheduled to mature before this year remain outstanding. Some 79% of those loans were extended to 2023, and another 10% were pushed to 2024 or later. Though CMBS loans represent only a small portion of the overall lending on hotel properties, they indicate the sizable amount of maturing debt looking to be refinanced or recapitalized.
Indeed, owners and investors are awaiting to see what the Federal Reserve and other central banks are cooking up to deal with inflation and decelerate the economy. In the U.S., there was some propitious news that inflation has calmed, falling to 3% in June compared with a year earlier, but still higher than the Fed’s 2% target. Expectations are that the central bank will resume its monetary tightening campaign after eschewing an interest rate increase in June, lifting the benchmark rate to a new target range of 5.25% and 5.5%.
For hotel owners, rising interest rates are an obstacle, especially those with floating-rate debt or those seeking to refinance a loan. In a piece by Dexter Wood, senior managing director of The Plasencia Group, earlier this year, he wrote that the “cost of interest rate cap protection has exploded over the past year,” with “many borrowers who purchased caps before the Federal Reserve’s aggressive hiking of interest rates are now faced with expiring caps, and the cost to replace them has increased by five- or six-fold. Interest rate caps are now effectively a component of elevated overall borrowing costs that create even more financial pressure for hotel owners.”
The current environment has made it harder for owners to meet their obligations. As Wood pointed out, options afforded to owners include fresh owner equity, bridge loans, preferred equity investment or another form of gap financing—all of which are expensive short-term alternatives, but could be the lifeline owners need until market conditions improve.
But can they wait? We’ve already seen cracks in the armor. In early June, Park Hotels & Resorts, a real estate investment trust that owns 45 properties in the U.S., stopped making payments on a $725-million loan tied to the 1,921-room Hilton Union Square and 1,024-room Parc 55, both in San Francisco, a troubled market that is highly dependent on business travel, which has still yet to return, and beset by a host of other problems from crime to homelessness.
On the other side of the country, the owner of the Margaritaville Resort Times Square filed for bankruptcy to try and stave off foreclosure. The owner, Soho Properties, cited difficulties related to the COVID-19 pandemic. The hotel opened in June 2021.
Future interest rate cuts could come to fruition as the markets calm, giving borrowers the lifeline they need. Still, the future remains murky at best and a sale of the asset can be the best choice toward repaying outstanding debt and alleviating stress.
FINDING REPURPOSE
As asset owners decide their course of action, various entities wait in the wings. An article published earlier this by HVS suggested that there could be a slew of hotels, especially in the economy segment, sold and ripe for residential conversion. “As economy and budget hotels are nearing the end of their economic life, some properties are finding new capital for renovations from buyers seeking to convert properties to residential use,” wrote HVS’ Rod Clough and Koby Kearney. “The upside of a residential conversion can be significant, particularly for a budget hotel operating at a below-market occupancy and average room rate whose owner is paying a significant portion of the limited rooms revenue to maintain a brand affiliation that is not providing much benefit. Not only could a struggling lodging property transition to a much higher occupancy with residential use, but the buyer could also eliminate significant brand affiliation and other overhead costs.”
According to HVS research, some 14,540 hotel rooms across the U.S. have been converted to something other than a hotel (for example: residential, office, student housing, senior housing) as of April 2023.
Speculation abounds, and though some argue that the global economy is not headed for recession, the so-called “soft landing” crowd, real estate—and its best use of it—is still open to debate. Some feel that the current hospitality headwinds are blowing so strong that it demands a recalculation, but, still, the surfeit of distressed assets many believed would come, has not.
“We still see decreased demand for hotels from business and conference travelers, the largest customer segment of the hotels that we seek to convert,” Wolf said. “Many of the hotels that we target have not returned to their peak 2019 revenue, are operating at low occupancy and are no longer accretive to the owner’s overall business. In addition, we are in a current environment with higher rates and sellers are facing higher carrying costs, which make sellers more willing to meet the market on pricing.”
Certes recently converted a Rodeway Inn close to downtown Nashville into Hermitage Studios, which offers furnished and unfinished units starting at around $1,000 per month. Other amenities include a gym, pool and dog run. Certes is currently repurposing a former SureStay Plus Hotel By Best Western in Raleigh, N.C., into a multifamily property.
Others aren’t as convinced of the opportunity and upside of hotel-to-residential conversions. “I don’t believe that hotels are the best asset class for developers to be targeting for multifamily conversions right now,” said Rachael Rothman, CBRE’s head of hotels research & data analysis. “The hotel industry is performing exceptionally well, outpacing other asset classes on many key metrics and attracting institutional investors who may have previously shied away from what has historically been perceived as a riskier asset class.”
Rothman doesn’t rule them out entirely. “In instances where we see hotel loan maturities coming due in the next few quarters, you may begin to see distressed hotel sales—something we really haven’t seen much of despite the lingering effects of the pandemic—due to the high cost of financing, which could force some hotels to trade at discounts. Those opportunities may present quality conversion candidates.”
In the case of Certes’ Raleigh project, the owner had two hotels and Certes structured a deal whereby the owner was able to unlock capital for a renovation of an upscale hotel he owned nearby the other. “This allowed us to repurpose the hotel to its highest and best use—multifamily,” Wolf said, adding that converting hotels is also a way to alleviate some of the housing pressures that cities face.
The best hotels to convert to residential are, not surprisingly, those with built-in residential amenities, such as kitchens—think extended-stay brands, such as Homewood Suites, Hawthorn Suites or Extended Stay America. Wolf added that hotels with large common areas work great for residential conversion because they can be transformed into things like a coworking lounge or screening room. In its Raleigh project, Certes is converting the breakfast area into a coworking space, the conference rooms into the gym and the hotel lobby into a tenant lounge.
RISKY BUSINESS
“There is greater risk associated with a hotel investment versus traditional multifamily as there is more uncertainty and volatility in connection with hotel ownership,” Wolf said. “Hotel demand is more closely correlated to market performance and seasonality than residential housing. Economic downturns and fluctuation in travel and lodging demand can have a significant impact on hotel revenue. In addition, hotel investors need to have a deep knowledge of the market and the nuances of operating a hotel in order to keep it running successfully.”
Hotels, depending on the market and type of asset, can be one of the most compelling plays for an investor, as CBRE’s Rothman pointed out. “A high-performing luxury hotel in a desirable, growing, high barrier-to-entry market is going to carry far less risk than a multifamily asset in a tertiary market seeing outbound net migration,” she said.
Because of the risk profile, hotels tend to have higher cap rates than residential properties. Hotel cap rates typically range from 8% to 10%, while residential cap rates are generally between 4% and 6%, depending on the market. “The current state of capital markets is causing cap rates to widen,” Wolf said. “The past couple years of a low-interest-rate environment drove stabilized multifamily caps in headline markets into the low 3%s, but those conditions no longer exist and investors are requiring higher caps to avoid negative leverage. The groups that bought multifamily at low 3 caps with floating rate debt will be squeezed as rates remain elevated.”
And while there hasn’t been a tsunami of distressed assets for the taking, some, like Wolf, believe otherwise, making them ripe candidates for conversion. “It might actually already be here,” he said.