By Stephen Gaylor
On Wednesday, March 15, 2017, the headline from the Economy section of the New York Times boldly announced that the “Fed Raises Interest Rates for Third Time Since Financial Crisis.” This is the second time in three months that the Federal Reserve has raised rates, yet only the third time in the past decade.
For those who do not deal with interest rates on a daily basis, it is important to note that the rate hikes which have recently taken place do not have a direct impact on the type of debt utilized to finance real estate, however, they do provide us with a glimpse of the future. Rates are going up, and they are likely to go up in a sustained, and extended manner.
What does this mean for hotel owners and developers? First, it means that the cost of debt is going to increase. By how much, we don’t know, but it will go up. It will mean that you, as a borrower, or the buyer of your property, as borrower, will have to pay more to borrow money.
But it also means more than just a higher cost for debt. Increased interest rates have a direct correlation to cap rate changes. As interest rates go up, capitalization rates go up. That means that hotel values will drop as interest rates increase.
This begs two questions: first, by how much are cap rates affected by interest rate increases, and second, how much are interest rates going to increase?
A recent scholarly article published in the Cornell Hospitality Report examined interest rates and cap rates for hotels from 1997 to 2015, and found that although there are numerous variables, “correlation between hotel capitalization rates and the 10-year U.S. Treasury rate over the period equals .68”.
For easy math, take a hypothetical scenario of a roughly $10 million hotel today trading at going cap rates. An increase on the Ten Year U.S. Treasury of a couple of percent could result in a decrease in hotel value of nearly $1 million.
Is this scenario possible? Consider this: the current Ten Year Treasury rate is roughly 2.4%, while the average rate over the past fifty years is 6.7%. As one of my mentors frequently stated, “everything eventually reverts to the mean.”
By how much are rates going to increase? This is not an easy question to answer, however the Fed has signaled and affirmed an expectation of increases, likely through 2019. Current consensus is that there will be an additional two rate increases in 2017 and the Fed continues to assert that it expects the federal funds rate to be 1.4% at year end 2017. Median expectation for 2018 and 2019 is three rate increases each year according to analysts with Natixis. Again, although these changes do not directly affect hotel lending, a number of hospitality industry analysts are predicting that interest rates on hotels could easily average over 6% by the end of 2017.
Over the next few years, hotel owners and developers will see a changing lending environment, with increased regulation, higher rates, and in many cases lower available leverage. Whether buying, selling, or developing a hotel, it is important to factor in potential changes to the debt markets and how those changes will affect your individual corporate strategy.