While hotel transactions slowed across the U.S. during the second half of 2022, California saw deal after deal through the end of the year.
According to the California Hotel Sales Survey 2022 Year-End from Atlas Hospitality Group, the state saw 483 individual deals last year, the second-highest number of deals in a year, down 5.3% from the 2021 record. At nearly $8.6 billion, 2022 had the third-highest dollar volume on record.
The state set a new record for median price per room at $151,636, a 10% increase over the record set in 2021. The highest-priced deal was the $641 million paid for the 260-key Montage Resort Hotel in Laguna Beach, formerly of the Strategic Hotels & Resorts portfolio.
At the time of his company’s midyear survey, Atlas President Alan Reay said he had projected sales to taper off in the second half of the year, primarily because of rising interest rates.
“That simply didn’t happen,” he said. “We almost had exactly the same number of transactions sold in the second half of 2022 as we had in the second half of 2021.”
Los Angeles County was the sales leader for the state, Reay said. The county had the most transactions in California at 76, down from 77 in 2021, and the highest total dollar volume of $1.8 billion.
The largest hotel sold was the 573-room Four Points by Sheraton Los Angeles Airport. The highest-priced sale was the 350-room Westin Pasadena for $189.7 million.
What sticks out further was that the median price per key jumped by 25% to $196,000, which was $40,000 above the median price per key for the entire state, he said.
“We've seen that kind of a jump before when maybe you have a state that has four or five transactions and you can get one or two sales that really skew the numbers, but to have the highest amount of sales and the highest dollar volume in any county and then have a median price per room up 25% — that's pretty astounding,” he said.
The Factors Driving Deals
Although hotels in California are popular targets for investors looking to cash in on the diverse set of demand drivers in the state, there are likely other factors at play in propping up those numbers.
A significant portion of those sales came from the state’s Project Homekey as well as 1031 exchanges, Reay said. Project Homekey is a state-funded program that provides county and local governments with money to acquire older hotels to convert to housing for the homeless. A 1031 exchange is a real estate investment tool that provides tax breaks to property owners who sell an investment property and acquire another, allowing them to defer capital gains taxes.
“I'm going to estimate that a high percentage of those deals in California transacted because of Homekey and 1031 exchanges,” he said. “Otherwise, I think we would have seen more of a dip like you've seen in other states.”
At the same time, it’s interesting to see that the increases in interest rates had little effect on buyer demand, Reay said. It’s the first time in his 30 years of tracking these deals to see this situation.
“We’re seeing deals in the second half of 2022 sell at cap rates that are equal to or below the cost of money,” he said. “By that, I mean if you’re purchasing a hotel 12 to 18 months ago, rates were 4%, and now you’re paying in that 7% to 8% range. People are still buying hotels at 6, 7 cap rates.”
There has been a tremendous amount of capital sitting on the sidelines watching for deals, Reay said. Investors are particularly drawn to California because of its strong economy and its demand drivers. They prefer to invest in existing hotels because of the high cost to replace those properties.
There are many new buyers targeting hotels, and most of those are looking to convert hotels to alternative uses, he said. The biggest buyer group comes through Project Homekey. Another large group is those looking to convert older hotels to apartments for affordable housing.
This is a relatively new phenomenon as Reay said that, for most of his career, when potential buyers wanted to convert hotels to apartments, he told them they’d have a difficult time finding cities that would give up the transient occupancy taxes and that would go through the rezoning process.
“I never heard back from them,” he said.
The federal and state governments are pushing cities harder on making more affordable housing, he said. The cities aren’t able to flip a switch and build affordable housing quickly in California, so many have turned to allowing older hotels, particularly extended-stay properties, to convert to apartments.
While the typical investor wouldn’t pay the price, bureaucrats see buying a hotel for $200,000 or $250,000 a key as a deal because the cost to build housing is $500,000 a unit, Reay said.
“The state is buying it because they're buying it at a discount to what it would cost them to build,” he said.
2023 Outlook
There has been a huge uptick in properties coming to market, and many of those have loans that mature this year, Reay said. There’s roughly $5.5 billion in hotel loans maturing over the next 18 months in California, and those who originated those loans at about 4% are now refinancing at close to 7% to 8%.
“That’s the motivating factor behind those deals,” he said.
If the deep-pocketed funds pull back, there will be a rest in pricing, and he’s still predicting a slowdown in terms of overall sales, he said. However, if Project Homekey gets more funding again, that will buoy the market.
The reset in pricing will predominantly be because of interest rate increases, Reay said. Hotels have performed well during the recovery, even surpassing pre-pandemic numbers. The travel and leisure market has been breaking all types of records for net operating income and total revenue, but that’s not the only factor at play.
“The issue is always going to be how much am I paying for my financing,” he said.
The flip side to all of this is Project HomeKey and conversions to apartments, Reay said. From an investment standpoint, the supply of lower-priced, limited-service hotels in California is not only not growing, it’s shrinking because of the hotels being taken out of the market.
“The barriers to entry for budget motels in California are just incredible,” he said. “No one can really afford to build the budget motel, so I think that the price appreciation in that sector is probably going to be very, very strong.”