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Timing the Sale or Acquisition of Hotels in 
Today's Volatile Market
 
by Rich Warnick - 1999

If Hamlet were a contemporary tale about a hotel investor, his famous soliloquy might look something like this:
 

To buy, or not to buy: that is the question:
Whether 't is nobler to take a fling at risk
and make an outrageous fortune,
or to take alms because the sea of troubles
of that risk took my savings and ended them?

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. 

  • Instability in world financial markets changed how investors viewed risk  ("flight to safety").
  • A market correction on Wall Street, which was particularly hard on lodging stocks, made previously free flowing capital disappear overnight.
  • A severe overhang in the amount of unsold commercial mortgage-backed securities (a principal source of capital for debt providers) shut off access to another prime source of public market capital.
  • Falling occupancy, predictions of declining RevPAR growth and fears of overbuilding dampened investor expectations of future industry performance.
  • At the same time, investors were feeling anxious about the durability of the U.S. economy.
Among the other effects of this capital crisis, transaction activity virtually ground to a halt in the fourth quarter of 1998.  Sellers who were accustomed to waiting lines at the title company found fewer buyers with access to the capital necessary to complete transactions.  Lenders pulled financing commitments or changed the terms, and public companies found themselves short of equity capital.  Perhaps more importantly, the "psychology" of the market changed.  With values falling, even buyers with capital were unwilling to commit to acquisitions that might be losing value.  One hotel REIT executive told me in early October that they couldn't risk buying a hotel now when it might be worth a lot less in two months.  This was a self-fulfilling prophesy - with fewer and fewer buyers, perceived values fell 20 to 30 percent from their pre-August 1998 highs. 

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:

    1. Because of oversupply, occupancy is continuing to decline.  Cap rates will be higher reflecting the buyers’ belief that profitability will not grow as fast and, in some situations, may decline. 
    2. There are, and in the near term, will continue to be, fewer buyers.
    3. The cost of capital has increased.  Even though lower interest rate indices have largely off-set the increased spreads  charged by lenders, two other factors have raised the weighted cost of capital , which is a proxy for cap rates.  First, when markets become riskier (as they are now perceived to be), equity capital demands higher returns.  Second, lenders have increased the amount of equity required (also in response to higher perceived risk). 
Depending on one’s point of view, the occurrences of late summer 1998 are very good or very bad.  Publicly-traded hotel stocks, developers of full-service hotels and sellers are clearly the big losers.  The winners are owners of existing upscale, full-service hotels and resorts, who are no longer threatened by the near-term entry of new supply.

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: 

  • Early Growth, 
  • Late Growth, 
  • Peak, Decline, 
  • Trough 
  • and Resurgent.
Value Early Growth Phase:  During the early growth phase, hotel occupancy rates increase, as do average daily room rates (at times, above the rate of inflation).  Because hotels are a high operating leverage business (high fixed cost as a percentage of total costs), cash flows increase at a disproportionate rate.  The performance outlook is good and investors with a lower risk tolerance begin to enter the market.  During this phase, hotels trade at easily discernable discounts to replacement cost.  Numerous new projects enter the development phase and some are financed, albeit conservatively. 

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 Peak Phase:  During the peak phase, occupancy is in a more serious state of decline  because of growth in new supply, and there is likely to be a great deal of unrealized supply financed and/or under construction.  This phase is usually marked by warnings from industry pundits of troubles ahead.  Since, at this stage in the cycle, most of the capital is from third party sources and, since those driving and/or influencing transactions have little to lose (its not their money) and much to gain (fees), the admonitions are largely ignored.  By this time, commercial lenders have "jumped on the band wagon" and are eager to place debt.  Ironically, this is the riskiest part of the cycle; yet debt and equity are widely available and relatively inexpensive.  New construction starts are prevalent.  In recent years, the peak has been marked by a few outrageous transactions, which seem (for good reason) to make absolutely no sense.

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.
 
Value Trough Phase:  During the trough phase, debt and equity sources continue to be influenced heavily by industry performance.  In response to perceived higher risk, equity is generally available only from high-yield private opportunity funds at near venture capital rates of return.  Lenders are generally unwilling to provide debt financing regardless of the terms and conditions.  New development is virtually non-existent.  Generally, projects financed during the peak phase have already opened, so few, if any, additional rooms enter the market.  Transactions in the trough are generally limited to "vulture" buyers taking advantage of distressed property owners (often lenders in foreclosure).  The change in direction from declining or stabilized values to increasing values is impossible to predict.  Based on our experience, most buyers at this stage of the cycle are attempting to predict when performance will bottom (a quantitative calculus) rather than when values will (a psychological or qualitative one). 
 
