Arthur Andersen Survey - Pace of U.S. Hotel Investment Remains Intense
By: Jeffrey C. Summers - Chicago, Fall 1996
The economic winds that brought prosperity to the U.S. hospitality industry continue to drive a hotel investment market that is fast and furious. An Arthur Andersen survey of select companies in the marketplace this fall reveals that more than 95 percent have invested in hotel properties in the first three quarters of 1996 - and 30 percent spent more money than originally expected. Indeed, one survey respondent described the acquisitions market as a "trading frenzy" as hotel demand continues to rise, while new supply entering the market remains limited, most notably in the full-service sector. Among the most aggressive buyers reported were real estate investment trusts (REITs) and major hotel brands.
This Arthur Andersen study serves as an update to similar investment surveys completed in 1995 and the first quarter of 1996. Like the previous studies, we polled a select group of some 20 major hotel companies, investment bankers, brokers, REITs and investment advisors. The survey findings offer insights about investor activity in the hotel market, as well as perceptions of when the market may peak.
Who is Buying and Selling?
The most active sellers of hotel properties were private owners, followed by banks and other financial institutions. This was consistent with the investor survey last spring, which identified a trend of increasing sales by private entities, which presumably have entered this sellers' market as prices continue to climb. While there have been some Japanese banks among the sellers, they have by no means flooded the U.S. hotel market with properties. Survey respondents anticipate more dispositions among Japanese investors during the next 12 to 24 months.
Meanwhile, REITs and hotel companies tied for first place as the most aggressive buyers. Hotel REITs, which have been under tremendous pressure to grow, have revealed an undiminished appetite for hotel properties. Indeed, REITs have been a major force in the market, driving up prices and fostering reduced capitalization rates on many deals, even as they enjoy a lower cost of capital (about 7 percent) compared to many other investors (on average 9 percent). REITs are generally perceived as enjoying a competitive edge in making hotel acquisitions because of their ability to raise cash quickly. Also of note - foreign investors from Hong Kong, Singapore, Taiwan and Malaysia have been purchasing luxury and trophy hotels, primarily in U.S. gateway cities.
Buyer Strategies
Clearly, the spotlight remains on the full-service hotel sector where replacement costs still exceed acquisition prices, even at the higher prices of today's market. Seventy-one percent of respondents indicated interest in acquiring full-service hotels, while only 17 percent said they were looking at the limited-service sector.
The two previous Arthur Andersen surveys highlighted the search for full-service hotel properties with strong upside potential. That continues to hold true with almost two-thirds of those surveyed expressing interest in such properties. Most respondents also recognized that such properties are now in extremely limited supply, with many of the best deals already off the market. At the same time, REITs, who are yield buyers, were seeking stable performing properties and have been generally risk-averse.
Terms of Purchase
The majority of acquisitions made by these investors were all cash. The cost of debt capital, when available, was cited at approximately 9 percent with the maximum loan-to-value ratio at 67 percent. Loan terms averaged 7.5 years, with amortization periods between 20 and 25 years. The survey thus suggests that there has been little change in purchase terms for most transactions during the past six months.
Investment Parameters
With the return to health of the hospitality industry, our previous surveys substantiated a shift from acquisitions based on historical earnings to deals focused on current and future earnings. This remains true, according to our recent survey results, but there has been a further transition based on two factors - the yield-driven requirements of REITs and a perception that the market is closer to peaking. The most frequently cited method of hotel valuation in this year's survey was internal rate of return (IRR), with average return requirements at 22 percent (leveraged) and 14 percent (unleveraged). These percentages are somewhat lower than those revealed in the survey conducted earlier this year when investors were seeking equity returns on average in the mid - 2Os. This no doubt signals that buyers are willing to accept a lower return given the strength of hotel fundamentals and reduced number of good properties available for acquisition.
The second most frequently used method of valuation was cash-on-cash return, reflecting the strength of REITs in the marketplace. REITs rely on short-term results, with short term results at the end of year one a pivotal consideration given the need to generate shareholder returns. They typically cannot wait for a return at the "back end" of a transaction. Discounted cash flow (DCF) was in third place in valuing acquisitions, but there has been a shift in the number of years used in projections. Respondents in this survey cited five-year projections in modeling as most predominant - a shorter amount of time than in the past. This very likely reflects the fact that the market is further along in the investment cycle, and thus closer to its peak. When DCF was used by investors, average terminal rates were cited at 11 percent and average discount rates at 14 percent. The underlying inflation assumption most commonly used was 3 to 4 percent, relatively consistent with the rate in the U.S. economy during the recent past.
When direct capitalization was used in transactions, investors were capitalizing the last year of a 12-month rolling average of cash flow with a capitalization rate of approximately 10 percent. This method clearly trails the other valuation methods in hotel deals, similar to our findings in the earlier surveys.
The Peak of the Cycle
Investors are clearly of mixed minds about when this investment cycle may peak. There was consensus that hotel fundamentals will remain solid with occupancies stable and rates continuing to move higher, thus assuring sustained profitability in the full-service sector. The investment market for full-service hotels, however, is closer to peaking, respondents believe. Nevertheless, 42 percent of respondents expected to increase their hotel investment activity in 1997, while another 42 percent expect to remain as active next year. With prices rising, the specter of new full-service hotel development also looms. While some uncertainty was expressed about when that cycle might begin, most respondents believed it would not occur to any great degree for at least 12 to 24 months. In the meantime, some respondents indicated that the limited service hotel sector has peaked following a period of rapid expansion of new product.
Overall, survey respondents voice strong optimism for the hotel industry and its prospects for the future. With demand at least keeping pace with supply, rates are likely to continue to rise, with stable performance forecast into the next century. In the investment market, there remains substantial amounts of capital pursuing a limited number of deals. While sound deals are still available in the marketplace, it would appear that the window of opportunity for the best of the hotel acquisitions has began to close.
Jeffrey C. Summers is Director of Hospitality Consulting for the Chicago office of Arthur Andersen.
©Arthur Andersen
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