|by Rich Warnick - 1999
If Hamlet were a contemporary tale about a hotel investor, his famous
soliloquy might look something like this:
It was starting to look easy in the mid-1990s. Sellers were making money, even if leaving something on the table. Buyers were paying aggressive prices but continued to enjoy a surprising degree of upside. But as we progressed into 1997, many began to question how long it would be before the bubble burst. In August 1998, we found out.
While the prior two years had seen capital flowing into the industry at unprecedented rates, several inter-related factors combined in late summer of 1998 to create a capital crisis that severely altered industry dynamics.
Of course, sellers didn't exactly see things the same way. Tell an owner that the $80,000 per room price he was negotiating in July would now have to be $62,000, and he quickly turned from a seller to a holder.
The net effect of this change in the market was a "re-pricing" of the industry on virtually a national scale. While values have hit bottom and are inching back up, they will not reach the early 1998 peak any time soon. There are three reasons:
The Affect of Lodging Industry Cyclicality on Transaction Decisions
When it comes to deciding whether the time is right to buy or sell, an understanding of industry cyclicality can provide important insight. However, for the purpose of understanding values, cyclicality cannot be looked at in the traditional sense.
From a traditional perspective, cycles have been measured in terms of occupancy or RevPAR. These indices are driven by the interaction of the demand for lodging accommodations and the supply of hotel rooms. However, while occupancy is a good indicator of the relationship between supply and demand, it is not a good indicator of cyclical value. For instance, consider the peak and trough of the last cycle. According to Smith Travel Research (STR), occupancy peaked in 1979 at 71.9% and then proceeded to fall in each consecutive year to a low of 61.9% by 1987. However, due initially to convoluted U.S. tax policy and, later, to a flood of international capital (especially from the Mid-East and Japan), hotel values didn't peak until the late 1980's, when occupancy was near the low point in the cycle. More recently, occupancy peaked in 1995 at 65.1%; yet, thanks largely to a surge of capital from Wall Street, values didn't peak until the first half of 1998.
The following discussion deals with phases in relation to values rather than industry performance per se. It is based on the premise that values reflect investor attitudes, capital flows and momentum. These factors are influenced by, but are not directly tied to, industry performance. Furthermore, the affects of the cycle may be amplified (positively or negatively) by macro economic events. The purpose of the phase descriptions below is to give the reader a set of benchmark characteristics to look for in order to understand where the market is in terms of cyclical values.
The six value phases addressed are:
Value Late Growth Phase: Increasing investor interest (i.e.,
more buyers) drives down equity yields. This, along with readily
available debt, translates into lower cap rates and higher prices.
Interest in acquiring hotels grows as prices approach replacement cost,
development activity accelerates. The availability of development
capital progressively increases throughout this phase and new projects
are aggressively pursued. Chain development activity is intense, as brands
seek to increase distribution and market share. Debt becomes increasingly
easy to obtain and equity yield requirements continue to decline.
As new supply comes on line, occupancies begin to decline. This phase
is typically marked by a significant change in investors: private, high-yield
equity is replaced by intermediated (third party) capital; that is, "other
peoples money." Many hotels purchased in the trough and resurgent
phases are resold.
Value Decline Phase: The decline phase is marked by a loss of investor confidence. It is generally accompanied by declining performance indicators, although that was not true across all segments during the most recent downturn (RevPAR and profitability in the upscale and luxury segments were not only increasing, but are projected to continue to do so). The decline phase seems to be caused by a combination of factors, which the author believes are not predictable. Moreover, the speed at which investors lose confidence in the industry seems to vary depending on the sources of capital at the time .
Once the decline phase has commenced, industry performance plays a much greater role in determining its severity and duration. While economic cycles have a direct impact on performance (demand is closely correlated with GDP), over-supply has been the primary cause of deteriorating industry performance. Therefore, the severity and length of the decline phase will depend largely on the degree to which the industry was allowed to overbuild in prior phases.
The decline phase will almost always be accompanied by falling occupancy because properties financed in prior phases are continuing to enter the market faster than the rate of demand growth. Depending on the severity of the downturn, ADRs may decline, flatten or increase at less than the rate of inflation. At some point in the decline phase, RevPAR will likely fall, and that will almost always result in decreasing cash flow.
