According to the Hotel Investors Gauge recently released by STR Analytics and introduced in the first edition of the Hotel Investment Barometer, investors indicate current cap rates on recent hotel transaction range from 6.4% to 10.2% with a median cap rate of 8%. Given the relatively weak, albeit improving, income performance for most hotels, 8% appropriately balances the risk of short-term leases and the potential for rapid improvement that characterizes the hotel industry.
Still, most private equity, which is heavily dependent on leverage in order to achieve its own measure of risk/return in the hotel sector, finds it difficult to justify an 8% cap rate. With debt, when it is available, hovering around 6% to 7%, according to the Hotel Investors Gauge, levered equity returns cannot drop low enough to typically justify that low a cap rate on trailing 12-month performance even for the most optimistic of appraisal forecasters. Therefore, most private equity and debt are forced to sit on the sidelines as hotel real estate investment trusts, for which cost of capital averages around 4.5%, are the only ones on the field for acquisitions.
Hotel REITS, once the target themselves of private equity that salivated (briefly in early 2009) at stock prices that were a fraction of the peak 2007 market prices, are now the 800-pound gorillas at the table. In fact, the following table illustrates the rollercoaster that public REITS have gone on during the past three years.
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Although we have been touting since late 2009 the industry needs to be prepared for the immense arbitrage benefit most REITS will unleash on acquisition targets in the United States, never would we have imagined their cost of capital would fall to and be sustained at the levels which they currently reside.
Low cap rates on newer hotel REITS like Chesapeake Lodging Trust, Pebblebrook Hotel Trust, and Chatham Lodging Trust are to be expected because of early market exuberance and the perceived income upside from potential acquisitions. But even the longer-term “legacy” REITS are valued in the sub-5% cap rate range. And that is why nine of the top 10 hotel acquisitions in 2010 have been made by six different REITs, according to STR Analytics research for the Hotel Investment Barometer.
So why isn’t everybody tapping the public route of a REIT structure? The answer is that undoubtedly more real-estate focused hotel investors will do exactly that. And in so doing we should see those REITS putting their 3% to 5% cost of capital to work by offering hotels 6% to 8% cap rates on acquisitions for the plethora of hotels coming to market that currently fall under the auspices of the special servicers and real estate owned bank debt.
Gregory Hartmann, MAI, CHA is Managing Director of STR Analytics specializing in data mining, comparative analysis, performance and capitalization trends, consumer research and strategic planning in the lodging industry. Jenny Nelson is a junior research analyst with STR Analytics.