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Immutable
Laws of Lodging Investment
By Richard Warnick, President,
Warnick + Company June 2010 As the
industry continues its
slow climb out of the Great Recession, investors are either licking
their chops
or licking their wounds. While many
investors will blame the sheer magnitude of this downturn for the
economic
devastation that occurred in the lodging sector, it is undeniable that
much of
the hardship was caused by – or at least exacerbated by – questionable
investment
decisions before the recession started.
It is equally undeniable that all those mistakes will be
repeated in the
future for a variety of reasons, not the least of which is a conscious
– or subconscious
– amnesia. As a veteran
of six economic
cycles of varying severity, I can say with conviction that, for those
who do
not want to repeat past mistakes (or for those new to the game who do
not wish
to make them in the first place), there are repetitive patterns that
are not
only clearly observable, but definitively predictive.
I have distilled them into 13 distinct observations
that are so incontrovertible that I refer to them as the immutable laws of lodging
investment. Heeding them
may not totally prevent
financial hardship in the lodging sector – especially in an era where
unexpected events like 9-11 can suddenly and radically disrupt normal
cycles…..nor
will it completely insulate investors from downturns as severe as what
we just
experienced. They should, however,
dramatically
reduce the likelihood of problems and mitigate adverse impacts if/when
they
occur. The
immutable laws of lodging investment, in no particular order, are….. 1.
With few exceptions, hotels are not an appropriate asset
class for a
long-term hold… because the
lodging business
(i) is highly cyclical, (ii) has high operating leverage (rapidly
eroding
profit during cyclical lows), (iii) is vulnerable to uncontrollable and
unpredictable external events (e.g., terrorist attacks, epidemics, oil
spills),
and (iv) is subject to extreme irrationality by those who control
pricing
decisions. So, the highest yields will
accrue to industry-savvy cyclical traders. 2. Never
fall in love with real estate. It is all too
easy for irrationality to
quietly creep into decision-making when one becomes too attached to the
allure
of a particular site, building, concept, or opportunity.
Emotional attachment has undone more
investors than affairs of the heart have undone politicians. 3. Location is
and always will be the most important criteria in differentiating real
estate –
and hotels are no exception. This law applies at both the macro/destination
level (e.g., airlift, demand base, local economy, labor market, etc.)
and the
micro level (access, visibility, surrounding uses, barriers to entry,
etc.). Market compression is no
substitute for location…..a lesson learned episodically when markets go
through
their inevitable declines. 4. Leave some
chips on the table. No one is smart enough to know when the
bottom or the top will occur. Those who
catch it just right are simply lucky.
You do not need to be a first mover during cyclical lows
to buy at a
good price – and there are plenty of signs to indicate when the sector
is
“nearing” the top (i.e., still time to exit). 5. Do not
equate luck with skill or intellect. Many lodging
industry investors, who made
money because they hit a cycle right, have gone on to lose it because
they could
not distinguish their good fortune from their ability. 6. Easy credit is
a leading indicator that the top is approaching. Because
lenders generally rely on the false security of well established
trends, one of
the first signs that the market is becoming risky is when lenders deem
it to be
safe (high leverage, easy terms, and narrow spreads).
Easy (easier) availability of construction
financing is an even brighter beacon because that spigot generally
opens at
about the time it should be closing. When
hotel debt becomes easy and plentiful, it may not yet be time
to run for
the exits – but the hairs on the back of your neck should be tingling. 7. If you can’t build a hotel so as to open in the initial stages of a growth cycle, you probably shouldn’t build it at all. In most instances, the only guaranteed winners of late-cycle new construction – especially for upscale and luxury full-service hotels and resorts – are developers using other people’s money, brands bent on growth, and (somewhere in the future) the second or third owner. This may be the most difficult of the laws to adhere to because it requires financing to be obtained at the time when most construction lenders are loathe to provide it (and, ironically, the only time in the cycle that they should). 8. Cap rates
should be viewed as a derivative of rather than an indicator of value. Viewed
in the context of real estate cycles, cap rates are the inverse of what
they
should be. That is, they are at their
lowest when the cycle is near the top, net operating income is peaking,
and
there is no place to go but down. They
are at their highest when the market has hit bottom, net operating
income is at
its lowest point, and the future holds the most opportunity for growth. 9. There will always
be a replacement source of irrational capital. Every
cycle manages to attract a source of capital that will over-value
assets as the
cycle matures. Indeed, these are the
buyers every cyclical investor prays for.
The trick is to take advantage of them – not become one of
them. 10. Leverage
over 65% loan-to-value is a high-risk strategy for hotels. The degree to
which a borrower chooses to lever lodging assets in excess of this
level is
inversely proportional to (i) the number of cycles the borrower has
experienced,
(ii) the amount of the borrower’s “own” money in the deal (versus other
people’s money), and (iii) the
borrower’s propensity to avoid risk. Even
experienced cyclical investors can be impacted by excess leverage
because of
event-related downturns that are entirely unpredictable. Indeed,
the only “safe” way to over-leverage
is to go all the way (i.e., little or no equity and non-recourse
financing) –
assuming the borrower won’t mind if the lender ends up owning the asset. 11. Understand
the nature of various industry participants and diligently observe
their
behavior.
It is easy to get swept up in excessive
exuberance, especially when the entire market seems to be moving in the
same
direction. But most industry participants
are self-serving entities that are unwittingly or intentionally stoking
the
cyclical flames. After all, developers
need
to develop, managers/brands need to grow, lenders need to lend, brokers
need
transactions, etc., etc. These (and
others like them) are the least reliable indicators of cyclical
downturns. The entities to pay closest
attention to are
industry-savvy agnostics – that is, those who are knowledgeable of the
business
and indifferent to advancing any agenda other than optimizing returns. They most likely have a strategy – and the
discipline to stick with it. 12. The degree
to which pricing is rational is inversely proportional to the amount and
cost of capital in the system. This phenomenon is clearly observable in the
market today as asset prices are unjustifiably high in comparison to
industry
performance and market uncertainty. Although
asset pricing has been exacerbated by
a dearth of available product (basic supply and demand), the central
cause is
plentiful low cost capital, particularly from the public markets. 13. The first
sign that a down market is about to turn positive is when the vast
majority of
industry participants have joined in its funeral dirge. Looking back on
this latest cycle, for example, it was early in the fourth quarter of
2009 when
Chopin’s Op.35, no.2 became the background soundtrack for nearly every
conversation about the lodging industry.
Thus the bottom in terms of asset values is already behind
us. Most investors, however, should take
comfort
from Law Number 4, because the only entities who can
(read should) take
advantage of the lowest cyclical pricing are those who can afford to
guess
wrong. |
Contact: Richard Warnick Warnick + Company 602-955-9393 [email protected] |
Also See: |
On
the Rocks - Observations on How the Economic Meltdown Will Affect Hotel
Management Contracts / Richard Warnick / March 2010 |