NEW YORK CITY-The economic slowdown of the past year and a half now appears to be gaining momentum and dramatically deepening into what some are labeling as the Great Recession. This downturn appears on its way to being as long--if not longer--than any of the 11 economic slowdowns that have occurred since the 1930’s. The seeds of today’s recession sprouted in the summer of 2007 as the subprime mortgage crisis exposed pervasive weaknesses in both financial industry regulation and the overall global financial system. The rapid rise in unemployment throughout the nation, further eroded consumer confidence, which in turn exerts further negative pressure on businesses--truly a vicious circle.
The operating metrics in the US hotel industry held up well during the first nine months of 2008. The collapse of Lehman Brothers six months ago appeared to be an inflection point after which businesses started to dramatically cut costs. Corporate and group meeting/convention travel, the backbone of demand for US hotel rooms, was severely curtailed. The "AIG effect"--i.e. the negative public image of business entertainment--dealt an additional blow to the US hotel industry, as it became politically incorrect for corporate America to travel and attend meetings and conventions. Smith Travel Research is reporting astonishing weekly declines in RevPAR (Revenue Per Available Room) throughout the nation’s major markets as well as in many of the world’s major cities.
Lodging facilities are more than bricks and mortar real estate. They house going business concerns with high levels of operating leverage. Without long term tenancies, the daily leasing of guestrooms forces hotels to utilize yield management techniques which include a continuous re-pricing of rents. The recent dramatic decline in US hotel RevPAR is resulting in an exponential diminution of lodging profits.
There is no question that during this recession, the combination of both limited credit availability and declining earnings has led to a swift and dramatic erosion of the market value of all types of lodging facilities. The absence of any significant volume in US hotel sale transactions has meant limited transparency as to the market re-pricing of assets, and therefore little if any empirical evidence to quantify the magnitude of decline of US hotel prices. During the next 12 to 18 months, loan maturities and the workouts of hotel investment failures will compel transactions to occur, which will eventually provide the market with pricing clarity and ultimately narrowing the longstanding bid/ask standoff between buyers and sellers of US hotels. Once sale transactions resume in earnest, the market will then establish the current true value of US hotel properties, allowing comparisons to the peak of 2007. In today’s "hazy" pricing environment, many assert their "gut" reaction that hotel prices have declined upwards of 50% from the crest--a notion which will ultimately be proven true or false by evidence gleaned from a liquid transactional market.
The following analysis provides a preview of what the market will ultimately confirm. The three tables below illustrate statistical calculations of the recent movement of US hotel asset prices due to changes in capital stack structure and return requirements, as well as lodging profits.
The availability of high levels of relatively inexpensive hotel debt and equity peaked in early 2007, and resulted in a Weighted Average Cost of Capital (WACC) or a capitalization rate of 6.2%, a decline of 240 basis points (bps) from 2005. Today, almost two years after the pinnacle, a dramatic rise of 380 bps of the WACC of US hotels results in a 10% capitalization rate. An examination below of the implied value of $1,000 of net operating income (NOI) indicates a 38% decline in value from the peak, solely as a result of the dramatic shift in the capital stack structure and return requirement of US hotels.
Layering changes in US hotel NOI into the theoretical analysis expands the study further as exemplified on the following matrices.
Given the current declines in US RevPAR, and factoring in the reverse effects of hotel operating leverage in a declining market, it will not be unusual for many lodging facilities to experience dramatically falling profits. The table above demonstrates that a 25% decline in NOI coupled with the 380 bps rise of the WACC of a US lodging investment, results in more than a 50% drop in the value of the asset, thus validating the "gut" reaction of many of today’s hotel investment market participants. Of course, these are only paper losses as no one would sell today unless they had to or were forced by circumstances
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Daniel Lesser is the senior managing director of the Hospitality & Gaming Group at CB Richard Ellis (CBRE) based in New York City. The views and opinions expressed in this article are the author's own.
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Daniel Lesser
Daniel H. Lesser, President & CEO of LW Hospitality Advisors LLC (LWHA), brings more than 35 years of expertise in a wide range of hospitality operational, investment counseling, valuation, advisory, and transactional services. He provides services to corporate, institutional, and individual clients as well as public agencies on all facets of hospitality real estate including: litigation support and expert testimony, site evaluation, highest and best use analysis, appraisals for mortgage, acquisition, and portfolio management, workout strategies, operational analysis, development consulting, property tax assessment appeal evaluations, economic impact studies, fairness opinions, deal structuring, and negotiation of management and franchise agreements. Mr. Lesser had been retained in connection with a broad variety of lodging assets throughout the Americas, as well as in Europe, the Middle East and Asia.
