The Federal Reserve's raising interest rates by 0.75 percentage points with indications of more increases later this year further increases the cost of debt for hotel developers and would-be buyers.

Even if rates reach a projected 3.375% this year, they would still be relatively low compared to previous levels. However, the rate hikes represent additional headwinds for hotel owners and developers already dealing with increased construction and transaction costs.

The inflation headwinds hoteliers face are largely driven by supply-chain disruptions, and the increase in interest rates will hopefully slow down overall growth enough to let the supply chain catch up, said Mat Crosswy, president at Stonehill Strategic Capital. Many supply companies that slowed down production didn’t have excess reserves, and when demand came back, it created a lot of inflationary pressures.

“The goal is to slow down that inflation and slow down the overall economy without going into a heavy inflationary environment with a recession,” Crosswy said.

Historically, the average cost of debt has been 6%, but Crosswy said he doubts rates will go that high again because economists have shifted how they think about fixing interest rates and the impact on the economy.

There could be a minor recession, but different than before, he said, as corporate balance sheets have pretty low leverage, banks have enough cash in their balance sheets, and individuals generally have cash but personal debt has increased recently.

On a macroeconomic level, the rate increases and other factors are creating uncertainty around development projects, but the impact of that uncertainty is still not fully clear, said David Pollin, co-founder and co-president of the Buccini/Pollin Group.

Even two months ago, there was certainty around the economy and interest rates being low while there was lingering uncertainty over the sustainability of the hotel industry’s performance in the recovery, he said. Now that has flipped.

“You can't fight the Fed, and every capital market participant, especially on the debt side that we're dealing with, is saying they've already told us what they're going to do,” he said. “We don't know if they're actually going to do it, but we have to be prepared.”

During the Great Recession, there was big pullback in the availability of debt, said Anne Lloyd-Jones, senior managing director and director of consulting and valuation at HVS. That hasn’t really happened this time.

Some near-term transaction activity could be driven by hotel owners and developers trying to act before the next increase happens, she said, noting that interest rates are just part of the strain on project feasibility.

More distressed hotel assets are likely to hit the market too, as cost pressures mount on hotel owners, and the concerns over the debt market could accelerate that, she said.

Hot transactions markets are high-end, resort and heavily leisure, Lloyd-Jones said. Pointing to the sale of the W Nashville for $950,000 per room, she said such a deal would have surprised anyone before and after the start of the pandemic.

One of the things to remember in pricing decisions is the use of the accelerated cost of development as a litmus test, and to weigh the cost of developing a new asset against the costs of replacing or refurbishing an exhisting asset, she said.

“The ceiling for an existing asset has been raised by the cumulative impact of replacement cost versus acquisition cost, and I think that’s one of the things that’s really driven it thus far, even before interest rates have gone up,” she said.

The interest rate increases will contribute to better supply-side dynamics, Lloyd-Jones said. They should allow markets to recover and get back to a balance between supply and demand more quickly than they otherwise would have.

The caveat, however, is no one knows what the recovery will look like as there are still lingering questions over business travel and group demand, she said. They don’t know exactly the timing, pace or magnitude for the recovery.

“The better supply situation is very helpful in the context of the challenges that the industry is facing in terms of recovery,” she said.

On the discretionary capital side, Buccini/Pollin Group has inflation baked into its operating model and is careful about how it underwrites projects, Pollin said. With the increasing cost of debt along with these other headwinds on development, the bar has to be set higher and feasibility is more difficult to establish.

Due to the hurdles in feasibility, development pipeline growth is expected to be 1% to 1.5% for the next few years, he said. BPG is looking at two development projects currently, and focusing on leisure markets that have hotel demand six nights a week.

“We don’t want to be in a business park where you’re good Monday through Thursday,” Pollin said. “We really want to have the business for the week. We want bleisure on the shoulder nights. We want strong leisure on the weekends.”

Executives have focused on the luxury and lifestyle space, with solid full-service brands that could bring in a significant amount of food and beverage revenue, he said.

On the acquisition side, there will still be significant transactions this year because there is a lot of capital raised for deals, and it is not rewarded unless it is deployed, Pollin said. For BPG though, many of the properties the company would want to pursue are fully valued, he said.

“As a value-add participant in the market, we really don’t see an opportunity for us broadly right now,” he said. “If we were a [real estate investment trust] or sovereign wealth or some other institution that was looking for consistent cash flow, different story.”

Instead, the company has focused on its private equity platform, Corten Real Estate Partners, he said. It’s done a number of different preferred-equity investments by teaming up with sponsors on projects and giving them leverage to carry out their own value-add strategy.

Crosswy said many construction projects are starting to get pulled or shelved due to having to contend with higher construction costs from labor and materials.

“Now you have to bake in being able to support this extra load,” he said.

For most developers, there will be a slowdown in projects and there will be a pullback in the capital markets, Crosswy said. There’s less liquidity and less predictability in how to price a deal as the market continues to be volatile.

“That's the biggest challenge right now,” he said. “A lot of people don't want to quote because they don't know where rates are going to settle in bond investors.”

Crosswy said Stonehill Strategic Capital's lending pipeline has slowed to a drip, particularly for construction projects and even new projects. At the same time, other projects and processes are accelerating.

“We’re seeing people make decisions a lot sooner, especially with our fixed-rate product,” he said.

Many are preparing by shoring up their portfolios out of concern over where rates will go, which is a positive development, he said. The cost of debt and the labor market are the two of the biggest headwinds hoteliers face, so they’re trying to eliminate one of those variables.

A lot of hotels that were going to be built in 2020 got shelved because of COVID-19, Crosswy said. Some of those projects have restarted over the past 12 months, but he said “I still think the industry will be underserved, and no matter what, development to me still has a lot of risk."

That said, "if you really know how to develop, it can be one of the most rewarding investments today," he added.

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