What is the current state of hotel investment and the lending market? What hotel sectors are struggling and which are exceeding expectations? JLL’s Senior Managing Director and Co-head of U.S. Investment Sales Jeff Davis chats with host Robin Trimingham about what the hospitality market is like right now and what we can expect in 2023.
Highlights from Today’s Episode
Jeff: I think the biggest question is inflation. Hotels are a great asset class to buy in inflationary times. And so will we see more money pour in because of inflation and the ability to reset rates every night? Potentially. The question is, can you buy these hotels and make any money in the near term? When you’re buying hotels at 5 and 6 caps and you’re borrowing at 8%, you got negative leverage going in. And the big question is, how long you gonna have negative leverage until you turn that positive?
Robin: Welcome to the “Innovative Hotelier Podcast” by HOTELS magazine with weekly thought-provoking discussions with the world’s leading hotel and hospitality innovators. Welcome to the “Innovative Hotelier Podcast,” brought to you by HOTELS magazine. I’m your host Robin Trimingham and my guest today is Jeff Davis, senior managing director and co-head of US investment sales at JLL. Today we’re chatting about emerging trends in the hospitality capital market.
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Robin: Welcome, Jeff.
Jeff: Hi, how are you? Good afternoon.
Robin: Well, I’m just fine. Thank you so much for taking a few minutes to chat with me today. I know we’re interrupting a very busy workday, so I’m gonna get right to the point here. Prior to the onset of the global health crisis, I think it’s fair to say that hospitality and tourism sectors were booming in many markets. How would you say the ongoing situation has impacted the hotel sector lending market?
Jeff: I think there’s two separate questions there because I think the lending markets are a much different place today than they were, I’ll say pre-COVID and slowly after COVID or post-COVID. And then the difference of how would hospitality fundamentals booming from an operations perspective in many markets. So, maybe if we separate those two out because I think they’re fundamentally different.
And I think the biggest difference today is, pre-COVID, the hospitality market from a fundamentals perspective, many markets were in sort of a stabilized setting, so other markets were booming, but I would say for the most part we were in the 11th inning of a 9-inning game from a run rate perspective, and then COVID came and COVID shut everything down, and everybody questioned when hospitality would start coming back and booming again. And COVID sort of dissipated. And what we’ve seen is we’ve seen fundamentals in the hospitality industry, especially in resorts and drive-to markets and I’ll say the leisure segment came back better, bigger than anybody would’ve ever imagined.
And that was a big, eye-pop for many people. And then the question became will group come back and will business travel come back, and you know, we’ve seen group come back, roaring back quickly as well. And I think it’s to the surprise of everybody how quickly the lodging industry rebound. The interesting thing, and this has really nothing to do with the pandemic where… Or maybe it does, is the inflationary environment right now, what the fed’s doing to raise interest rates. It’s the first time and I think in my career where we’ve seen hospitality fundamentals going in one direction so strong and capital markets in the debt markets going in the opposite direction.
And there’s a real disconnect there because the risk measured by, I’ll say the debt markets traditionally for real estate would take into consideration fundamentals. Well, the disconnect is there’s zero measure between the two. So, the answer to the question is the debt markets are impacting the lodging markets, the lodging markets and fundamentals are actually very strong and stronger than one would’ve thought coming out of COVID as quickly as they rebounded.
Robin: Well, I think you’re making an excellent point and, you know, I was doing the research in preparation for our discussion and they were talking about there being before COVID, a supply and demand imbalance and how they thought that COVID was gonna more or less right the boat and that things would sort of normalize. But that’s not really the situation that you’re describing to me. Where are we at with this?
Jeff: Well, when you’re talking about the supply and demand balance or you’re talking about the supply of new hotel rooms coming into markets relative to the demand for new hotel rooms or you’re talking about the occupancy rates in markets because those are two different things. So, we’re talking about occupancy from a fundamentals perspective. I mean occupancies have come back in many of these markets. I don’t think we have an occupancy issue at the moment. I think we have a rate integrity issue of building back rate in a lot of these markets.
