(Cap)Rating Perceptions of Risk

by: Patrick Quek and Lawrence E. Henry MAI

June 1998 - Looking for a place to put extra cash?  Your choices range from the safety of Grandma’s cookie jar to Fleet-A-Foot at 30-to-1 at Belmont.

For investors in commercial real estate, the choices lie somewhere between the ponies and the fig bars.  Once inside the arena of commercial real estate, the investor has a variety of options, each with its own level of perceived risk.  In real estate, just as in other forms of investment, those who dare to place their money in riskier investments want a greater return on their dollars.  Conversely, conservative investors prefer a greater sense of comfort and are willing to sacrifice a few percentage points on their return.

Hotels Are Risky As Compared To …

One way to measure the relative perceptions of risk for different types of real estate investments is to examine their respective capitalization rates (cap rate).  The cap rate measures the relationship between income and value for a specific point in time.  In turn, the value of the property then influences decisions regarding the amount of a loan, the budget for development expenditures, or the purchase price for a property.  In general, the higher the capitalization rate, the greater the perceived risk of the investment, therefore the greater the desired return on investment.  The following table compares the capitalization rates for transactions of different forms of commercial real estate.

Captialization Rates
1988 11.1% 7.3% 8.3% N/A
1990 10.2% 8.2% 8.7% N/A
1992 11.9% 9.8% 9.2% 7.5%
1994 11.2% 9.7% 9.3% 7.7%
1996 11.0% 9.3% 9.2% 8.6%
1997 11.1% 9.0% 9.1% 8.0%
Sources: PKF Consulting, Korpacz, and ACLI

As depicted in the chart above, the capitalization rates for hotels have always been greater than the rates for office buildings, industrial developments, and shopping centers.  This is consistent with the general belief among real estate investors that the income stream for hotels is less certain than the income to be derived from office buildings, industrial sites, and shopping centers.  Not only do office, industrial, and retail buildings benefit from the relative assurance of long-term leases, but they are far less marketing- and management-intensive when compared to the operation of a hotel.  For the risk associated with the uncertainty of daily rental revenue, plus the headaches of operation, hotel owners want a greater return on their investment.

How Much Return For The Risk?

How much of a premium return do hotel investors want for the risk they perceive they are taking?  To formulate this measurement, we looked at the difference between the respective annual capitalization and discount rates for hotels and the return from other less risky investments.

Growth in Investment Criteria
10-Year Treasury 7.8% 8.8% 8.4% 6.9% 7.8% 6.4% 6.4%
AAA Corp. Bond 9.1% 9.9% 9.3% 8.2% 9.5% 7.4% 7.3%
Hotel Interest Rates 10.1% 11.6% 11.5% 8.9% 9.9% 9.6% 9.1%
Hotel Cap. Rate 10.9% 11.1% 10.2% 11.9% 11.2% 11.0% 11.1%
Hotel Discount Rate 13.8% 14.6% 15.0% 16.0% 14.7% 14.6% 14.1%

Given the relative assurance that the federal government will pay back on its bond obligations, the return from a 10–year Treasury note is considered one of the least risky forms of investment.  Secondarily, bonds from a corporation with a triple A rating are perceived to have a greater level of risk, and therefore pay a slightly higher (one percent on average) rate of return.

Comparing the spread between hotel capitalization rates to the 10–year Treasury notes, we find a fairly consistent differential (± 2.3%) that averaged 3.6 percentage points over the 11-year period.  This is the premium desired by hotel investors to compensate for the risk they are taking.

The two most extreme exceptions from this 3.6 point spread occurred at the beginning of the recession (1990) when the difference shrunk to 1.8 percentage points, and 1992, the final year of the recession, when the differential grew to 5.0 percentage points.  For the most part, these extreme spreads can be attributed to the movement in hotel cap rates during that period.  The low cap rate in 1990 is indicative of the lingering positive outlook from the 1980s and the low number of transactions that did occur during that year.  Conversely, the high cap rate in 1992 reflects the “bottom fishing” purchases of hotel relics from the recession.

Which Hotels Are Riskier?

While hotels have consistently been perceived to be riskier investments compared to other forms of real estate, the relative perception of risk among the different types of hotels has varied from year to year.  The following chart compares the spread between the average annual cap rates for the various types of hotels and the respective annual rates for 10-year Treasury notes.

Percentage Point Spread Between 10-Year Treasury Notes and Hotel Capitalizaiton Rates
Resort 3.4% 2.9% 1.3% 5.1% 3.4% 3.8% 4.1%
Full Service 3.1% 2.3% 1.9% 5.1% 3.2% 4.5% 4.6%
Limited Service 3.2% 2.7% 2.2% 5.0% 3.7% 5.4% 5.4%
During the building boom of the late 1980s, all hotels enjoyed favorable perceptions, thus resulting in a lowering of return requirements.  As the “hot” new product type, limited-service hotels were thought to be invincible.  The combination of low development costs, relative ease of operation, and high consumer acceptance attracted investors, therefore lowering their return expectations.  On the other hand, resorts were more expensive to build and/or buy, and therefore required a greater rate of return.

Looking at the recovery of the 1990s, we find a switch in the perceptions of hotel investors.  The recent surge in limited-service hotel development seems to have frightened investors, thus resulting in an increase in the cap rate.  At the other end of the spectrum, resorts are enjoying a favorable outlook benefiting from both a strong economy (more disposable income for leisure trips) and a limited amount of new construction.  In 1996 and 1997, the spread between resort cap rates and 10-year Treasury notes was the lowest among all property types.

Interestingly, full-service hotels have experienced the most consistent perception among investors, with cap rates always falling in between limited-service and resort hotels.  However, the relative consistency of full-service hotel cap rates is probably due more to the fluctuations experienced by the other property types, as opposed to anything attributable to full-service properties.  Full-service hotels are not as vulnerable to economic changes as resort properties, nor have they experienced the surges seen in limited-service development activity.

Objectivity Follows Subjectivity

We acknowledge that the rise and fall of capitalization rates and other investment criteria is subject to several factors, not just investor perception.  However, it should be noted that, in a recent survey of investor perceptions, PKF Consulting found that full-service luxury hotels and upscale hotels were perceived as the most favored property types, while economy limited-service hotels ranked as the least popular with investors.

From a historical perspective, capitalization rates appear to have accurately reflected the relative performance levels of hotels during the same time period.  Unfortunately, the results are mixed when using cap rates as a predictive measurement of future performance.  This too is consistent with the recent conservative trend of valuing hotels based on their most recent levels of performance, as opposed to a projected income stream.  Maybe the lesson hotel investors have learned is that the industry is cyclical, and the only certainty is that history repeats itself.

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Patrick Quek is president and CEO of PKF Consulting, an international hospitality consulting firm headquartered in San Francisco.  Lawrence E. Henry MAI is located in the firm’s Philadelphia office.


* * *
For additional information contact Robert Mandelbaum at the firm:
email rmandel@pkfc.com
PKF Consulting
3391 Peachtree Road
Suite 420
Atlanta, GA  30326
phone  (404) 842-1150
fax  (404) 842-1165

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