Underwriting in a time of inflation

Inflation has an unwelcome way of calling on us to Pay the Piper. If we look to the months, and, now, years, following the black swan event we call the novel coronavirus pandemic, even with plunging occupancies and revenues, the fire sale on distressed hotel properties that many predicted or feared never happened.  

As occupancies plunged and many properties closed at least temporarily, hotel owners and their property and asset managers were able to negotiate forbearance with lenders; raid CapEx and FF&E reserves to use as operating funds; defer in many cases property maintenance and brand-mandated PIPs; and take advantage of federal Payroll Protection Programs to keep as many staff as possible earning a paycheck.  

Lenders lacked the appetite to take over struggling properties due to the “no-fault” uniqueness of the situation and, in part, because pre-COVID, the hospitality industry was scoring quarter after quarter boosts in RevPAR. Paradoxically, property managers also learned to significantly pare operating expenses, and aided by lean staffing at many hotels, profit margins actually improved at many properties even as the pandemic raged on.  

But the dynamics are now changed. We are in a volatile interest rate environment where we expect the cost and availability of debt to continue to be an issue for the next 12-18 months. It is inevitable that rising interest rates will lead to rising cap rates that threaten valuations. 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. In addition, the consensus on how long it will take to “normalize” the debt markets will impact how much hotel assets get “devalued” in this debt market upheaval.  

For example, consider that a hotel that had US$1 million net operating income (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 in theory that NOI has to increase by 30% to maintain 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 this inflationary climate, treading water is not good enough in terms of maintaining valuations.  

The above examples assume a permanent shift in interest rates, which we do not believe is the case. It seems the consensus is that there will be a settling of the debt markets within the next two years. If so, investors will be expecting a price reduction equal to the difference in debt costs incurred over the next few years, as compared to those costs in a less volatile market.  

Furthermore, in less volatile markets, buyers may be willing to pay the seller for part of the upside in a potential deal (such as the ability to add value by capital expenditures, or repositioning to a new brand or management). In this current climate, it’s our expectation that buyers will want to capture more of the upside given the increased perception of risk in doing a deal in this market.  

We do have to be reminded that each market and asset are different. Valuation can’t be simply derived from an NOI and cap rate calculation. More general factors like current cost of capital, anticipated market growth, barriers to entry, the 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 valuation. 

However, supply chain and labor concerns linger on through recovery, with all hoteliers experiencing continued, significant expense increases, which is adding to the uneasiness in markets today as the Fed keeps boosting interest rates.  


Taking a broad view of the hospitality industry, we can consider divergent underwriting scenarios or two opposite ends of a barbell.  

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 be able to employ the in-place debt and its existing terms to drive value. In these cases, refinancing, which was attractive for many owners during the pandemic, might be on the horizon here. On the other hand, owners facing short debt maturities and/or large CapEx events may have to transact. This latter group will have some tough decisions to make as properties are brought to market.  

Clearly, current performance will have a huge impact on underwriting, in addition to overall property class and specific market dynamics, especially the farther out that 2019 appears in our rear-view mirrors. For example, the leisure market is still doing well, and it will be easier to underwrite strong properties, albeit at higher debt costs, versus properties that are still underperforming far into 2022. 

 How do we make up debt gaps for transactions that portend unacceptable leverage and conditions and, presumably, a market tilted to the buyer’s advantage? We expect to see more instances of seller financing and other creative structures to let people step into existing debt. Examples include the assumption of existing loans in place, along with some seller paper. We are already witnessing sale-leaseback structures.  

Mezzanine lending will feature prominently in many of these deals, as well as other forms of bridge lending. Overall, the motivated buyer will accept a higher cost of capital shorter term, with the expectation of being able to refinance at lower rates sometime in the future.  

Realistically, we are hearing the sentiment that lenders will not be as lenient with forbearance agreements this time around. In response, buyers, sellers, and their financial consultants will come up with creative solutions, as suggested. In our experience, if the property fundamentals (location, condition, competitive posture, revenue, etc.) are attractive, transactions can take place in a time of inflation. 


Story contributed by Andrew Broad and Matt Dower of RobertDouglas.