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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   June 2018

Add Value in Down Times

Explore the cyclical nature of hotels to help clients make smarter investments

Add Value in Down Times

Hotels operate in a cyclical industry that is unusual with respect to more typical real estate properties. That is because hotel real estate is intertwined with an operating business. Consequently, the value of the real estate is affected by the hotel industry’s economic cycle, which commonly lasts about eight to 10 years.      

Fluctuations in this economic cycle cause the profits of hotels to rise and fall. At the end of a cycle, there may be substantial changes to the net operating income (NOI) of a hotel property. Lenders, commercial mortgage brokers and investors need to be cognizant of where the hotel industry is in the cycle and the direction it is headed.

Along with changes in NOI come fluctuations in capitalization rates, or cap rates, which are calculated by dividing a property’s NOI by its current market value. The cap rate is an industry risk tool and floats with the economics of any cycle. As the cap rate drops, due to a robust portion of the real estate cycle or a positive burst in the larger economy, the value of a hotel asset increases.

If this cap-rate reduction coincides with a strong business environment, the value of a hotel can increase significantly in a short period of time. This is one of the great attractions of the hotel business but, unfortunately, the reverse scenario is true as well.

Economic background

In 2008, the hotel industry was at a peak after six solid years of growth. Cap rates were low and recent years had witnessed significant growth in NOI. Hotels were the sweetheart of real estate at that moment — until, suddenly, they were not.

In 2009, cap rates began a steady climb, lowering the values of hotel properties at the same time NOIs also were decreasing. This created an implosion of profits for many hotels and their owners, who were unable to refinance or sell and lost their assets to banks and servicing companies. This condition lasted for about two years and then began to correct itself.

The next seven years proved very strong, with the annual growth of RevPAR (revenue per available room, which is a major index for judging hotel values) steadily increasing, including double-digit increases in some markets. As risk factors diminished, cap rates also settled down and hotel values began to rise. Solid growth during this seven-year period put the hotel real estate market — along with the stock market — in strong positions right up to the start of 2018. And then the cycle slowed again. This is an example of why all industry players should be aware of hotel-market dynamics.

RevPAR in 2017 was relatively flat compared to 2016, and 2018 estimates are looking relatively flat compared to 2017. Lenders, mortgage brokers and investors can expect this trend to continue into 2019 and maybe 2020. Investors who did not understand the cyclical realities of the industry may see their investments looking softer than forecasted.

In many cases, just before cycles cool down, there are record sales because investors believe the trend will continue. The reality is, there are always downturns. Savvy investors can ride these waves successfully. And the changes in cycles can create value-add opportunities for real estate assets.

Lender sensitivity

Commercial lenders — and, consequently, mortgage brokers — need to be in tune with the hotel marketplace. This is not too hard to do as there are plenty of sources to compare notes with in order to understand what is happening. You should be cautious about listening to real estate brokers or others with a vested interest in a robust cycle. Even if the market is crashing, they usually will not acknowledge it. This makes sense as their livelihood relies on a healthy market.

The value-add portion of the deal is the result of a property that was riding high and is now in financial distress.

During the run-up to these downturns, investors often make the most egregious errors and acquire assets with too much basis in costs. Although these investors may be well-capitalized and, as such, are less risky to lend to, they can be the first victims of a downturn. Mortgage brokers should be aware of the market and read the signs. Knowing when you are in a midcycle point between hot and cold, for example, is critical to helping lenders and borrowers make the right decisions.

The basis cost, or the original amount invested, is the critical component of investing wisely. Remember that a hotel is a dual product combining hard real estate and operating-business elements. The asset’s NOI, when mixed in with the prevailing cap rate, can dramatically change the value of the property. It can be discouraging to see the market cool, the cap rate rise and — as in present times — an increase in interest rates for debt. It’s a double whammy. Consequently, the amount being invested becomes critical and is something likely to be studied carefully by lenders.

Value-add potential

Value-add real estate transactions are those in which an asset can be acquired at a significant reduction in cost compared to the replacement cost. Consider, for example, a hotel that was producing $1 million of annual NOI. The cap rate at that time, reflecting the strong part of the cycle, was 7.5 percent.

The property would have a value of about $13.3 million So, an investor pays that amount to purchase the hotel. When the deal was underwritten, there may have been a rationale to increase the NOI by 5 percent annually, based on the hotel’s historic economic growth, while also assuming a steady cap rate.

Now, imagine what happens if the cap rate rises to 9.5 percent and the NOI only increases 2 percent. The hotel suddenly loses more than $2 million in value. And, even more troubling, the debt-service-coverage ratio in the loan agreement is now in jeopardy.

The value-add part of this scenario comes when the investor, seeing the value of his asset deteriorate and being required by his bank to add equity, decides to sell the hotel as quickly as possible. A hotel that was worth $13.3 million at one point may now be worth $9 million or less. It’s the same asset, but the cycle has changed. Additionally, during the slow reduction in value, the investor might have stopped repairing the asset, creating more stress. All of this leads to an opportunity for a new investor to buy the asset for well below its replacement value.

Reset the clock

Commercial mortgage brokers should know that lenders are sensitive to all of the above factors when they are approached for financing on these types of assets. It’s important to remember that the asset itself hasn’t changed. It was simply much more valuable at a different point in the cycle.

Essentially, the clock can be reset. A new buyer could be purchasing the hotel at a discount price that helps lower the risk to the lender. The value-add portion of the deal is the result of a property that was riding high and is now in financial distress.

A new buyer can end up with a great deal if they are there at the right time. This is exactly what happened in 2010 and 2011 after the bottom fell out of the growth cycle from 2002 to 2009. Savvy investors picked up hotels at 50 percent of their prior values and reset the clock. This was the start of a run-up in asset values from 2011 to 2016 that ended with sales prices that were similar to those in 2008.

Lenders may view a value-add asset as an opportunity to lend to borrowers who aim to duplicate the upward thrust of past cycles of hotel assets. Mortgage brokers can help lenders avoid risk if they do their homework and can answer the following questions:

  • Where is the asset in the industry cycle? 
  • What past and present statistics are available to review the asset’s history? 
  • Did management change as the hotel’s property value dropped, and was there a special loan servicer or temporary management company involved?
  • Was there a lack of capital investment in the asset, allowing its physical appearance to be downgraded?

•  •  •

All of the above factors are reasons why, with a new owner, the value of a hotel asset can be restored through better management as well as by riding out the slow reversal of the cycle. Commercial mortgage brokers who keep this in mind may find excellent opportunities in the coming years to close deals with a lot of future potential. 


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