But when you’re talking about what really concerns the hospitality industry, when you mention the word “supply” is the number of new rooms that are getting built. And so, pre-COVID would’ve seen a little bit of imbalance because we were seeing some supply creeping into markets and that was impacting lodging fundamentals pre-COVID, and there was a lot of concerns about the new supply of hotel rooms.
COVID stopped everything in its tracks. So, the question becomes what happens post-COVID to supply. And I think you can turn back to question number one, with the cost of debt right now and the ability to access cheap financing, the ability to start new construction is gonna be quelled. That’s a good thing for the hospitality industry from a supply-demand perspective with rooms. Nobody likes to hear that there’s new supply coming on because that tapers fundamentals and performance. So I think the one good thing about the lending markets is that I think it will help mute the supply concerns that we would normally see in a booming market where fundamentals are saying, “Hey, if things are so good, why don’t we build more hotel rooms?”
Robin: No, I imagine that you’re speaking from a North American perspective essentially, today. When I look at what’s going on around the world, there are some resort areas where they’re putting things up for sale and they’re only partially constructed. And there are other markets where it’s a classic historic hotel and they’re trying for basically years to find a buyer. So, I know that this situation, there’s quite a bit of disparity from one region to the next, but what would you say is the outlook, I’m gonna ask you, for North America?
Jeff: I think the outlook for North America right now is, again, are we talking about lodging fundamentals or the ability to consummate a transaction for a sale? I think we gotta be careful because if we’re talking about sales of hotels versus what markets are improving around the globe, I’d like to differentiate that because otherwise, it’ll be… I may go off on a tangent here.
Robin: I think I’m gonna let you answer both of those because we have a global listening audience, so I think they’d, like, be interested in your perspective on both questions.
Jeff: I think the transactions market is vibrant. There’s a lot of capital that was raised worldwide and globally to buy real estate. I think a lot of that capital was raised with the intent of buying distressed during COVID. That distress and that blood in the water never came. That capital’s been sitting on the sidelines waiting to be deployed. I think that capital is looking at opportunities all around the globe.
And so, I’ll take North America for an example. Yeah, it’s been a robust transactions market. I think all our eyes right now are on debt. We’re feeling the effects of it here in North America. I think the rising interest rate will bleed into the European markets and the Asian markets. I think the ability to play the currency game from offshore capital to the US, it may be favorable. I think the biggest question is inflation, hotels are a great asset class to buy in inflationary times.
And so will we see more money pour in because of inflation and the ability to reset rates every night? Potentially. The question is can you buy these hotels and make any money in the near term when you’re buying hotels at 5 and 6 caps, and you’re borrowing at 8%? You got negative leverage going in. And the big question is, how long are you gonna have negative leverage until you turn that positive? I think that’s gonna be the story both in North America domestically and around the world as this, I’ll say economic crisis impact up-bleeds globally.
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Robin: So, when you’re talking about a situation in which you’re negatively impacted by the cost of borrowing, what kind of a debt structure makes sense?
Jeff: It’s not even a debt structure, just, it’s what you can borrow. It’s the cost of capital right now. It doesn’t matter if you put 55%, most people wanna put 60% to 65% debt on an acquisition. It’s all a matter of the cost of the borrow. I mean, pre-COVID and even during COVID, we were borrowing it all in coupons of let’s call it 4% money, 4.5% money, all in coupon. Today that cost to capital is 7.5% to 8%. So, if you buy an asset that’s only yielding 5 or 6 and your cost of borrowing is 8, you are negative 3 going in the gate. So, it makes it much more difficult to constantly hotel transactions.
Robin: So, would you say then that the business plan for how you’re going to use this property in the first three years is really going to become even more important than it would’ve been before?
Jeff: Well, it’s business plan becomes… I mean, if you’re buying a cash-flow property, business plan is pretty much already set and running. The question is, are there value add opportunities to do to the property that can generate more cash flow in the near term to generate more positive yield on the property? It’s all about cash flow, it’s about pricing the deal where you can buy it and having positive leverage.
