The last four years have been a Homeric journey in hospitality. Like Odysseus lashed to the ship’s mast to avoid being drawn into disaster during a perilous journey, investors have had to similarly brace themselves. In this case, the threatening Sirens were quick in succession: COVID, supply-chain disruption, inflation, high interest rates.
For many owners, the pandemic and higher interest rates represented existential challenges. Triage replaced strategy and success was measured by the ability to fight another day. However, as long-term rates have subsided and the prospect of similar declines in short-term rates has improved, we are entering a new phase in the market.
Today, with liquidity returning to the market, there is an opportunity for owners to begin the process of carefully evaluating their portfolio and determining where and how they will deploy capital in the coming years. We see an interesting tension in the capital markets, signaling that the next leg of our journey will also be fraught with challenges. There’s a definite yin-and-yang dynamic: Even as supply chain and labor cost growth begin to moderate, the return to a more normalized balance of leisure and group travel demand requires owners to be nimble and will drive capital allocation decisions. Though the worst of inflation appears to be behind us, we are still dealing with a dramatically higher cost of capital than any reasonably aggressive investor would have underwritten.
Overall, recovering net cash flows are under steady pressure, which portends greater difficulties to continue meeting expectations for net operating income growth in the second half of this year and into 2025. While an election year traditionally means actions to stimulate and support the economy, if recession looms, owners will try to tighten their belts further and remain reluctant to spend on CapEx.
Crunch Time
The present hospitality investment environment is rife with myriad challenges. One includes pending debt maturities that need to be refinanced in a substantially higher interest rate environment than when these loans originated. At the same time, as interest rates stubbornly remain higher for longer, capitalization metrics create a bias toward lower asset values. Meanwhile, CapEx pressures aren’t going away; in fact, they continue to be an important factor in deal negotiations, in many cases driving both buy-sell and financing strategies.
Given these financial pressures, owners need to carefully consider the properties in their portfolios and come to an honest assessment of current valuation relative to debt obligations. However, this doesn’t mean that valuation is determined by a simple cap rate, especially for distressed, but otherwise value-add assets.
From the owner’s perspective, the true value of a property is based on the reasonable expectation for cash flow to increase over time. As the window for deal-making compresses, a seller’s negotiating leverage can rapidly dissipate. This valuation analysis is heavily reliant on possessing real-time market knowledge and understanding what buyers are truly willing to pay for assets without financing contingencies.
As hotel owners formulate portfolio strategies going forward, we are advising them to plan for continued volatility in the capital markets and to not be lulled into complacency by the prospect of a falling fed funds rate. Though the need to restructure and recapitalize at this point in the cycle is often driven by debt obligations, picking which assets in a portfolio to sell or hold often comes down to an owner’s capacity to write a check for loan paydowns or capital expenditures, looking beyond investment horizon and risk tolerance considerations.
The cost of capital is high, a reminder of why, on a stabilized basis, hotels tend to trade at the highest cap rate of any form of commercial real estate. The good news is that there is liquidity in the financial markets and though equity solutions are difficult right now, many entities who have been sitting on the sidelines remain eager to deploy capital, especially in taking subordinate debt positions.
Within this framework, owners of hospitality portfolios should—and quickly—analyze their options, also considering preferred market and property type allocations. All investors only have a finite amount capital to deploy—spend it in efficient manner.
Story contributed by Douglas P. Hercher, founder, and Stephen O’Connor, principal & managing director, RobertDouglas.
