With 2018 in the history books, it’s a good time to reflect on the hospitality sector and consider the realities in the marketplace. Commercial mortgage brokers and lenders can use the beginning of a new year to prepare their strategies and take stock. Business opportunities abound in the hotel sector when the stars align and 2019 may be one of those years.
The market also is fraught with concerns. Lenders and brokers should use this time to analyze where the industry is headed and focus on the segments where the stars are shining brightest. So, this is a good time to take a reality check and see if you are in the right spot to take advantage of the coming year in hospitality.
Hotels have had an unusually long run of recovery for an industry accustomed to the usual seven- to eight-year market cycle. The hotel sector experienced several years of rapid revenue growth following the industry meltdown in 2008 and 2009, but the rate of that growth has slowed in recent years.
In 2017, for example, revenue per available room (RevPAR) rose solidly again, but the growth rate was flatter than in 2016 and was significantly less than the 9 percent-plus growth in the early years of the recovery, according to CBRE Hotels. This past year also produced relatively flat RevPAR growth compared to 2017. This flattening trend — if two years can be considered a trend — could be an omen that the industry is cooling off.
RevPAR is a key performance metric for the hotel sector that factors in the average daily rate (ADR) of a room and its occupancy rate. The successful RevPAR growth of 2017 was led by increases in the average daily rate. This was understandable, as it follows the normal pattern of cycles.
During meltdowns, hotels typically reduce room rates to increase occupancy. As the sector recovered, hotels increased room rates, but the occupancy rate has stopped growing and is projected to fall in 2019. Hotels have remained profitable, however, and the supply of new rooms has continued to grow. The plateau in occupancy levels that began in 2017 could have been due to the industry’s focus on ADR, but it also could be an early hint of an approaching slowdown.
This year began with a few other issues that could impact both the hotel sector’s fundamentals and the costs of acquiring hotel assets. Interest rates have been rising. Hotel lenders have tightened their standards on loan-to-value (LTV) ratios, requiring more equity in their deals. Wages across the U.S. have been rising, a factor that could raise hotel staffing costs and lower profits. The market has shown some signs of volatility and capitalization rates have been slowly rising, a sign that the sales prices and values of hotels could begin to fall.
These signals of a slowdown also might be signs of opportunities. They may foreshadow a coming sell-off. So, mortgage brokers can advise their hotel- sector clients that it is a good time to have some cash on hand.
Expectations for 2019
There have been many market cycles over the past 40 years. When a cycle begins to end, the playing field changes in predictable ways. Here are five predictions for 2019:
• Hotel management will make a push to increase occupancy levels at the expense of average daily room rates. This move will put downward pressure on hotel margins as the revenue generated by the growth in occupancy typically generates less revenue than increases in ADR.
• The construction pipeline of new hotels will slow down. Existing hotels will carefully consider property renovations as they struggle to keep their franchises intact and keep up with their competitors.
• Boutique properties will continue to gain popularity, a trend that started gaining speed a few years ago. Most boutique properties will be independent and challenge established brands.
• Brands that debuted in 2018 will continue to expand in a push for franchise fees. Marriott International now has 30 brands and continues to grow. Hilton and IHG are following this trend.
• Investors will turn away from select-service properties in favor of full-service properties, where the best bargains will be found when calculating the costs per room for acquisitions. These properties can be converted to soft brands or independent boutique properties and have a huge edge on established assets, given their low cost per room.
The hotel real estate sector abounds with opportunities to purchase properties when the market begins to turn, and 2019 may be one of those years. Hotel owners could be under increasing pressure to sell or refinance, which also could put lenders in the driver’s seat. There are several reasons for this.
Lenders have been lowering LTVs, forcing owners to contribute more equity to refinance maturing commercial real estate loans. Similarly, the downward trend in hotel margins could wreak havoc with prior forecasts for net operating income. This is true for hotel loans underwritten three to five years ago, when the forecast was brighter. The slowing trend of RevPAR could mean investment forecasts will be jeopardized, forcing investors to consider selling.
Rising cap rates will lower the value of hotels, creating pressure on ownership groups that must prove their asset’s value to a bank. Faced with declining values and unsuccessful attempts to refinance, owners may find themselves in a perfect storm and need to sell their assets. This pressure may open the door for more sales and new mortgages.
It’s a new world in the hotel sector, too. Many of the conversions and new construction in 2019 involved unbranded boutique hotels or soft brands that established companies created to capitalize on the move toward boutique hotels. Some of these soft brands include Autograph by Marriott, Moxy by Marriott, AC Hotels by Marriott, the Ascend Hotel Collection by Choice Hotels, Curio by Hilton, Tribute by Marriott and The Unbound Collection by Hyatt. This trend will continue, not go away.
The increase in unbranded hotels can be dangerous to established hotels as they can erode the established hotels’ transient base. At present, these unbranded hotels are favored by millennials. Although branded hotels are trying to capitalize on this movement with their soft and boutique brands, there will be some fallout in the industry, mainly in the full-service hotel segments.
Investors will have opportunities to acquire these full-service properties at prices significantly less than their original values. Savvy investors will be able to buy value-add assets, which will present excellent opportunities for commercial mortgage brokers. The risks are low and the chances for success are high when approaching these types of deals.
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We must remember that we are entering a descending and unstable market for hospitality properties. In one way, this is bad for existing owners who continue to feel the pressures of this market, but it is good for those on the sidelines who can spend their equity on potentially deeply discounted properties. Hotels that are operating marginally can be purchased at a discount when the present ownership is unable to refinance, or when renovation costs are too high to justify holding on to the asset.
Lenders should choose their customers carefully. The property that has the most potential to grow can signify your best and safest customer, but the property that is already at the top of the market could easily become your next problem. This year will present both kinds of opportunities.