While commercial real estate as a whole continues to navigate uncertainty, the hotel property market is experiencing a unique set of challenges and opportunities. Hotel owners and operators currently face a significant divergence in hotel operations performance across different locations and sectors. Meanwhile, potential buyers and sellers are grappling with how to accurately value hotel properties and manage rising debt costs and interest rates, leading to a complex and depressed deal market for hospitality properties.
Divergence in hotel performance
The hospitality industry is a complex tapestry of destinations and sectors, each dealing with its own factors influencing hotel performance, including individual property location, client base, age and condition. For the most part, hotel fundamentals continue to show strength in the United States. Based on STR data through August 2023, for this year, occupancy for all hotel properties has held at 66% (0.3% decrease from 2022), average daily rates have held at $154 (1.8% increase from 2022), and revenue per available room has held at $101 (1.5% increase from 2022). These metrics are near record highs; however, it’s important to note the performance data varies by property.
Location is one of the most pivotal factors determining hotel performance. It encompasses not only geographic coordinates but also the broader context of the surrounding area. Even with the nascent return of business travelers and office visits, urban hotels in major metropolitan areas have struggled to return to the strong fundamentals of the pre-pandemic years. In addition to rising costs to operate urban properties, the supplemental burdens of the depressed retail and restaurant real estate markets have made urban hotels less desirable to some leisure and business travelers. Further, public safety concerns in many metropolitan areas have discouraged some casual tourists from visiting these areas.
CBRE data shows the San Francisco office market closed out the second quarter of 2023 with an overall vacancy rate of 31.6%, a net absorption of approximately 1.8 million square feet. These figures are double the national average for office vacancy rates and have significantly affected the recovery of hotel rates in San Francisco. The state of recovery of group travel, specifically corporate-sponsored events, will likely push the needle for urban properties seeking an occupancy and rate boost.
In contrast, resort properties have continued to excel since the early months of 2022 and are poised to perform similarly in 2023. Through August 2023, metros such as Orlando and Miami boast rolling 12-month occupancy rates and average daily rates that exceed 72% and $190 per night, respectively, and continued growth in room supply with a combined 6,000 rooms under construction.
Challenges in valuing hotel assets
During the early stages of the pandemic, when hotel operations were temporarily halted, there was significant speculation by industry experts, investors and hotel owners as to the anticipated discount of hotel properties transacted in a distressed market. In reality, most deals were transacted more closely to pre-pandemic market values, and the deals market has not quite differentiated between distressed assets and distressed buyers.
For most hotel properties, the deflation of guest volume was entirely due to government restrictions, and recovery has reflected activity commensurate with pre-pandemic years.
But even as operations recovered, the often reduced cash flow and inability of some to reinvest in capital maintenance projects have compounded property issues over the last few years. Some hotel owners are facing significant property improvement plans, either voluntarily or through new debt agreements, and there are concerns about whether property renovations will improve operations or the resale value of hotels. These distressed assets have created a market bubble that has tested investors' risk appetite, and they likely do not provide valuation discounts that cover costs or meet the required rate of return on capital. With continued increases in cost for construction materials, labor and permitting, calculating the correct property value to complete hotel deals has been challenging.
Looming loan maturities and evaluating potential transactions
Even more concerning are the impending loan maturities of hotel properties with commercial mortgage backed securities (CMBS) loans that can potentially serve as a catalyst for transactions in the hotel property market. According to Trepp data, in August, 30-day delinquency rates for hotel properties reached 5.31%, significantly exceeding the six-month average of 4.45%. Delinquency rates compounded with $28 billion in CMBS loans maturing in 2023 and $18 billion in 2024 have created a potential distressed owner crisis that may infuse the transaction market with significant assets.
Even with the possibility of an oversupply of existing hotel properties with fewer suitors pursuing opportunities, quality hotel assets will likely transact, given the strength of operational fundamentals, significant and uncertain costs of long-term construction projects for new properties, and the uncertainty over long-term interest rates.
Unfortunately, the cost of carrying debt, difficulties in underwriting, and limited financing options have created a squeeze on transactions. CoStar data for the second quarter of 2023 shows hotel transaction volume was approximately $3.5 billion – a 70% decline from the second quarter of 2022 and a 49% decline from the second quarter of 2019. Since March 2022, the Federal Reserve increased interest rates 11 times for an aggregate increase of over 5.25%.
The ability for investors to recover a return of capital with effectively the same operating results can be incredibly difficult. Typically, in an elevated interest rate environment, the valuation of hotel properties will decrease, but hotel owners with strong operating metrics and longer maturity dates on outstanding loans have the opportunity and incentive to retain assets. Additional costs for underwriting and insurance have more than tripled in some instances, effectively striking down deals after parties have agreed. With banks pulling back the reins on issuing new debt or refinancing at significantly higher rates, alternative lending through private equity debt funds or other channels has become more popular but likely more expensive than traditional lending platforms.
The hospitality industry presents a complex landscape where some locations and sectors thrive while others face challenges. The difficulty in valuing hotel properties has created a somewhat depressed deal market, but looming loan maturities may lead to future opportunities. In the face of these challenges, many hotel owners are choosing to hold their assets, banking on solid fundamentals and waiting for greater industry clarity. Navigating this market requires careful consideration of the specific factors at play and adopting appropriate strategies to seize opportunities and mitigate risks.