The Lodging Market Looks Ahead
New equity could make this sector more hospitable for investors.
Just a short time ago investment in hotels and
resorts was relatively straightforward — lodging industry fundamentals
were positive and cheap debt was abundant. Lodging, the then-darling of the
financial and investment markets, provided a premium return over more mundane
investments in industrial facilities, office buildings, and shopping centers.
Transactions hit record numbers as existing owners took their profits, and
new owners were poised to continue the trend.
This scenario changed last year with the collapse of the commercial mortgage-backed
securities market and the resulting standstill in the commercial finance and
property markets. Today, hospitality investment is more complex. As market
performance flattens, debt becomes more difficult to source and questions arise
about the underlying economy and the possibility of a recession. On average,
U.S. hotel values are off at least 10 percent, the mortgage market is thin,
and transaction volume is far below 2005–07 levels.
“Busted deals” characterize many of the opportunities presented
to public and private equity buyers pursuing hotel investments. These deals
often involve properties or development projects that need capital and have
no financing sources.
When defaults occur on the existing debt and the lender doesn’t want
the property back, the stage is set for action. The primary play with busted
finance deals is purchasing the note from the lender at a discount. The alternative
is to wait for a lender foreclosure or another event that allows the lender
to sell the underlying asset to satisfy the lien.
Adapting to a New Reality
Given the current lending environment, these types
of opportunities will be a part of the hotel capital and investment markets
for the next 12 to 18
months. But there are capital alternatives to a sale or basic debt financing
that will accomplish many of the same objectives. Several of the most promising
alternatives involve de-leveraging the investment with new equity.
In the hotel sector there is a significant amount of short-term debt, senior
and mezzanine, with two to three years remaining. With no change in the hotel
lending markets expected over the next six to eight months, many owners must
consider de-leveraging with new equity for needed capital. This offers an opportunity
for commercial real estate investors interested in entering the hotel market.
Given the lack of property investment activity in today’s market, commercial
real estate professionals may want to investigate the hospitality market for
clients looking for value-add or turnaround opportunities.
More than other types of property investments, hotels are local-demand-oriented.
Many U.S. markets continue to operate at very acceptable levels because those
markets have strong demand and limited new supply. Today’s hotel investment
market brings lower prices, less leverage, higher debt service coverage ratios,
and very little pro forma underwriting.
2008 RevPAR Forecast Change, 2Q08
RevPAR Change (%)
| 50 major U.S. cities
|New England and Mid-Atlantic
|Mountain and Pacific
Source: PKF Hospitality Research
The hotel investment market will be involved in significant de-leveraging
for the next two years. There are two ways to de-leverage: Wait for the market
and values to return to previous levels and beyond, or recapitalize with new
equity dollars. New equity can come in many forms including renovation work,
debt reduction, establishment of financial reserves, or re-branding initiatives.
How De-Leveraging Can Help
Hotel owners are exploring creative ways to structure
joint ventures with many types of prospective partners, including passive
investors, operators, developers,
and hybrid equity/debt or mezzanine lenders. While they can be structured
several ways, successful joint ventures generally involve two or more parties
who accept the current situation, understand the alternatives, and create
a new entity that aligns the parties’ interests in a common plan. Specifically
the parties should consider the following points for a successful result:
assign specific responsibilities and roles;
select the most appropriate form of ownership;
be considerate of existing senior debt covenants;
rationalize a term of the relationship and consider exit strategies;
confront control and deadlock resolution issues; and
provide for allocation of profits and other benefits.
The following examples
illustrate two ways de-leveraging through joint-venture partnerships can
provide solutions. In both cases, the owners are electing
to hold the properties and cannot or will not consider a discounted sale.
In the first example, owners of a California hotel have determined that a
renovation and potential rebranding will restore the property’s value.
Planning for a $5 million renovation, the owners had to face the current reality
that their existing senior debt (CMBS) cannot be replaced or removed economically
because of the high cost of defeasance as rates have remained low.
A management company with investment dollars is proposing to create a joint
venture that would include a management takeover, infusion of needed renovation
funds, and assumption of the existing loan. The current owners get cash to
dilute their position, a carried interest/equity in the new venture while giving
the new partners control of the operation, and preferred return on all new
In a second case, a Washington developer owns a site for a hotel that is working
its way through a lengthy public approval process. The land is held in fee
and subject to a third-party development loan (11 percent interest only) that
has funded most of the costs associated with the entitlement process and an
interest reserve. The developer’s plans were to continue the process
and refinance the development loan with another lender, including enough funds
to complete the approval process and interest carry during that period. However,
the owner cannot refinance in this debt climate.
The market appears solid and the project is well-conceived and -planned, but
the problem lies in finding the capital to proceed to final approvals and construction.
Another developer has approached and offered to enter a joint-venture development.
The new partner is offering to pay down a portion of existing debt and fund
all entitlement activities. The new money comes in as preferred equity and
receives a preferred return on cash flow and sale or refinance. If all goes
well, both parties will combine to make a better development team.
Good Investment Potential
As the stock of existing U.S. hotels continues to
age, market dynamics change along with guest profiles. There always will
be opportunities to reposition
hotels by rebranding, investing, and/or operating from a different perspective.
Today’s U.S. boutique hotel market reflects this repositioning opportunity
in most major cities, where older properties have been revitalized and repositioned
with an entirely different demand base.
The opportunities are constant, but the liquidity in the credit markets provides
the glue that holds it all together. Given the prospects for recovery in 2009
and 2010, those with significant equity and a plan can expect great rewards
in the next several years. Downside risk is mitigated by owning and investing
in barrier-to-entry markets such as Boston, New York, San Francisco, and Seattle.
Most urban centers and other destinations that have broad-based market support
are benefiting from an influx of foreign visitors, driven in part by currency
and buying power as the dollar has slid.
But potential investors must be aware that geographically, there are significant
differences in hotel markets. One simple characterization of a market area’s
strength is expressed by the relationship of projected revenue per available
room, or RevPAR, growth compared to the consumer price index. What is very
clear in this comparison is that individual market outlooks have changed in
a short time. During 2007, of 50 major markets tracked, 35 were projected to
have RevPAR growth above CPI levels in 2008. Only nine markets were expected
to fall below CPI levels. As of 2Q08 only 22 markets — less than half — are
expected to surpass CPI growth in 2008 and an almost equal number, 21, will
fall below CPI pricing increases. This underlines the significance of location
in hospitality investments.
This debt-challenged environment has dampened owners’ plans to sell
and made buyers less aggressive. Many existing hotels are over-leveraged, but
investment opportunities are available in specific markets and with different
approaches, such as de-leveraging, that will bring new equity into hospitality