Robin: You were talking earlier about the cost of new construction. How would you say all of the supply chain issues, that a lot of different areas of the hospitality industry were experiencing, impacts the cost of acquisition and the ability to assess whether or not this is a good deal?
Jeff: Well, can you say a construction? So, I think construction versus acquisition, but we could talk about acquisition when it comes to CapEx, but we’re seeing construction costs and related costs for capital expenses on hotels from the supply chain. And then you tack on inflation, 20% to 25% increases in the cost to do anything in a hotel today. That’s labor costs, materials, and supply costs. So, it has an impact on your ability to build new hotels, but again, it has an ability on how you’re pricing hotels that are gonna require refurbishment or renovation.
Robin: Fair enough. Let’s talk about ESG. And from your perspective, and I’ve asked a bunch of different people in the hospitality industry what they think of this. What’s the long-term impact of ESG on capital markets when it comes to hospitality and hotel industry?
Jeff: Well, I think ESG is a global issue. The hospitality industry is a global industry. It spans all borders and all markets and, you know, look, ESG is a top radar concern for all companies. You know, it’s a forward-thinking model, which I think is great that everybody’s focused on, but it requires certain new compliances and checking boxes and making sure that companies are doing the right thing because everybody’s interconnected. So if you’re raising capital, you have to have an ESG program. If you’re deploying capital, you have to have an ESG program. If you’re vying for those dollars in competition with those, you have to have an ESG program. So, it’s all interconnected and it’s top of mind for all companies and corporations. We’re seeing it every day in the industry.
Robin: Look in the crystal ball for me. What’s your outlook for 2023? Where is all of this going?
Jeff: We’re gonna see a lot of distress in the hospitality industry, unfortunately. I think it’ll be a huge buying opportunity for those that are looking to deploy capital. I think we’ll see that second half of 2023. It’s inevitable. If hotels are still recovering in certain markets and cash flows are still recovering, and the cost of your debt on a floating rate basis is gone up by, you know, three, three and a half percent, hotels are gonna have trouble meeting their debt service obligations.
You’re gonna have hotels that are gonna break through debt service coverage ratio covenants. You’re gonna have hotels that have refinancing issues as they look at maturity events through the second half of next year. That’s gonna create a huge opportunity for capital, both from a preferred equity and rescue capital perspective, but from an opportunity to buy hotels, the values, and I’ll say buying opportunities they were looking for during COVID.
I think that’s where we’re headed, unfortunately. I think the resort markets will continue to do well from a sustainability of cash flow perspective. I think group and conference sectors will be the darling child of 2023. We all want to be out meetings, conferences, we wanna do it much more frequently. We want to be out socially. And so that’s gonna be the sector to keep your eye on. And I do believe, I’ve said this all through sort of the end of COVID, keep your eye on business travel because it’s coming back quicker than people think. And in harder times when your boss says it’s time to come back into the office, if you want to keep your job, you’re coming back to the office to keep your job.
Robin: Yeah, I have to agree. Business travel people in some markets, they’re dying to get out of the house and in others it’s, you know, I’ll travel if I must. If you are a hotelier listening to this podcast and you know that debt obligation is gonna be a real problem for you coming into 2023, what would be your key piece of advice for these guys?
Jeff: I think it’s how do you squeeze as much juice out of the same lemon and get as much cash flow outta your property managed costs effectively. I mean, look, it’s not a lot outta your control. If you have floating rate debt in your property and the Fed rates keeps raising interest rates, the cost of your money is going up. So the only thing to combat the cost of your expenses is to generate more top-line revenues and make sure we’ve got more cash coming to the bottom line to service that debt. So that means proper top-line management, revenue management, yield management opportunities, but also being cost minded and cost-effective in managing the hotels. Every nickel matters.
Robin: Absolutely. Jeff, I wanna thank you so much for your time today. You’ve been listening to the “Innovative Hotelier Podcast,” brought to you by HOTELS magazine. Join us again soon for more insights and information specifically for the hotel and hospitality industry.
You’ve been listening to the “Innovative Hotelier Podcast” by HOTELS magazine. Join us again soon for more conversations with hospitality industry thought leaders.