Impact of higher interest rates on deals, Part 2

In Part 2 of HOTELS series on the impact higher interest rates will have on dealmaking, the discussion turns to asset values, how much new development will be affected, and which segments will be most influenced by more expensive debt.

Yesterday, HOTELS talked to its panel of experts about the broader implications of higher rates on M&A, as well as its impact on bid-ask spreads. Click here to read Part 1.

Again, read what brokers, owner/developers, analysts and consultants said in early July about these hot button questions. 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.

HOTELS: How are higher rates going to impact asset values? 

Kevin Davis: The impact on asset values is incredibly dynamic and is also a function of deal specifics. If we assume March as a baseline, which is when the Fed started raising rates, I’d say that values are off approximately 5% to 8% today [mid-July]. I think the market absorbed the first 100-125bps of Fed rate increases without much value deterioration, but now that the Fed is on a much more aggressive rate increase path, we’re settling into value declines of 5% to 8%. Certainly, strong operating performance in some demand segments and some markets are offsetting the impact of rates, but the more recent rate movements are generally overwhelming improved fundamentals.

Carlos Rodriguez, Sr.: The replacement cost is going higher, which helps the value of existing hotels over time and allows hotels to sell for higher values than anticipated.

Brandon Tarpey: Well-located, generational hotel and resort assets will have limited impact on value. The most impacted hotels will be cash-flow plays such as the limited-service sector.

Flip Maritz: They can only go down, right? Except when they do not (unique, beach front or mountain assets). Trophy is about the most overused word in the hotel business!

“There are just too many unknowns, and many developers are opting to put their pencils down rather than to try to deal with the ever-changing math.” – John Fareed on how rates are impacting development

H: How will higher rates impact development?

Patrick Scholes: Rising construction and financing costs as well as supply chain issues are dampening pipeline growth for projects in early planning stages, although most hotels under construction are highly likely to open even if on a moderate multi-month delay.

In addition to concerns around a possible recession, decelerating new unit pipelines for most hotel C-Corps is a reason we cite for the pull-back in hotel stocks.

Davis: Development deals are getting done, but the current market volatility has made executing those deals very challenging. I’m pleased to report that we were involved in the successful financing of a US$1.25 billion hotel development deal that closed in late Spring, and we are working on another US$3 billion hotel/mixed use development, but these deals require a lot of fortitude.

Our team is executing over US$3 billion of hotel construction debt and equity placement, but to get a deal done you need a strong sponsor with a track record, great real estate and a compelling story. The high cost of development pushes the cost basis of many ground-up deals to the peak of, or in excess of, market comps for existing assets. This dynamic adds to the complexity of capitalizing new development. The bottom line is that deals are getting done but new supply is muted and likely will be muted for a long time, which means that this current wave of development deals will have a long runway to perform before new supply re-emerges many years in the future.

Tarpey: It’s becoming enticing to build again with the recent movements in commodities such as steel and lumber. Labor is still an issue, but overall, I think we’ll see well-priced development sites and a lull of new supply coming to the market.

Maritz: Again, it will be material. The combination of higher rates, recent new supply increases and the shift in travel patterns (away from business transient/urban centers toward leisure/resort) will mostly kill new urban development with all the usual carve-outs/exceptions.

John Fareed: Our hotel company clients have all shared that ‘if deals are not coming out of the ground, they are either being put on hold or cancelled altogether.’ This is driven by a number of factors, including rising interest rates, but also because of rising construction costs and delays due to logistics and/or labor shortages. There are just too many unknowns, and many developers are opting to put their pencils down rather than to try to deal with the ever-changing math.

Rodriguez: There will be a slowdown in development due to the higher interest rate, and more difficult capital markets environment for obtaining loans, and higher constructions costs. All this will bring down the rate of new development.

H: Which segments will be the most impacted? 

Tarpey: Certainly, group and convention hotels will continue to be a tough investment at any price, as corporate spending is starting to slow down due to a potential recession. Any cash-on-cash investment such as an airport hotel or middle-of-the-road limited-service hotel will be impacted.

H: What will be the impact on leisure versus business deals and development? 

Davis: The Fed rate increases will undoubtedly slow the economy and I believe that leisure-oriented assets will likely be most impacted as consumers dial back travel to save money. Leisure-oriented assets have roared back with performance that exceeds 2019, so those assets may give back some of their gains. Interestingly, group and business transient focused assets are still in the midst of a recovery from the worst downturn those segments have ever experienced, so it’s possible that those types of assets could continue to see improving performance in the face of a slowdown. In that case, the pace of improvement will slow, but could remain positive.

Tarpey: Leisure spending and travel will start to slow down with inflation and a soft Euro as the U.S. leisure market will normalize from its record highs. This will impact future projections for buyers and therefore what the asset is truly worth today.

Business travel is already being restricted by public companies due to cost cuts. This will mostly impact the major brands.

Development is an opportunity for the right buyer with patience and cash.