By Jeffrey C. Summers
Few questions pose greater interest to the hospitality industry than the current investment environment, which is clearly in a state of flux. The pace of hotel property sales has slowed with the successful workout of most distressed debt, but changes in ownership patterns driven by acquisitions is creating a new industry profile. To assess current investment activity, Arthur Andersen this spring conducted a survey of select hotel investors, both domestic and offshore. This initiative complements an Arthur Andersen study earlier this year on hotel lending. The recent survey of 22 investors -- including investment bankers, brokers and developers -- was designed to yield information on the equity side of the equation. Who are the dominant investors? What investment parameters and goals are driving these acquisitions of hotel properties?
On the buyer side, the market is currently dominated by domestic investors, although there are still foreign players seeking acquisition opportunities. Overall findings of the study reflect considerable variation among investor groups in motivations and strategies in acquiring properties. On the seller side, commercial banks and insurance companies have accounted for an estimated 65 to 70 percent of properties offered in the marketplace during the last year, but it was the view of many executives surveyed that hotel property sales by private entities are beginning to emerge as a stronger force. Private owners were reluctant to sell at the bottom of the cycle during the severe slump in property values. Assuming they had adequate capital wherewithal, these private owners held -- hoping for the rebound. Now that the hotel industry has returned to financial health, they are more motivated to sell. In contrast, most institutions have already liquidated their REO portfolios under regulatory pressure to sell.
On the buyer side, the market is currently dominated by domestic investors, although there are still foreign players seeking acquisition opportunities. The proportion, however, has changed from two or three years ago when foreign investors were more active than domestic, particularly in the full-service sector. These offshore investors were apparently less "shell shocked" by the plummeting of U.S. real estate hotel values in 1991-1992, than was the domestic investment and lending community. Many non-U.S. investors, particularly those from Asia, were also coming from national economies in a stronger stage of the economic cycle.
Largely absent, for the moment, are hotel Real Estate Investment Trusts (REITs). Hotel REITs exploded on the scene in late 1993 during a narrow window that ended in the fall of 1994. During that short period, hotel REITs had abundant cash available for acquisitions and tended to outbid many other players. As interest rates rose last year, however, acquisition activity among hotel REITs dissipated.
Executives surveyed believe that values are "inching up" as hotel industry economics improve and more private players test the water. It is no secret that the hotel market is performing well with the barrage of favorable press spurring interest in the industry. Many in the real estate investment community perceive hotels as currently out-performing other forms of real estate. Expectations are high, however. A larger price disparity between buyers and sellers exists in the market compared with a year ago, and there was a consensus that deals are taking much longer to close, in part due to sellers dragging their feet as the market continues to improve from an operating standpoint.
There were conflicting views about the amount of product available for acquisition in the market. Some executives surveyed believe that there has been a slight decrease in product during the past year, while others say that factor has remained relatively unchanged. One important issue does appear to be the potential impact of Japanese hotel dispositions in the future. Japanese-owned and financed properties in the hotel sector may eventually come to the market in larger numbers, but in all likelihood, it will occur slowly over time without widespread marketing to potential buyers. Pre-sale exposure of these assets is likely to be subdued, even in the case of well-known properties, which may lead to some surprise sale announcements.
There was general agreement that the amount of equity capital available for investment is substantial, and that competition for deals continues to grow more intense. A handful of large capital groups formed to invest in hotel properties is deemed the strongest competition. There is some evidence to suggest, however, that the players who were involved in a speculative wave of hotel acquisitions during the depth of the economic recession have retreated. In hindsight, these acquisitions made from 1991 to late 1993 are now revealed as a move of ³smart money² into the industry near or at the bottom of the real estate cycle. Opportunities offering the potential for exceptionally high returns have been replaced by sound deals offering lower potential yields, yet priced to reflect the solid rebound of the hotel industry.
Generally, the dominant investors in the current marketplace fall into three groups.
Investment Funds. Capital groups, which have frequently formed alliances with hotel management companies, include investment funds specifically targeting the hotel market and others that have a wider real estate mission.
Hotel Companies. Both the industry leaders and smaller chains are pursuing buying strategies that are unique to their corporate needs in building market presence in various parts of the country. The investor survey strongly suggests that hotel companies are once again expanding after several years of dormancy, in some cases revisiting strategic plans involving new markets. In the full-service sector, expansions are focused almost exclusively on acquisitions of existing properties, with new development not generally on the horizon. The limited-service sector, however, is characterized by both acquisitions and new construction activity, leading to concern about the prospect of eventual overbuilding similar to what was seen in the late 1980s.
Institutional Investors. At this time, neither insurance companies nor pension funds are significant equity players in the hotel industry. Insurance companies (which hold both hotel equity and debt) are in the marketplace very cautiously as both buyers and sellers of hotel properties. Pension funds remain primarily on the sidelines as a result of the perceived risk of hotel investments and conservative investment strategies regulated under ERISA. Fund managers also believe that there are few pension fund advisors that understand the complexities of this form of real estate. However, institutions, including pension funds, are becoming increasingly willing to provide debt capital to the hotel industry.
