News for the Hospitality Executive
Lodging Investment Roadmap - a National Perspective
on the hospitality investment market
What will be the level of investment activity for the balance of 2009 and 2010?
For the remainder of 2009, we anticipate a modest level of investment/transaction activity.
Most acquisition opportunities coming to market during the balance of 2009 will mainly consist of distressed assets or hotels becoming available as a result of foreclosure action. However, it should be noted that lenders have not been quick to put properties on the market once they take control of an asset.
Opportunity funds and investors who have been patient are beginning to test the waters, but the lack of sellers and attractive deals have been limiting factors in transaction activity. Compounding the situation is the significant gap that continues to exist between buyer and seller (mainly lenders') pricing expectations.
Lenders are only now - slowly and cautiously - showing some interest in putting money back into hospitality properties, and Wall Street lodging analysts are finally forecasting an improving outlook for the hotel sector. This will eventually create interest in, and an appetite for, hotel product. We at The Plasencia Group expect transaction levels to pick up considerably starting in mid-2010.
Lenders have been reticent to foreclose and moreover the transactions expected to take place during the first half of 2010 will likely involve discounted note sales. But as more and more owners face operational pressures, debt service challenges, and maturing loans, many will be forced to consider handing the keys back to the lender. This will result in the first wave of hotel sales by lenders.
Several successful corporate bond sales have recently been completed - a sign of confidence in the public markets that had previously been missing. Furthermore, as the financial picture becomes clearer during 2010, more debt sources for hotels will become available, resulting in an increase in transaction volume, likely during the latter portion of the year.
What is happening to values and capitalization rates?
In some cases, short-term capitalization rates have increased to double-digit levels for both fulland select- service hotels, where they will remain for at least six to 12 months. This is primarily due to the distressed nature of the assets along with significant capital requirement that were needed. However, as more debt comes into the market (at higher loan-to-value ratios) and more non-distressed properties begin to appear, cap rates will drop. Also, as demand recovers and net operating income begins to "normalize" following this period of uncertainty, values will also become easier to predict thereby giving lenders greater confidence in underwriting.
It is important to note that market sentiment with respect to hotel acquisition underwriting appears to be moving away from valuations based on capitalization rates and more in favor of traditional net present value (NPV) or discounted cash flow (DCF) models. Discount rates used in these approaches to valuation have increased between 300 and 500 basis points since the peak of valuations in late 2006 and early 2007. Additionally, the debt service coverage ratio (DSCR) stress test has been brought to the forefront of underwriting, something that appeared to have been lost in the last leg of the most recent up-cycle.
Pricing discussions also suggest a reticence to value properties using long-term forward projections. As a result, most investors are utilizing a combination of trailing 12 months, 2009 and 2010 forecasts, as well some forward proforma credit. Combined with the risk-adjusted return premium that is once again required for hotels, cap rates for upper-upscale product would result in increases of 200 to 300 basis points over 2006 and 2007 levels.
With certain assets having only limited opportunity to reduce operating expenses at any appreciable level, net operating incomes have likely dropped anywhere from 30% to 50% on most upper-upscale assets. There are good signs, however, that larger group business will return in 2011/2012 and begin the upward trend. In fact, we have noticed that pace in 2011 and 2012 for many properties with traditionally strong group accounts is picking up.
Opportunity funds and others with deep pockets will likely look at the inherent value of the underlying real estate as opposed to a cap rate valuation analysis to underwrite deals. Because traditional buyers typically rely mainly on cap rates as their valuation technique, we expect that such investors will be on the sidelines until industry-wide NOI margins recover, which is not likely to occur before 2011.
Who will be the primary buyers and sellers?
The early major sellers will likely be lenders and financial institutions ridding themselves of their real estate-owned (REO) portfolios or those that have acquired assets through a foreclosure process or note purchase. Many of these sellers are faced with redemption requests from their fund investors and are now needing to sell assets in order to satisfy such requests. Buyers of note pools will also be looking to liquidate certain non-strategic assets.
Buyers, on the other hand, will be plentiful, just as they have been in the past when opportunities present themselves. The majority of buyers, in the near-term, will have defined return parameters and available equity, which will allow them to purchase assets on an all-cash basis.
Public REITs that have recently executed new public offerings for the first time in a long time have the ability to acquire hotel assets. In many cases, their cost of capital is more favorable than that of equity funds. Yet, there are also a number of private equity funds and other patient real estate players who have been quietly waiting to acquire foreclosed hotels from lenders. All of these groups will be the initial buyers, but they will be quickly followed by more traditional owners who have kept their leverage low and their powder dry. Many other owners will try to stick it out, hoping for an upturn, and methodically working with their lenders to pay down debt, restructure and extend their loans.
Buyers who are active over the next 18 months will be forced to be low-leverage investors (those who are comfortable with lower loan-to-value ratios on acquisitions), REITs and opportunistic funds that are new to the hotel space. There are numerous hotel funds active in the market today poised to quickly employ their acquisition capital to purchase hard assets and hotel debt, mainly in larger cities or gateway markets. In secondary markets, local groups or private, highnet- worth investors are likely to emerge as the prominent buyers. Due to the paucity of traditional or sophisticated buyers in secondary and tertiary markets, we expect that pricing in those markets will be at discounts with "carry-back" financing and other lender-generated bridge financing in order to consummate deals.
What types of assets will be sold?
