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Hospitality: Buy, Sell, Build?
After a period of strong gains in RevPar (revenue per average room), the hospitality industry (depending on your point of view) is in a "frothy" state, or is a good place to invest. Gisle Sarheim, a senior associate in HVS International's New York office, recently examined the state of the hospitality market and whether it is time to buy, sell, build or be bought in a report titled "U.S. Hotel Investments: State of the Union 2006."
Buy Hotels
Both large and small deals in 2005 had one thing in common-low cap rates, particularly in the major metro markets. A total of 126 transactions in major metropolitan markets last year had an average cap rate of only 6.6 percent. HVS International Data also indicated that New York City cap rates averaged 5.3 percent last year, based on 13 sales with reported cap rates. (In the 2000-2002 period, cap rates in the U.S. exceeded 11 percent.) However, rising interest rates and improving cash flows in the first quarter of 2006 have caused a slight rise in cap rates, with HVS data indicating an average cap rate of 7.3 percent on 17 transactions.
Debt Financing Available
One reason for the low cap rates for hospitality properties has been the combination of low-cost financing and high loan-to-value (LTV) ratios. These in turn are attributable to a surge in CMBS issues containing hospitality loans. This represents a major turnaround from the large number of delinquent loans originating in the 1996-1998 period that resulted in over $1 billion in loan defaults in 2003, equal to 31 percent of total CMBS defaults. In sharp contrast, hotel loans in 2004 amounted to 7 percent of all CMBS loans and 9.4 percent in 2005. At the same time, overall CMBS issuance has increased substantially in the past two years.
Suggested Investments
According to the HVS report, "Despite high per-room prices and pressured yields, there are still numerous opportunities in the market for successful acquisitions." These primarily are properties that suffered from falling profits and/or defaulted on loans. Such properties may need a facelift, a repositioning or a change of brand. But with necessary capital expenditures combined with an experienced management team, these can often be around to yield healthy returns.
Sell
Last year, public companies dominated the sell side as they continued to transform themselves into pure management and franchise companies. This improved their image with Wall Street, which never favored the traditional "hotel company" model that combined ownership of real estate assets with a hotel operating company. The fact that a major portion of value was tied to slow growing real estate assets hindered the growth of the companies even though the "own and operate" model permits the maximum control of hotel assets. Such major corporations as Hilton, Starwood, InterContinental and Marriott disposed of a substantial number of their assets and used the proceeds to repay debt and fuel further growth, while at the same time ensuring control of the hotel operations with lease-back and management agreements.
In the current seller's market, private operators should utilize the opportunity to sell properties in markets that are at risk of oversupply. Sarheim points out that the cyclical nature of hotel real estate should never be underestimated. While external influences can impact hotel performance, the ultimate curse in the industry is oversupply.
In considering whether to sell a property, the questions to ask are whether RevPar is in line with the market, whether the property is in good condition or needs upgrades and renovations, and whether a strong base of loyal customers are likely to stay with the hotel indefinitely.
Build
Four years of limited new supply combined with the current impressive industry fundamentals "is an open invitation for construction of new supply," according to the report. Construction funds also are more readily available, although sharp increases in construction costs may put a damper on the next building boom. According to the Construction Cost Index, published by Turner Construction, construction costs rose by 5.5 percent in 2004 and another 9.5 percent in 2005, with continued increases expected this year.
Despite the negatives, the overall supply pipeline at the end of the first quarter of this year consisted of more than 3,300 projects totaling 448,000 rooms, the highest pipeline total since the record year of 1998. (Only a portion of these new rooms will come on line this year.) To some extent, the new hotel rooms will replace those converted to private condominium units. As with other property types, the best construction opportunities are those in markets with significant barriers to entry. Manhattan, New York is the best example; hotels there had an occupancy rate of 85 percent and average room rate of around $232 in 2005.
"U.S. Hotel Investments: State of the Union 2006" can be accessed at www.hvsinternational.com.
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