Access to historically cheap money is waning as interest rates spike in global markets. Debt is available, but it is definitely more expensive.
Where rates will settle and when they will eventually slide back down again remains unclear. What is clear, however, is that higher rates appear to be somewhat of an impediment to a growing number of hotel buyers, especially those requiring higher leverage. Couple that with accelerating performance and it creates a recipe for bigger bid-ask spreads and a more challenging environment for acquisitions.
All-in borrowing costs are in the 5.5% to 8% range (depending on leverage), wrote R.W. Baird analyst Michael Bellisario in June. “Simply put, the math doesn’t pencil well for buyers; all-cash and/or unlevered buyers (e.g., Hotel REITs) have a relative advantage today, but they do not appear overly motivated to ‘lean in’ just yet,” he said.
That said, veteran developer and dealmaker Flip Maritz, Broadreach Capital Partners and Maritz, Wolff & Co., told HOTELS it is tempting and easy to draw broad conclusions about the impact of higher rates on deals, but he believes they are just one material component of a complicated ‘stew’ affecting the hotel business broadly right now. “Inflation, inventory, COVID (probably not over yet), politics (local and global), social unrest, labor availability and cost, technology all combine to create about the most complicated and confounding investment environment I have ever experienced,” Maritz said. “Are interest rates the ‘cart or the horse?’ I would argue they are a symptom, not a cause.”
HOTELS reached out to brokers, owner/developers, analysts and consultants in early July to ask a series of questions about the potential impact of the higher interest rate environment on dealmaking. Among our sources for this story are Kevin Davis, JLL Hotels & Hospitality Group; C. Patrick Scholes, Truist Securities; Flip Maritz, Broadreach Capital Partners and Maritz, Wolff & Co., Brandon Tarpey of M Development; Carlos Rodriguez Sr., CEO of Driftwood Capital; and John Fareed, global chairman, Horwath HTL.
Over the next few days, we present thought-leadership on a number of questions surrounding this key questions of the moment. Here is Part 1:
HOTELS: What is your broader take on higher interest rate’s impact on M&A?
Kevin Davis, JLL: The high cost of debt has a significant adverse impact on M&A activity, and most large deals for that matter. Given where hotel cap rates are, we’re now seeing situations where buyers will incur negative leverage – debt costs are higher than cap rates – which makes it harder to buy. Also, hotel CMBS spreads are near post-COVID wides. The volatility in CMBS make this form of financing much less accretive and reliable, which is significant because CMBS frequently finances hotel M&A transactions and large trades.
Brandon Tarpey, M Development: I believe we’ll see an increase of transactions falling out of contract due to unexpected negative leverage. This will create an environment of hotel’s being offered at discount to back-up buyers. It will slow the overall pace of deal flow. However, there are plenty of buyer’s who will transact at a realistic price.
Flip Maritz, Broadreach Capital Partners and Maritz, Wolff & Co.: I see a material impact, particularly due to credit availability, much less higher rates. But great assets usually find a buyer and great buyers usually find a way.
John Fareed, Horwath HTL: Even since the interest rate hike, we’ve been tapped by two large hotel companies to assist them with developing a list of strategic targets for acquisition which are aligned with their company’s values, philosophy and overall goals—whether that’s to grow total number of keys, number of properties in the pipeline or even to counter act the scarcity of labor.
Carlos Rodriguez Sr., Driftwood Capital: It’s definitely going to slow down M&A deals. Some deals will still be made but it will be more difficult to make the numbers work.
Patrick Scholes, Truist Securities: It has been difficult for the public REITS [in the U.S.] to compete with private equity due to the higher leverage levels private equity firms are able to take on for an acquisition. Subsequently, opportunities for development within existing owned hotels were highlighted over opportunities to go on acquisition sprees. Additionally, hotel REIT management teams we spoke with last month [in June] at the NAREIT conference noted a bit of a ‘pause’ at that moment in the transaction environment due to reluctance by owners to sell when their revenue forecasts keep improving combined with the cost of debt ratcheting-up for potential buyers.
While buyer-seller dialogue remains very active and capital remains fairly plentiful, the biggest change this year is lending rates. With lending rates going from 4.5% nine months ago to 7% today, for example, investors are factoring in more growth to their underwriting to pencil-out acquisitions. Debt markets were a little more challenging than three months ago [April] and the importance of getting the labor assumptions correctly modeled.
Other points: some underwriting assumes negative cash flows going in; debt markets are expected to come back more perhaps by the fall; with the exception of Watermark’s non-listed REIT being sold to Brookfield (BAM, Not Rated), there remains relatively few comps of note within urban full-service (even excluding the Watermark resort assets). That activity may improve later this year given the attendee base and activity present around the main halls of the conference.
Buyers of urban full-service hotels (possibly including a REIT?): Traditional PE, sovereign wealth, high-net worth. These entities have a longer-term timeframe (five to seven years at minimum, HNW even longer), and probably can withstand the potential incoming macroeconomic volatility that may challenge some public market stock prices.
H: Will buyers avoid paying at peak multiples?
Tarpey: Unless it’s a brand with a strategic acquisition opportunity, we’ve all started to pull back from the recent multiples that have traded.
Maritz: Some will; many won’t. The best way to justify high multiples is that old canard about replacement costs, which are currently exceptionally high.
Rodriguez: It depends on the product type and market. Hotels get to price the rate they charge daily, so that’s a hedge against inflation. Hence, quality hotels in great destinations with barriers to entry will continue to command a premium, while low-barrier-to-entry hotels with lower quality brands will be more challenged.
H: How would you describe the state of bid-ask spreads with strong performance yet higher rates and hurdles?
Davis: We are beginning to see a growing bid-ask as sellers look for yesterday’s pricing and buyer’s look for tomorrow’s pricing. Following the next Fed meeting later this month [July], it’s likely that the lending index, SOFR, will have increased almost 300bps since March, and could increase another 50bps before year end. Moreover, credit spreads have increased at least 100bps since March, resulting in loan coupons that are higher by 400bps compared to earlier this year and may end the year 500bps higher. The cost of debt is shaping buyer expectations far more than any improved operating performance. Of course, there’s the fear that the Fed rate increases could lead to a hard landing, in which case the improvements in operating performance could reverse.
Tarpey: The bid-ask spread was already influx due to COVID economics. Today’s interest rate environment will expose real sellers and not groups testing the market – which is much of what we have seen recently.