Value Resurgent Phase:  The resurgent phase is characterized by a rebound in occupancy, room rates, and cash flow.  It is driven by a continuation of, or resurgence in, demand growth combined with little or no new supply.  As signs of a recovery become evident, equity sources begin to lower their return requirements.  Generally, debt is only available under stringent conditions to heavily capitalized borrowers (low debt to equity ratios; some form of recourse or guarantees). Development financing is not generally available, although projects that were not financed during the prior cycle may be "taken off the shelf" and preliminary planning for new projects begins.  There is increased interest in acquiring hotel real estate and values start to rise. 

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 . 
 
The Here and Now - The Where and When
 
If every cycle mirrored every prior cycle, any student of history would become a millionaire.  There are always complicating factors and the current cycle has more than its share.  For instance, by traditional measures, we are in a decline phase.  However, this decline phase differs from the last in several key ways:

  • Severity – For many of the above reasons, this downturn will be far less severe and it will not last as long4.
  • Economy – Unlike the last cyclical downturn, the fundamentals of the U.S. economy remain sound.
  • Segmentation - While the last cycle affected all segments of the industry, the current decline is impacting different sectors of the market in dramatically different ways.  Most affected are budget, economy and mid-priced properties (both full and limited-service).
  • Shorter Hiatus in Transaction Activity - The slowdown in transaction activity typical of the decline phase is being off-set by dispositions of hotels owned by Japanese banks, the selective pruning of consolidated portfolios and re-deployment of that capital (e.g., Starwood) and distressed sales by over-extended companies like Patriot American. 
  • Capital Availability - Unlike the prior decline, there is plenty of capital waiting on the sidelines for the right deals.  Desirable acquisitions continue to be upscale and luxury hotels and resorts, and larger center city hotels (e.g., Grand Wailea, Century Plaza and Four Seasons New York). 
  •  Ownership, Capitalization and Deal Structure - Much of the distressed selling in the last cycle was due to under-capitalization (individual developers with no money in the deal and non-recourse debt), over-leveraging (loans of 80 percent to more than100 percent of value), inefficient operations and operating agreements providing little motivation to pay debt and equity returns.  Today, most properties are not over-leveraged, and most owners have real equity at risk.  Further, many of these existing loans are recourse to the borrowers and most borrowers had to show some level of financial strength in order to obtain the loan.  Management fees are more performance based and contracts have performance clauses.  By and large, operational efficiency has increased. 
 
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: 
  • An honest assessment of the competitive strengths and weaknesses of your hotel.  A dangerous and often made mistake is underestimating the vulnerability of your hotel to future competition or, stated differently, overestimating your ability to maintain RevPAR in a declining market. 
  • Local area supply.  This includes an assessment of land availability and entitlements, proposed projects, hotel chain development interest in the market, expansions, renovations, and repositionings. 
  • Significant factors affecting demand.
  • Sales activity and buyer interest in the area.
  • The cost and availability of capital for existing hotel acquisitions and new construction.  This includes paying close attention to who is providing the equity for these transactions  (as pointed out above, the nature of the equity can provide clues as to where a market is in the cycle). 
For most owners of budget, economy and mid-priced hotels, the current outlook is bleak.  Clearly, there are, and will continue to be, buyers for this type of product.  But prices are going to be low and it will be three to four years before they begin to rebound. 

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.
 

  • Are there barriers to entry?  That is, is the property vulnerable to new supply?
  • Is the property being under-managed and can it be operated significantly better?
  • Is there a re-branding/re-positioning strategy that would allow the property to achieve a significant performance increase over its present level?
  • Is the seller under stress?  Does the price reflect that fact?  A good benchmark is whether the price represents a significant discount to replacement cost (after required renovations).
  • Is there some significant advantage to the method of financing (cost of capital)?
  • Does the property have strategic value (usually applicable to chains)?
  • Is there some macro event on the horizon (e.g., an expansion of the convention center)?
If the answer to one or more of these questions is no, buying now may be the boxing equivalent of leading with your chin.

Summary

In conclusion, I would like to leave the reader with the following thoughts. 

  • Hotel real estate is a local business.
  • Values are determined more by what we think than how we are doing.
  • Our perception is influenced more by where we are than where we are going.
  • It is essential to understand the difference between the industry “occupancy cycle” and the “value cycle.” 
  • If you don’t recognize and then monitor the right signs, you won’t know where you are in the cycle until it has passed you by.
###
 
Contact:
Rich Warnick
President 
Warnick & Co.
rwarnick@primenet.com
 --
 
Also See: Arizona Lodging Insights Year End 1998 / Warnick & Co. / March 1999
Arizona Lodging Insights / 1st Qtr 1998 / Warnick & Co. / July 1998 

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