While demand, supply and the economy impact hotel values, it’s the capital markets that are the true arbiter of value. The economy sets the revenue per available room levels, while the normal issues such as location and competitive set are factored in.
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Joel Ross |
However, the level of leverage and the accepted cap rates determine true value. Cap rates are a direct reflection of the return equity rates investors demand to earn on their investment and their view of future earnings and valuation. So, at a 7-percent cap, investors assume strong growth and high future values because of cap-rate compression, which is what we had the past five years. At 12 percent, they expect slow growth in values and demand a much higher risk adjusted return. If you can’t get leverage to buy an asset, as is the case in most situations today, you have to look at a risk adjusted return on all equity, so you would use a high cap rate. The cost of capital for equity is very high relative to debt, so the value going in has to be much lower to justify the buy. If leverage is frothy, as it has been in the past several years, and the equity required to buy a property is low, then you can use a low cap rate because you’ll assume a high return on equity based on the high leverage because of a much lower overall cost of capital. If there’s little or no leverage, as we now have, supply demand or other factors make less of a difference. You’re still faced with high equity levels and a high cost of capital. It’s the risk adjusted cost of capital that determines the value.
Currently, investors consider hotels to be high risk and the recovery period to be long, so they require a 25-percent-to-30-percent internal rate of return. Values going in are low today.
Five years from now
Let’s look at where the debt markets will be in five years. As I said in my last column, hotel lending will be extremely conservative for many years. Securitization as we have known it is dead and will remain so. The definition of securitization is: I make a loan and sell the whole risk to some sucker in a series of rated tranches. That’s never returning.
Once again, hotels have demonstrated they’re at high risk of substantially lower net operating income when the economy sours, so in the future lenders will make sure—through tighter underwriting and much lower leverage—they never get caught again as they are now. This low leverage means cap rates stay high and values dip lower than they otherwise might have been during the past 10 years.
Add to this the fact most objective industry executives agree 2009 RevPAR will be down 20 percent or so—2010 will be down another 3 percent to 10 percent. From peak RevPAR in July or August 2008 to the trough in third quarter 2010, the decline in RevPAR is likely to be somewhere around 25 percent to 30 percent. This means values will be back to where they were 13 or 14 years ago, or maybe lower.
The economy will take a long time to grow back to a level of strong growth. Hotels will take even longer. Unemployment will be slow to decline in 2011. Corporate travel budgets will increase but much more carefully than in the recent golden age of excess.
Hotel lending will just start to return in 2011 and likely won’t be of any material volume until 2013. Then it will be based on historic cash flow, so it’ll remain low leverage, likely 60 percent to 65 percent based on 10 percent cap rates. That’s not going to change for many years, maybe 10 years or longer.
Equity investors will recall what this downturn did to hotels because the lenders will still be selling foreclosed properties into 2012. It took 10 years to go from US$50,000 in 1996 to US$100,000 per key in 2006, and that’s with the sloppy underwriting and excessively high leverage provided by conduit lenders.
If we have far more conservative lending and a low base equal compared to 1996 and demanding equity investors, it’s simple not possible values will shoot up during the next five years to much higher levels than they reached during the froth of the last few years.
The way to make a lot of money buying hotels is to buy them at high cap rates or very low per room prices during the next three years and to operate them much better than the last guy. It’s not through cap-rate compression brought on by excessive leverage which was the fool’s game of the past several years. Any attempt to compare this time to other downturns is a gross failure to understand what’s happening in the financial world. This is a genuine, full-scale restructuring of the capital markets and regulation on a scale not seen since the ’30s.
The world’s bank regulators have decreed we won’t have high leverage again. That will be the law. Wall Street died because of securitization and its offshoots. It’s not returning. Low leverage and tough underwriting means rational valuations—10-percent-to-12-percent cap rates on hotels will be the norm for several years. Investors will continue to demand high returns on hotel equity.
Compounding the value issue will be the fact many hotels won’t have had any cap ex for several years while in foreclosure or during the extremely lean times we’re in. There’s no cash or financing to do it. They’ll require renovation dollars to be spent by the new owners. The need for this additional capital expenditure will mean lower purchase prices—lower values. Interest rates will be far higher in five years because of the high probability of high inflation and an almost certain decline in the dollar because of the massive deficits the new administration will be creating.
The capital markets and cost of capital will drive value again. You need to pay close attention to the capital markets and the future combined cost of capital to be able to have any hope of projecting hotel values in five years to seven years. It was an understanding of what was happening to the capital markets, and the unsustainable insanity in lending that allowed me and others in the capital market to project the coming economic collapse in spring 2007.
You, too, can see the future more clearly if you just watch interest rates, underwriting leverage levels and criteria, risk adjusted returns demanded by equity investors and the level of the deficit, and the dollar versus other currencies. There’s a lot of money to be made in hotels during the next 10 years if you know what to look for and how to capitalize your deals. It’s all in the buy.
Smart extensions
Lenders and owners, and lenders who’ve foreclosed, need to return to planet earth. Extending outstanding excessively high loans is only further damaging the situation and extending the crisis. Values are down 40 percent to 50 percent. They’re not going back up soon, and they’re not going anywhere near 2007 levels for many years—maybe 10 to 12 years. Extending the current loan at the current leverage level doesn’t solve anything—it makes it worse for the borrower. The property can’t pay. Just because a property is covering debt now because a London Interbank Offered Rate (LIBOR) loan with no floor and a low 2007 spread, doesn’t mean things are OK. They’re not. The loan won’t get rolled at current rates or at that leverage.
Loans need to be restructured much lower now. The lender needs to take the hit now and reduce principal. The borrower needs to put in more equity to fill part of that gap. Lenders prefer to kick the problem down the road with a simple extension. That’s bad lending practice and your risk officer shouldn’t allow it.
The smart and only right thing is to lower the principal and reset the loan for a five-year term. If this isn’t done, we’ll be in this mess for many more years. Sellers need to understand they have nothing to sell in most cases. Their asset isn’t worth the loan balance, and it’s not going back where it once was in three or five years. The capital markets won’t allow that to happen. This is no different than what occurred in the residential market.
Joel Ross is principal of Citadel Realty Advisors, successor to Ross Properties, the investment banking and real estate financing firm he launched in 1981. A Wharton School graduate, Ross began his career on Wall Street as an investment banker in 1965. A pioneer in commercial mortgage-backed securities, Ross, along with Lexington Mortgage, and in conjunction with Nomura, effectively reopened Wall Street to the hotel industry. Ross also was a founder of Market Street Investors, a brownfield land development company. A member of Urban Land Institute, Ross conceived and co-authored with PricewaterhouseCoopers The Hotel Mortgage Performance Report. Ross served two tours in Vietnam with the U.S. Navy.