Despite broader market volatility and the increased cost of capital, deals are getting done. The question remains: what will the market look like in 2023? HOTELS asks the experts.
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 what they had to say in November about 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.
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 the 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, conversion of older or distressed assets to other uses, including in mature suburban markets, will help relieve capacity issues in some markets.
H: What 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 are 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.
H: Will debt availability improve or worsen in the near term?
Hecker: Banks have money to lend, and higher interest rates create opportunities for improving margins/spreads. So, I think we’re going to see improving debt availability for the hotel sector.
Human: That is the big unknown. The market is already pricing in substantial rate increases, so it is more about availability than cost moving forward. This really all comes down to the extent to which trading becomes affected by the current inflationary pressures and turmoil in the capital markets (i.e. whether or not economies do sink into general economic recession). Right now, trading remains robust, but there is little visibility and lead times are short. If countries do fall into recession, the availability of debt from traditional lenders is more likely to shrink than recover.
Petiz: Debt availability is likely to be tighter going forward as lenders will be more careful about leverage ratios offered in their borrowers’ business plans. Despite a relatively large pool of liquidity right now at banks and debt funds, we do not believe that lenders will lend ‘for the sake of lending’ and will be prudent allocators of capital assessing transactions on the basis of: (i) who is the borrower; (ii) who is the target; and (iii) what is the business plan.
Meikleham: Unfortunately, it’s very hard to obtain an acquisition loan or construction loan right now. If they’re available, it’s expensive and only getting worse.
Broad: The cost and availability of debt will continue to be an issue for the next 12-18 months.
H: Will there be an increase in non-traditional debt sources, and what will it look like?
Hecker: With the liquidity in the market and rising interest rates, private equity can potentially be put to use for alternative lending, mezz financing. There’s also increasing “green” lending and the hotel sector has plenty of opportunities for “green” improvements and carbon emission reduction.
Human: The debt funds will step in to take advantage. We may see some of the considerable amounts of dry-powder equity looking at lending.
Petiz: Absolutely. Already we are seeing several new players becoming sources of non-traditional debt (or quasi-debt) capital, including preferred equity, convertible as well as sale and leaseback capital. Although these forms of financing have been available before, there is a new breed of investors with deep pockets entering the space, and able to think about and structure strategies that meet borrowers’ objectives in the face of current macroeconomic conditions.
Broad: Assumable debt and seller financing will become more common as a way for sellers to maintain pricing and, overall, keep deals flowing.
H: Who are the most active buyers and why?
Hecker: Private equity seems to be everywhere now and taking an interest in the hospitality sector. Sovereign wealth funds, as well.
Human: Europe is looking pretty interesting for dollar-based buyers, but it’s hard to see the PE funds being particularly active in the near term. That will, of course, change if there is distress. We will probably see the greatest activity from long-standing European investors who do not require significant leverage and see long-term value.
Meikleham: I believe any group with cash is going to be very selective in the coming year. Most of the buyers that I’ve talked to believe there will be more distressed assets to buy and distressed loan sales to buy, as well as rescue capital opportunities in the next two to three years.
Spencer Scott, Berkadia: We anticipate the most active buyers in 2023 will be private cash buyers. The common themes surfacing in Q4 are increased inquiries from family firms, inquiries from 1031 exchange buyers and outreach from entrepreneurial firms with “fund raised” ready to go.
Ryan Lindgren, Berkadia: All cash buyers and/or buyers with deep banking relationships have a material competitive advantage over the rest of the market right now. The advantage of all-cash is obviously the elimination of expensive debt, but it also provides certainty to a seller and could speed up the closing timeline. Buyers with deep banking relationships are getting out-of-market debt terms that are 300-400bps inside of market debt, giving them a clear advantage over groups that don’t have those relationships.
Broad: As always, property fundamentals like asset condition and quality, location, market potential and so on drive the most successful deals. Motivated all-cash buyers or low leverage buyers may win the day in the present financial environment, as well as those buyers who are creative with their capital structure.
H: Predict transaction volumes in North America versus EMEA versus Asia Pacific?
Hecker: I can’t get quantitative about volume, but North America is typically the biggest market and is expected to remain so. Asia Pac remains limited primarily to Japan and Australia, with smatterings of deals in Thailand, Indonesia, Malaysia and the Maldives. Europe is somewhere in between.
