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High Prices Pushing Hotel Investors Into Select Service, Second-Tier Markets

Hotel Property Sales Increase Leads All CRE Sectors Over Last Four Quarters As Investors Scramble For Available Properties
July 22, 2014
With hospitality property operating metrics strong and getting stronger and capital chasing a limited number of available properties, the lack of high-quality assets on the market is pushing investors into the select service and extended stay segments, second- and even third-tier markets and other alternative asset classes.

The heated competition among buyers may even be contributing to a new round of consolidation in the lodging REIT sector, according to Fitch Ratings, citing the recent $1.95 billion acquisition by American Realty Capital Hospitality Trust of the former Equity Inns portfolio. At minimum, the transaction further reveals the extensive investment capital available for hotel acquisitions.

REITs that own select service hotel properties could be possible acquisition targets, Fitch notes.

Lodging property profits are up, debt is more readily available at attractive terms, capitalization rates are stable and investors -- heartened by strong lodging metrics -- expect values and sales activity to continue to increase, according to PKF Consulting USA, LLC's annual Hospitality Investment Survey.

However, many survey respondents indicated that owners are holding on to their high-yielding hotel assets as the outlook for NOI growth remains strong. As a result, investors compete for the limited number of hotels available on the market for purchase, said Scott Smith, vice president in the Atlanta office of PKFC.

"This has created a competitive environment for buyers, effectively driving up pricing," Smith said. "In response, some investors are now targeting alternative asset classes such as select service or extended stay, or focusing on secondary and tertiary markets."

One major reason that fundamentals are so strong is that supply growth is expected to remain below the long-run average of 1.9% through 2016 before rising to 2.1% in 2017, according to PKF's survey conducted in the spring, which tracks changes in investment and financing criteria over the prior 12 months.

Modest levels of new hotel development should keep occupancy high and allow operators to raise average daily rates (ADR), resulting in robust revenue per available room (RevPAR) growth through 2016.

"With supply growth forecast to remain below the long-run average, the outlook for exceptional returns on hotel investments appears to be positive," Smith said. "The only outstanding question among the respondents to our survey is how long can the industry maintain this peak performance?"

At the same time, property level net operating income (NOI) increased for the typical U.S. hotel by 10.1% in 2013, just below the 2012 year-over-year increase of 10.2%. Double-digit annual gains in NOI are forecast to continue through 2015.

The previous cycle's lodging REIT M&A activity was dominated by private equity firms taking advantage of CMBS debt as a low cost source of merger financing, relative to the more leveraged loan and high-yield bond markets that traditionally fund leveraged buyout activity. CMBS may be re-emerging as a force in such deals, with two deals totaling $2 billion in one week in late June alone.

In addition to ARCH's recent megadeal, NorthStar Realty Finance recently acquired a 90% interest in Innkeepers USA's $1 billion portfolio and is said to be on the hunt for more select-service properties.

NorthStar lost out in the bidding for a 47-property portfolio owned by Clarion Partners, an $800 million deal ultimately won by Blackstone. But the New York-based REIT is said to be shopping portfolios owned by Hyatt Hotels and Texas-based K Partners Hospitality

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