Debt financing generally continues to be available in the early part
of the decline phase. However, as markets deteriorate, it becomes
more difficult to obtain debt, or it is offered under more stringent underwriting
criteria. Since low yield equity sources have fled the market, equity
is typically only available from very sophisticated, high-yield sources
with a longer-term investment horizon. These higher return requirements
increase cap rates. That, in combination with decreasing cash flows,
causes the market value of hotels to decline. Transaction activity
typically slows in the early part of the decline phase, as sellers have
not yet adjusted to the reality of declining values. Distressed sales
will accelerate transaction activity in the latter part of this phase.
Making the Knowledge Work
As everyone knows, buy low, sell high is a standard governing all traded investments. However, since no one can accurately predict the bottom of the trough or the top of the peak, other than by luck, how does one time the acquisition or disposition of an asset on a cyclical basis? While it will not derive the lowest buy price, the best time to buy a hotel - balancing risk and reward - is in the resurgent phase (assuming availability of reasonably priced capital). As previously stated, this phase is marked by an extended period of little or no new supply, increasing demand, and prices which are well below replacement cost.
Conversely, the best time to sell is in the latter part of the
growth phase (assuming, of course, one's basis affords a profit at such
a time). This period is generally marked by acquirers paying prices
which approach replacement cost, a shift in equity capital from private
to third party, and substantial increases in new construction financing
by institutional lenders (especially commercial banks). In fact,
a relaxation in commercial lender underwriting standards is one of the
best indicators that it may be time to get out .
Macro Markets - Micro Decisions
One of the most significant changes in the hotel industry in the past several years is the amount and speed of available information. Industry pundits and Wall Street analysts abound. There is a major conference every month and published data (print, fax and Internet) overwhelm us. With all this information, and with Wall Street controlling such a large part of the industry, many would think that lodging would begin to act like an "efficient market" . . . if it were not for one not-so-minor point. Real estate (hotels included) is a local business.
The fact that occupancies are falling does not speak to whether someone would be happy to own a hotel in Manhattan right now. Even within a given locale, individual segments and sub-markets behave differently. A 60% occupancy sub-market with a variety of brands and hotels of varying age and condition will likely have properties which run 75% and properties which run 45%. Averages are misleading; as one of my ISHC colleagues is fond of saying, “a man can drown in a lake with an average depth of one inch”.
The simple fact is, industry generalizations (including my own written above) must be balanced with local market realities. My hometown, Phoenix, Arizona, is a good case in point. In the wake of thousands of new limited-service hotel rooms, overall market occupancy declined substantially. Industry experts bashed the city as one of the most overbuilt in the country causing lenders to redline the market. Indeed, most budget, economy and mid-priced hotels will struggle in the next two years; yet, there are few informed investors who would not be happy to own a luxury resort in this market.
Wrapping Up - A Seller's Perspective
When it comes to understanding why owners miss the window of opportunity for a sale, we find that more often than not, it is not lack of expertise or greed, but rather, carelessness. Monitoring the real estate cycle in dynamic markets takes a lot of work because many factors must be evaluated on a continuing basis; these include:
The situation is not as dire for upscale and luxury hotel owners. While we do not believe pricing will return to the peak of early 1998 at any time soon, the severity of the fall in prices has already started to abate. Commercial mortgage-backed securities will likely be a viable outlet for financing by mid to late 1999 and bank credit facilities are exhibiting slightly more relaxed underwriting criteria. The last half of 1999 through the first half of 2000 bears close monitoring. It may be the best chance to exit before new full-service supply begins to impact the market. The key will be to get out before cap rates rise in anticipation of this new wave of supply.
Wrapping Up - A Buyer's Perspective
There is reason for buyers to exercise extreme caution at this time. Unless sellers do something dumb, it is too early to buy most budget, economy or mid-priced hotels (we are one to three years away from the kind of stress that will result in bargain prices (trough and/or resurgent phases) and four to six years from the period when acquired properties could be resold for a profit (late growth phase). Indeed, with a real possibility of significant new full-service supply in the coming years, this may be an optimistic assessment.
The potential for acquiring upscale/luxury properties is highly dependent
on the answers to the following questions.
In conclusion, I would like to leave the reader with the following thoughts.
|Also See:||Arizona Lodging Insights Year End 1998 / Warnick & Co. / March 1999|
|Arizona Lodging Insights / 1st Qtr 1998 / Warnick & Co. / July 1998|