Investment parameters, strategies and yield requirements vary quite significantly among the three groups that collectively drive the investor marketplace. Almost all investors in the full-service sector, however, can be described as opportunistic as they seek properties offering a strong upside potential at pricing substantially below replacement costs. Replacement costs for full-service hotels remain considerably higher than acquisition pricing, even after adding on for capital refurbishment or other expenses associated with repositioning. This stands in sharp contrast to the limited-service sector where new construction is underway, and acquisitions are being priced close to replacement cost.
Organizations surveyed reported that there is little interest or deal activity involving turn-arounds of distressed properties that are truly "broken." These include hotel properties that either have deferred maintenance items that cannot be cured or are located in areas unlikely to recover as a result of factors such as shifts in economic development patterns. Investors appear to be seeking historically underperforming hotel properties that have good potential for repositioning, while opportunities to buy distressed properties at very low "bargain" prices are a thing of the past. Most investors indicated they are reacting to property already on the market that is being offered by motivated sellers, as opposed to proactively pursuing acquisitions.
The majority of deals cited among entities surveyed are currently being completed on an all-cash basis, due to the liquid position of many of these investors, coupled with the shortage of available debt and its relatively high cost. Investors approaching a deal in an all-cash position also enjoy a competitive edge due to their ability to close a deal quickly. Some of the investors, however, have secured a line of credit and plan to layer permanent debt into the transaction at a later time. In very few instances are investors lining up financing on a deal-by-deal basis, even though the investors surveyed believe that debt capital is becoming more available, albeit at a high cost and with strict underwriting requirements. These investors confirm the findings of the earlier Arthur Andersen survey of debt providers. Debt capital available is reported at interest rates between 275 and 400 basis points above various benchmarks, such as the Prime rate, Treasuries or LIBOR. Today's hotel investments are not highly leveraged, with loan-to-value ratios averaging a maximum of 60 to 65 percent, while debt service coverage ratios were reported in the 1.5 range.
For some of today's investors, debt capital has become more expensive for two reasons. Actual interest rates charged by lending institutions are up significantly as a result of Federal Reserve actions. In addition, hotel property sales two years ago often involved seller financing offered at favorable interest terms at a significant discount to conventional mortgage rates. This is now much less common. Therefore, while actual interest rates are at least 300 basis points higher than they were 24 months ago, effective interest rates may have risen by twice that amount for an investor who had closed deals based on favorable seller financing.
Current acquisition strategies reflect diverse missions by investor category. Capital groups generally have focused on acquiring underperforming properties in nonetheless strong and improving markets. These investment funds are generally looking for returns on equity of at least 20 percent -- and often closer to 25 percent -- and they have defined a shorter-term investment horizon of five to seven years, with clearly defined exit strategies. Targeted returns on equity, however, are down from the 25 to 30 percent commonly sought in recent years. These groups expect to improve performance through capital refurbishments, significant management improvements and possible "reflagging." As a result, many of these groups have aligned themselves with hotel management companies. This is a key strategy employed to give investors direct control over management, and with it, the ability to more closely align their objectives with the property's management.
In contrast to capital groups, hotel companies are generally seeking acquisitions that match strategies to build market share nationally. Their investment horizons are longer-term, and hotel chains expressed a willingness to accept a lower return on equity than the investment funds, generally around 15 percent. These companies are usually both owners and operators, however, and they typically factor management and other fees into the equation when calculating overall returns. The largest hotel chains already have a presence in most major markets, but companies surveyed report they are looking to fill in gaps to strengthen their presence in select metropolitan areas. Smaller chains have strategically targeted certain cities for expansion.
As a rule, institutional investors are spending more time managing what they currently have remaining in their portfolios, rather than seeking new properties.
Institutional investors are generally interested in investment-grade, lower-risk transactions with yield requirements in the mid-to-high "teens." Their focus is on strong potential from long-term real estate appreciation. The level of activity, however, is low, and acquisitions activity is cautious and tentative. The focus continues to be on asset management, rather than acquisitions. As a rule, institutional investors are spending more time managing what they currently have remaining in their portfolios, rather than seeking new properties.
The survey yielded no clear preference on locational targets among any investor group. Most capital groups and hotel companies appear to be focusing on expanding a geographically diverse portfolio.
It is also clear from the survey that hotel properties encumbered with management contracts do not fare well as targets for acquisitions. The vast majority of today's buyers are seeking properties that are "free and clear" of existing management. Hotel properties encumbered with existing management contracts are not only more difficult to sell, but typically command a lower price at the negotiating table. Historically underperforming hotel properties are the target of many of today's investors, and it is logical that buyers want to change management. Investment groups typically seek upside potential in improved operations, while hotel chains clearly want to install their own management in a newly acquired property. Sellers may find it beneficial, as a result, to weigh the cost of buying out a management contract versus the potential for improved pricing of the property. Institutional investors are less compelled to remove management companies, providing these companies have a strong record.
