Anyone recently attending The Lodging Conference in Phoenix had a great opportunity to take the temperature of the Lodging Industry. Although there were probably few or no radical epiphanies, there were a number of common threads to the various conversations occurring both on and off the panels. Here are some of them:
Supply Growth/Overbuilding Concerns
There was very real and definitive concern that we are approaching a stage in the market where overbuilding will become an issue. There was general consensus that construction money is much more available today than just six or twelve months ago, but that new construction deals can still be difficult to get done. This most certainly goes to the capital stack gaps discussed in my last column. The real question to be answered is, “when will the eventual shift in balance come resulting in new supply negatively impacting operating metrics in a material way?” This will trigger a tightening of capital and set the downward cycle in motion. Most people still feel we have through 2014 or even 2015 before new supply will become an issue.
Increasing Interest Rates And Their Impact On Cap Rates
Anyone involved in deals today is acutely aware of the recent spike in interest rates and widening of spreads. The cost of capital on fixed rate debt is up 100 basis points from the low experienced just a few short months ago. Active market participants acknowledge that cap rates have risen along with the cost of capital increase, but the sales market remains frothy. Robert W. Baird Research put out an interesting analysis on the recent cap rate increases and the implied increases in NOI required to maintain a hotel’s value. The simple math is that if cap rates move from six percent to seven percent and NOI grows at a ten percent rate, you still experience a four percent decline in value on an unleveraged basis. With 60 percent leverage, the decline is 14 percent. What NOI growth are you assuming in your acquisition models today, and are you accounting for the inevitable cap rate increases? Sensitivity analyses relative to these assumptions would be advisable.
Targeted Equity, Prevalent Debt
The common belief is that there is significant equity on the sidelines ready to move on any deal meeting the required hurdles. This is certainly true for deals in major markets, with critical mass and a believable upside story. However, equity still eludes smaller projects in secondary and tertiary markets. The old adage is true, smaller deals can be as, or more, difficult as larger deals to get done. As perceived risk has lessened, so have equity yields moved down from the required levels in 2010 and 2011. At return rates from 10 to 15 percent, preferred equity can be very cost effective where mezzanine debt is an issue. Debt continues to be very targeted in favor of certain parameters, specifically, larger deals. For example, our firm has been in the market with a $27 million bridge loan on an excellent value add deal and have gotten a number of responses that the deal is too small. There is definitely a trend at this point in the cycle favoring larger deals for both equity and debt.
Is Debt Underwriting Criteria Loosening Too Much?
There were a few stories being told about a severe loosening of debt underwriting criteria, but this has not been our experience. It’s certainly true that lenders are willing to stretch for deals and this is evident in many areas of the loan agreements we are now negotiating. One thing to consider is that the market has not seen the transaction volume that contributed to the loosening of standards in the 2006-2008 timeframe. Deal volume is more controlled this time around, allowing for a better due diligence process. We continue to see lenders taking a thoughtful approach to their underwriting of hotel deals.
Potential for ADR growth
While we continue to see moderate to strong ADR growth, we have not reached prior peaks on an inflation adjusted basis. This leads many to believe that, combined with only moderate supply growth, room rates still have some run room. Since the hotel business remains a street corner business, this may or may not apply to certain markets. ADR growth has been greatest at the upper end of the market, and this is expected to continue. Smith Travel anticipates ADR’s to grow about 4.5 percent over the near term.
Other interesting discussions centered around where people feel we are in the real estate cycle, with most believing we have at least 18 to 24 more months of strong fundamentals driving asset values. Some cite Blackstone’s recent announcement to pursue the Hilton IPO as an indicator that we are near the top of the cycle. The lack of growth in group business is still troubling, but may represent future opportunities for positive demand trends. Finally, there was a distinct absence of talk about distressed deals and workouts. The coming wave of maturing debt may change this, but for now it appears to be smooth sailing. Having been through four market downturns, my advice is to enjoy this part of the cycle while it lasts.
William (Bill) Sipple is executive managing director of HVS Capital Corp (HVSCC), where he leads a team of professionals that provide a wide range of real estate investment services on an international level. HVSCC is the investment banking arm for HVS, and has extensive experience in debt and equity raises, asset sales, and capital structuring. You can contact Bill at (303) 512-1226 or wsipple@hvs.com. His “Inside Finance” column will appear regularly on LodgingMagazine.com.