Human: Volume will almost certainly remain highest in North America – it always is and it is the market that sees the quickest correction in a downturn. Then Europe. Middle East will continue to see low levels of transaction activity.
Petiz: North America is expected to continue to lead transactional volume due to its sounder and more stable economic position, especially as it relates to energy and utility prices.
We expect EMEA and Asia Pac to see a natural deceleration mainly due to geopolitical issues. However, there will be regional standouts such as Spain, Portugal and Italy in Europe and India and Australia/New Zealand in Asia Pacific.
H: How much leverage is being required to get deals done?
Hecker: 60% is the norm.
Petiz: We expect to see a set of less aggressive, better equitized buyers succeeding in more auction processes than in prior cycles. High-leverage purchasers will have a blended cost of debt in the high single digits which will require near flawless business plan execution and leaves little margin for error, making those few and far between.
Meikleham: I’m hearing 60% leverage is the new norm on the few acquisition loans I’ve heard about.
Broad: The least expensive debt will be found on deals with 14+ in place debt yield (likely equating to 50% to 55% LTV). The lower the debt yield, the higher the interest rates. Fixed– rate conservative debt today is in the low 7s. Floating rate debt on “value-add” deals is SOFR +600; we are approaching and exceeding double-digit interest rates for these deals.
H: How will bid-ask spreads evolve in 2023?
Hecker: Basically, the buyers are the ones shifting their prices upwards, not sellers decreasing theirs. Accordingly, more gaps are expected to get filled in 2023 versus 2022 due to the amount of money exceeding the actual deal flow.
Human: The spread is probably as wide as it has ever been right now. One way or another, we expect it to narrow next year, either as the risks of recession recedes and buyers have more confidence, or recession bites and sellers adjust their expectations.
Petiz: Transaction volumes are expected to see a lull as buyers will be more cautious in the face of near-term macroeconomic headwinds and leverage cost and availability. Similarly, not many sellers will be under pressure to transact and, as such, will have very firm views on the value of their assets. The bid-ask bridge may be large enough to terminate or postpone several sale processes.
Meikleham: I expect offers to be between 10% to 15% below what they were in June 2022 going forward. It’s much easier now for an acquisition executive to explain to their investment committee why they should not buy an asset, rather than why the deal makes sense.
Broad: Owners who have strong cash flow and remaining term, say three years and more, on their loans will either hold on to their properties, or, if they do transact, will use the in-place debt and its existing terms to drive value. On the other hand, owners with short debt maturities and/or large CapEx needs may have to transact. This latter group will have some tough decisions to make.
H: What are the most coveted asset types?
Hecker: It remains prime city center, full-service hotels, but increasingly seeing resort deals with a more varied range of asset types in terms of product classification. Domestic markets were helpful in propping up in-country resorts, more so than city properties.
Human: Luxury gateway, as always. London still remains very popular. The trend towards investment in resort hotels in Mediterranean markets should remain because there is still so much opportunity to exploit in that type of asset.
Petiz: As per our earlier answer, we believe that luxury and extended-stay assets will be most resilient to any operating downturn and hence most highly sought after by investors. To the extent that valuations start going down, then other segments will certainly become attractive as investors look out to recovery and a new upcycle in 2025 and beyond.
Kyle Stevenson, Berkadia: I would say extended-stays, distressed deals with lender financing are the most coveted asset types right now. There’s also a huge drive toward leisure resorts.
Broad: Buyers seem to be chasing quality – newer construction or those that were recently renovated, while moving away from aged assets. In many ways, this supports overall industry valuations, as the impulse right now, with a strong assist from the brands, is for property remodels and brand conversions, as opposed to languishing portfolios of distressed properties.
From a property type perspective, extended-stay assets are in favor, especially in the mid-market/economy segments where they seem to be providing much-needed housing in many locales. We are familiar with such portfolios with 90% occupancy and an average stay exceeding two years. This will continue to appeal to retirees, some empty nesters and those who cannot qualify for or rather not pursue today’s mortgage rates and conditions.
From a location perspective, traditional leisure markets or markets with a leisure component still seem to be in favor, particularly higher-end properties.