In general, the survey revealed that investors prefer to acquire properties that do not involve ground leases. This issue, however, does not have the "deal breaking" power of management contracts, although the number of years remaining on a lease is a critical factor. Investors usually require that a land lease have at least 40 years remaining to ensure that it will not have a negative impact on future resale opportunities. A remaining term of less than 40 years is usually a deal breaker.
The market for hotel acquisitions has clearly experienced a sea change in the last one to two years -- shifting from acquisitions based on historical earnings to deals focused on current and future earnings. Discounted cash flow (DCF) analyses and internal rates of return (IRR) are the most widely used methods of valuation currently, compared to direct capitalization of the prior year's income, which was the primary basis for acquisitions two years ago. When a DCF method is used by investors, prospective cash flow is generally projected out between seven and 10 years. Terminal capitalization rates were reported in the 10.5 to 12 percent range, with the majority in the upper end of that range. The investment funds are seeking income yield, rather than appreciation, and a number of these investors specifically pointed out that they are valuing potential deals using residual capitalization rates that are no lower than going-in caps. By eliminating a capitalization rate spread, this method assures that the purchase price reflects a sought-after return on equity that is derived from expected cash flow. Discount rates ranged from 11 to 15 percent. Investors also reported varying cap and discount rates by property type and location. Targeted cash-on-cash returns were generally in the mid "teens." Unleveraged equity returns being sought averaged in the high "teens," while targeted leveraged returns were as high as 25 percent.
When a direct capitalization method is used, most investors are capitalizing the last year of a 12-month rolling average of cash flow with a range of capitalization rates between 8 and 10 percent. This reflects a drop of 100 to 200 basis points in direct capitalization rates from two years ago, when they were in the 10 to 12 percent range. Some investors also are examining discount to replacement cost as a key to determining targeted bid prices. Full-service properties are trading at an average of 70 percent of replacement costs, according to reports of organizations surveyed. This is up from two years ago when the average hotel traded at a discount from replacement cost closer to 50 percent at that time. Still, the spread between trading price and construction cost is sufficiently wide to discourage most developers from contemplating new construction in this segment. Limited-service properties were reported trading at 90 to 100 percent of replacement costs -- and on occasion above that level.
Base management fees generally were being calculated at approximately 3 percent, with replacement reserves for furniture, fixtures and equipment (FF&E) in the 4 to 5 percent range. Reserve percentages tended to be slightly lower for hotel properties with higher food and beverage revenue or if the property was newer.
Investors also are casting a keen eye at opportunities to improve returns by reducing excessive fees paid out to a management or franchise company for marketing and accounting services. In addition, operating expenses layered in by an owner/operator also were being scrutinized in the search for ways to boost operating cash flow.
Clearly, investors have shifted their perspectives from looking to the past to looking to the future. However, two notes of caution arise from this shift. First, while investors are willing to look to the future for yields, lenders are currently not willing to accept these future expectations to support a loan decision. Loan underwriting remains focused on current net operating income. Second, it is important to know where a property being contemplated for purchase lies on the cash flow potential time line. Today¹s sophisticated investors know whether they are valuing upside potential -- or whether such upside has already been exhausted.
For the near future, new construction in the full-service sector does not appear to be a factor that will influence the market, nor do conditions suggest the possibility for overbuilding any time soon. With limited-service hotels trading at or close to replacement costs, the real play in this sector may be financial engineering in how the deal is structured. The potential for creating upside value in limited-service acquisitions simply does not exist to the extent that it does with full-service properties. If overbuilding in the limited-service end of the industry does occur, this may ultimately contribute to consolidation as smaller operators find it more difficult to compete. There also may be a growing overlap in portions of these two segments as certain upper-end limited-service hotels compete relatively effectively with full-service operations at the lower end.
Taken in total, the survey suggests that there are substantial amounts of money pursuing a somewhat limited number of hotel deals. While there are still solid investments to be made in the hotel industry, the window of opportunity may be closing. The contrarian investor -- the truly opportunistic buyer who acquired properties at the bottom of the real estate cycle -- is no longer to be found in the marketplace.
The overriding consensus in the hotel investment market is one of great enthusiasm, however, as fundamentals remain solid and improving. Room rates are rising at a rate in excess of inflation, as occupancy also improves. The industry is clearly in good health, and there are sound reasons for investor activity. A focus on creating upside value, particularly in the full-service sector, bodes well for the hotel industry as economics continue to improve across the country.
Jeffrey C. Summers is Director of Hospitality Consulting for the Chicago office of Arthur Andersen Back to Arthur Andersen Article Index