“Wall Street is gearing up for rate cuts” read the lede in a recent Wall Street Journal article that presupposes interest rate cuts could be coming soon, a salve to investors everywhere who have either been on the sidelines in wait or owners who have assets ready to sell but can’t find a credible buyer.
The Journal, citing data from the CME Group, refers to interest rate futures, which last week indicated “a roughly 60% chance the Fed will lower rates by a quarter-of-a-percentage point by its May 2024 policy meeting, up from 29% at the end of October.” The same data also pointed to four total cuts by the end of the year.
The Fed began raising interest rates in March 2022 in order to counter rising inflation to its current target rate of 5.25% – 5.50%. The federal funds rate is used to control the supply of available funds. Raising the rate makes it more expensive to borrow, which lowers the supply of available money. That, in turn, increases short-term interest rates and helps keep inflation in check. Lowering the rate has the opposite effect, bringing short-term interest rates down.
For investors who rely on leverage to get deals done, higher interest rates are a bane. Should the Fed decide to retrench, the expectation is a pick-up in hotel transactions and more appetite to build new hotels, given the opportunity to do so.
“If anything else, it’s going to certainly spur more activity because part of the reason why transaction activity has slowed dramatically is because of the rise in interest rates,” said Dan Lesser, CEO of LW Hospitality Advisors. “If it goes that way, it’s definitely going to loosen things up.”
Michael Sonnabend, managing member and co-founder of PMZ Realty Capital, which originates loans, is equally confident that any cut back in rate would benefit the hotel transactions market, which up to now hasn’t been electric by any stretch. “It would make transactions a little bit easier to come by,” he said.
Sonnabend said the idea of a rate drop had an equally important effect; should they drop, people will think there are more to come. “Because there are many doing floating rate deals, even if interest rates are lowered slightly, people always think they’re going to be lowered more,” he said.
Lowering interest rates allows cash flow to work better on covering debt service and can potentially obviate the need for rate caps, which pile onto transaction costs. A rate cap is essentially an insurance policy that a borrower buys that protects them against undesirable movements in a floating interest rate.
Though hotel transaction volumes are down, Lesser said that there remains a surfeit of capital available on both the debt and equity side. One thing he has been witness to in the past couple of weeks, he said, is a narrowing of the spread between the base rate and the actual lending rate. “If interest rates were to come down, you would see spreads come down as well. It’s nothing but positives for transaction activity.”
Ankur Shah, CFO of Access Point Financial, a direct lender, doesn’t believe interest rates will ever get back to 2019 levels and that the market has actually become comfortable that there will be no further rate increases but rates may be at current levels for longer, resulting in some semblance of stability that factors into underwriting.
Shah thinks there are two elements at play: an owner’s willingness, but also need, to sell, and buyers in the market hunting for deals now as rates potentially come down. It still isn’t easy, as the high cost of capital has resulted in a rather wide bid-ask spread.
Hotel fundamentals, however, remain buoyant. STR’s global update in November showed 79% of markets with growth in RevPAR compared to 2019. In its final revision of the year, it also raised its forecast on both ADR and RevPAR for 2023. “Looking ahead to the new year, we anticipate continued growth in RevPAR,” said STR President Amanda Hite.
Owners, Shah said, have no real compulsion to sell unless there is pressure from limited partners or debt maturities coming due. “There was a tremendous amount of capital deployed in 2017 and 2018 and that’s starting to come due,” he said.
Though interest rates are still having a mitigating impact on the ability to get deals done, buyers are calculating what a deal done today would mean five years out. “At some point, interest rates are going to drop,” Shah said. “An owner will be able to refinance the debt and the lower interest rates will increase the value of the asset.”
One element that is gumming up the works are seller expectations against reality. Many owners believe their assets to have a certain value that is not shared by others. “When buyers and sellers are trying to get together, the sellers obviously still have a higher price expectation than the borrowers,” Sonnabend said. “The problem for a lot of borrowers is once they come to an agreement with the seller, and they want to finance the deal, it’s a problem to get deals done in the current interest rate environment.”
Could a drop in interest rates put more shovels in the ground? Conversions have made up a large portion of growth within hotel brand systems as a way to expand net unit growth, a key performance indicator and Wall Street measuring stick for companies such as Marriott International and Hilton.
According to Lodging Econometrics, in 2024, Marriott is expected to lead new hotel openings with 192 new hotels totaling 22,298 rooms, for a growth rate of 2.5%, followed by Hilton with 176 new hotels/with 20,004 rooms (a growth rate of 2.5%) and IHG with 111 new hotels /10,924 rooms. In 2025, Marriott is projected to open 256 new hotels/29,572 rooms (3.1% growth rate); IHG is expected to open 202 new hotels/19,390 rooms (4.4% growth rate); Hilton is slated to open 139 new hotels/14,780 rooms (1.8% growth rate).
These growth rates are lower than historical rates of between 6% and 7%. Lower interest rates, however, lower the cost of capital, which, theoretically, lowers the threshold to achieve the economic feasibility of a new hotel. “I don’t think you’re going to see shovels in the ground in downtown San Francisco anytime soon,” Lesser said. “At the opposite end of the spectrum, Miami is on fire.”