We expect to see asset sales across the entire spectrum of hotel product
offerings. "Leverage did not discriminate" during this last up-leg of the
cycle. As a result, we will see economy hotels being as financially stressed
as the five-star coastal resort. Many of these properties will be given
back to the lender and later sold. As previously stated, there will likely
be very few nondistressed
Assets which are likely to be acquired are those in primary markets which, due to supply or leverage issues, are near foreclosure. Facing foreclosure, the mortgagor will likely try and seek a discount of the note or move to an outside sale. As an alternative, we expect many strategic buyers to purchase mortgages from select lenders with the eventual expectation of forcing a foreclosure. In this instance, only sophisticated investment groups with ready capital will be the key players in this "loan to own" arena.
If, over the next several quarters, lenders continue their willingness to restructure or extend existing loans, most hotel assets put on the for-sale market will come from institutional owners. As such, the success of execution will come from the high quality assets in the strongest markets. The basics of good underwriting such as looking for barriers to entry, multiple demand generators and brand contribution, will be the main focus. Full-service, upper-upscale brands with a historically dominant market position will be highly desired. Seller financing will significantly facilitate a transaction as will flexibility with management and franchise opportunities.
On the other hand, resort and luxury segments are those now in the most trouble and appear to have the longest turnaround in this cycle. While certain investors are poised to take advantage of truly "distressed" situations, many banks, CMBS servicers and other lenders are moving slowly in taking back these assets. More than likely, the existing owner of these high end assets may be sending the keys back in the mail, especially if cash flows are insufficient to cover payroll.
What are the tell-tale factors that will signal an upturn in the market?
Historically, the hotel industry leads an economic cycle in the downturn while it lags the cycle in the recovery, and this time is no different. As a laggard, it must obviously wait for a recovery in the economy, including stabilized unemployment on a regional and national level, modest GDP growth, and the return of business travel.
Improved group bookings at hotels will also signal that better days are ahead for the economy and the industry. Group demand has always been a critical factor in the full-service arena and forward bookings (actual signed contracts) will be a strong indicator, especially in the relatively seasonal markets. In addition, new capital spending on delayed improvements or renovations, postponed by the current owner or the result of a structured debt transaction, will also signal a return of confidence. The Plasencia Group is already seeing signs of increased group booking pace, albeit at moderate levels.
From a transaction perspective, the availability of debt for acquisitions will be a key indicator. As of this writing, we are aware of a number of major balance sheet lenders who have reentered the hotel lending arena, although more stringent underwriting criteria and lending parameters have been put in place. From an operations perspective, RevPAR is expected to grow in 2011 -- the first time in two years. Many in the hotel sector may even become believers once again at some point in mid-2010, as RevPAR declines lessen.
What about M&A activity?
Industry consolidation has typically followed economic downturns. However, until the credit markets loosen up, we would expect limited mergers and acquisitions in the near term. Nevertheless, once credit becomes more readily available, there are several hotel groups in the public and private sector that will require strategic capital infusions and/or a merger to stay solvent. We expect to see some of the smaller hotel REITs merge with other REITs, or they may themselves privatize by initially purchasing their own stock at the current relatively depressed stock prices.
Where should investors in the lodging industry focus?
All focus at the current time should be on the debt markets. Once debt becomes available in meaningful amounts, there will be a significant number of distressed assets available for acquisition. However, investors should be prepared for lower LTVs and full-recourse debt. Investors looking at the distressed debt market as a strategy to source opportunities should consider:
Owners should do everything in their power to hang on and get through 2010. Hotel demand will eventually return to some sense of normalcy, although average daily rates (ADRs) will certainly take a bit longer. In the meantime, owners should continue to improve operating margins and, if in distress, negotiate in advance with their lenders to forestall any possible foreclosure. Investors may need to be patient for a bit longer, waiting for the right distressed deal to come along - and they undoubtedly will. Those investors will need to be nimble and ready to move quickly. More important, our experience tells us that those with equity in hand will pick up the best deals. After months and months of delays, it is likely that distressed sellers will be more apt to take deals that can speed up the disposition/liquidation process.
Investors should focus on assets in traditionally strong locations, especially those with upside potential via a renovation or flag change. A property that is less than 15 years old should also be a prime candidate. Economic recovery will turn those properties into winners. We also believe that select-service hotels are better opportunities than full-service assets in those select locations that cater mainly to the business traveler.
Full- and select-service hotels in many of the major markets will perform well, assuming appropriate acquisition pricing, and should have an exit strategy that achieves aggressive investment return hurdles. From a timing standpoint, acquisitions after mid-2010 may afford the best opportunity for attractive pricing and a relatively short-term market recovery.
What is the single most important factor having the greatest impact on the lodging sector in 2010?
Without a doubt, the availability of reasonable debt will have a substantial bearing on the lodging sector in 2010. If debt becomes available in greater amounts, transactions will be fast and furious. Until this occurs however, transaction volume will be limited and property capital expenditures will continue to be delayed, further exacerbating the already weakened sector conditions.
The state of the overall economy has always had the most direct effect on the hotel industry. GDP was down approximately 3% in 2009 but is expected to increase to 2.8% in 2010, a net 5.8% move to the positive. However, the hotel sector typically lags GDP performance by two to three quarters. Nevertheless, the industry should begin to see meaningful signs of recovery in the second half of 2010 as hotels experience less attrition in group bookings and a pick-up in transient (corporate and leisure) business.