It’s Always Darkest Before the Dawn | By Scott Smith, MAI

In the 2008 edition of PKF Consulting’s Hospitality Investment Survey (HIS), the lack of liquidity in the market was the driving force in declining investor expectations. As industry participants now contemplate the worsening economic recession and its impact on lodging revenues and expenses, the 2009 edition of HIS reveals that investors anticipate a significant decline in operating incomes and resultant loss in property values unlike anything we have seen in past recessions. However investors have also indicated that with the “dawning” of an expected lodging rebound in 2011, today’s distressed and “dark” environment will provide exceptional investment opportunities to those investors with the ability to take advantage. As has been said many times – “It is always darkest before the dawn.”

Similar to our last survey in 2008, there continues to be major resetting and de-leveraging in the real estate market based on the current recession. Loan-to-value ratios are decreasing, capitalization rates are increasing, and net operating income estimates are falling. All this has resulted in significant value diminution. Owners are unwilling to sell assets in this environment and as a result, transactions have been at an all time low during the past 12 month period.

The lack of debt financing and the declining growth in income continues to increase the perceived risk premium for most hotel investors. As a result, the difference between current hotel owners/sellers expectations and buyers continue to be very wide. Investors are fearful of near-term downside risk and see uncertainly and an unreliable upside. This will result in fewer transactions in the near term. As owners become increasingly compelled to sell (or lenders begin to foreclose), we expect the transaction market to improve in the latter half of 2009. These transactions will be limited to sales of single assets and smaller portfolios and will include a lower asset class. Funding will be provided by private equity investors that have been anticipating deep discounts in price. Should poor operating profits and lack of debt financing continue to persist for the higher class of assets, we anticipate that buyers will have an unparalleled opportunity to purchase investment grade property at discounts ranging from 20 to 40 percent.

The following bullet statements highlight just some of the findings of the 2009 edition of PKF Consulting’s Hospitality Investment Survey.

Investment Criteria

• Overall hotel capitalization rates have increased 122 basis points from 2008 to 2009. Survey respondents indicated that most of the increase is due to declining NOI and limited short term upside.
• On average, the older the property, the higher the perceived risk resulting in a higher capitalization rate.
• The 4.52% spread between the overall capitalization rate and discount rate suggests owners’ expectations for growth in net operating income over the rate of inflation.
• Debt coverage ratios remained at levels similar to 2008 suggesting that lenders continue to be cautious in their underwriting.
• Investors continue to price the cash flows of hotels in the full service segment higher than limited service hotels.
• Capitalization rates for forecast NOI increased 120 basis points, whereas terminal capitalization rates remained the same.
• Both full-service and limited-service hotels continue to offer attractive equity yields and cash-on-cash returns.

Mortgage Criteria

• Current mortgage terms for both limited-service and full-service hotels indicate a tightening of the underwriting criteria resulting in increased capital costs.
• From 2008 to 2009 there has been a dramatic shortening of the length of the average loan term.
• With little or no fixed rate mortgages available, variable rate mortgages protect the lender from anticipated increases in interest rates.
• As lenders face more scrutiny in their underwriting to limit potential foreclosures and loan defaults, conservative (i.e. more costly) underwriting criteria will be the norm throughout the remainder of 2009 and into 2010.

Summary

As the 2009 survey indicates, we have indeed entered into one of the darkest periods in the lodging investment cycle. Most investors indicated that the downturn in the lodging sector will be deep and longer than anyone could have imagined. However, this is a cycle and each cycle has its “dawn.” Although current economic indicators are weak, investors are certain that exceptional opportunities will surface ahead as owners are forced to sell or raise additional capital. Expectations call for capitalization rates to moderate and that hotel values in the short term will continue to decline as profits decrease. Only those sellers that have to sell – will, and at a discount. As in past downturns, distressed hotel sales taint the overall health of the lodging investment market. Those well capitalized owners with good quality assets in premium locations will hold for dividend yield and wait for the next cycle.