The Hotel Investors Gauge launched by HotelNewsNow.com and STR Analytics at the end of the third quarter of 2010 illustrates the growing level of optimism in the hotel real estate sector. The results provide valuable insight related to underwriting parameters, investment perspective, and future outlook for hotel assets.
Download the complete Hotel Investors Gauge here.
There are two key issues affecting the hotel investment marketplace: distressed assets and a large amount of capital available for investment. Basically, while investors and lenders are dealing with foreclosures, bankruptcies, and loan modifications, they are also actively pursuing new acquisitions and financing opportunities. And in some cases these groups are the same. Of those surveyed, 26% of the investors who are actively pursuing acquisitions currently have assets that are in default, bankruptcy, or foreclosure. On the debt side, 38% of lenders who stated they are open to funding new loans also recently foreclosed on distressed assets.
The current viewpoint of prospective investors stands in stark contrast to the grim reality the investment community faced in 2009, with no available debt and a continuous decline in cash flows. Today, two-thirds of investors anticipate occupancy to return to its prior peak by the end of 2012. More than half expect average rate to rebound by the end of 2013. This is far more optimistic than what most projected earlier this year when 2015 appeared to be the targeted year for occupancy and average rate to return to the peak levels of 2007/08. Moreover, close to 70% of investors anticipate net operating income to recover to previous peak levels by 2014.
Below is a summary of the key underwriting factors for investors and lenders. The blue bars illustrate the range of answers by the majority of respondents and the yellow dot represents the median value of all the responses for each factor.
Investors
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Investors’ return expectations appear to remain in tune with historical ranges, with a median internal rate of return expectation of 19%. Most investors are underwriting leveraged returns between approximately 16% and 22%. Investors are looking for both long-term holds as well as quick flips that take advantage of what is believed to be a rapid rebound in performance during the next two to three years. The median hold period is only five years, although the range for the majority of respondents ranged from 3.5 years to almost 12 years. The median cap rate on trailing 12 month cash flow was 8%, but is obviously highly dependent on an individual asset’s situation. Consequently, the majority of expected cap rate responses ranged from 6.4% to 10.2%.
Lenders
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Lenders indicated a broad range of loan sizes and terms. The majority of responses showed loan-to-value ratios ranging from 38.8% to 70.0%. The most common LTV ratio indicated by lenders was 60%. Most lenders stated that they provide floating rate loans. The LIBOR spreads indicated by financiers were widely varied among the respondents, with most falling between 310 to 725 bps above LIBOR. The median LIBOR spread was 450 bps. Short-term and long-term loans are both available, while the most common loan term among respondents was 5 years. Most lenders expect debt coverage ratios to be between 1.3 and 1.7, with a median debt coverage ratio of 1.4 among the respondents.
Required Growth in Cash Flow
Using the return parameters of investors and the typical debt terms being offered by lenders, we derived the assumed growth in net operating income necessary to achieve the 19% internal rate of return threshold. The chart below shows the cash flow of a typical acquisition where the investor would acquire an asset for US$12.5 million (US$1 million trailing 12 month cash flow at an 8% cap rate). The lender would provide a US$7.5 million (60% LTV) floating rate loan at 450 bps above LIBOR. (We also assumed LIBOR would increase during the loan’s five-year term.) In order to pay debt service and provide investors with the necessary returns over a five-year hold period, the property’s net operating income would need to increase at a compounded annual growth rate of approximately 6%.
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If you would like to participate in future Hotel Investors Gauge surveys, please email me at shennis@stranalytics.com. The Hotel Investors Gauge is conducted quarterly. The online survey takes less than 3 minutes to complete. Respondents to the survey are the first to receive the full compilation of results.