What are the risk factors you’re currently looking at when determining whether to build or buy (or to do neither)?
Robert Stiles, principal and managing director RobertDouglas: “When considering to build or buy, many of our clients end up limited by, and therefor focused on, the availability of debt and equity financing. There are healthy and established debt and equity markets for existing hotels—particularly those with yield. Development financing, however, has become particularly difficult for those seeking full-service and luxury non-recourse financing—both debt and equity. As such, liquidity is serving as a bit of a governor on upper-end development, driving most clients to pursue existing asset acquisitions.”
Ted Arps, SVP, business development, Davidson Hotels & Resorts: “Certainly market (revenue per available room) growth projections is the number one concern. Determining a hotel’s projected RevPAR Pen requires determining the hotel’s mix of business and share, which is dependent on pegging market growth. As 2017 is around the corner, there is relative confidence in next year’s projections. However, 2018 and beyond is more difficult, with much trepidation about whether growth will come or not. Adding the impact of supply additions and determining whether new supply will induce demand or not complicates the projections. From a build or renovation standpoint, projecting construction costs can also add to the risk. Given these factors, finding opportunities where conservative projections still lend to favorable returns is the key right now. Deals with lots of levers and where management, brand and capital infusion can improve a property’s positioning within its comp set that are not dependent on market growth are ideal.”
Camil Yazbeck, partner and investment director of hospitality and leisure, Patron Capital: “There are risk factors attached to both development and buying pre-existing assets. For example, with pure ground-up development, there could be risks associated with length of time to secure planning permission, potential construction delays and cost overruns; while with an existing business, it can be difficult to estimate the time taken to implement refurbishments or turn things around, particularly given that hotels are management dependent and not as straightforward as pure real estate. For us, though, risks associated with development tend to be less predictable, and we therefore favor investment in pre-existing assets. With any investment, we develop a clear vision prior to purchase about what to do with the asset, the value we will add and who we will exit to. Considering these factors helps us to determine whether the investment will work for us.”
Corry Oakes, CEO of OTO Development: “The factors we consider have not changed, but the conditions around those factors constantly evolve. We are deep into an economic cycle and no tree grows to the sky forever. On the development side, the element of time creates more uncertainty that must be factored into the project underwriting, and we have become more cautious. Despite that caution, we still see some deals that continue to make sense for us. As a general part of doing business, we consider the current market performance, the characteristics of demand in the market, the current and expected future market economic performance, the quality of the current supply and the pending supply additions.”
W. Michael Murphy, head of lodging and leisure capital, First Fidelity Companies: “As an intermediary, I look only at the risk of failing to secure capital for a client, in which case I do not get paid and the client is disappointed or left in the lurch. So my focus is on whether there is a realistic chance of obtaining the desired amounts of debt and/or equity for a client, and this hinges on the realism of the client, the realism of his forecasts, the proper scrubbing of his financials to assure an accurate and lender friendly assessment of past performance.”
How do the development and transactions landscapes differ, compared to a year or two ago?
Stiles: “There has definitely been a downshift on valuations among buyers; sellers are not quite there yet. Given the deceleration in RevPAR increases, value growth momentum has left the house. With slower revenue growth and accelerating cost inflation, buyers will have to create every new dollar of valuation—there is no momentum to surf.”
Arps: “We have started to see a small increase in cap rates in some markets, thus narrowing the gap on bid/ask. As market growth has flattened, property performance increases have not been as significant, so property pricing is coming more in line. As many CMBS maturities are due in 2017, the market may be very active. The REITs that have been quiet are now starting to look seriously at some deals as well as selling. Certainly, as has been discussed throughout the year, the many distractors to the market have caused pause—Airbnb, labor rates, foreign investment, (online travel agencies), brand consolidation, etc. One positive is at least having the election behind us, thus mitigating the uncertainty.”
Yazbeck: “Wider political events have caused a certain degree of nervousness in comparison to a couple of years ago. Though the immediate effects of the EU referendum and Trump’s victory have not been as acute as many feared, it is possible there may be some economic slowdown and further uncertainty to come, and this is affecting the market in terms of transaction volumes and developers having the confidence to put spades in the ground. These political factors are bringing opportunities too, however, and we believe that transaction volumes are set to increase as more non-performing loans in countries across the continent hit the market. We are optimistic the U.K. will remain an attractive safe haven for global investors. Appetite for Europe more generally also remains high, with property markets increasingly supported by global investment and reliant on healthy overseas economies in order to grow. In rapidly changing times, we have found that pricing is often a stumbling block in transactions, with liquidity risk and duration risk regularly misprinted. This particularly affects generally thin markets, which historically have not had a lot of liquidity.”
Oakes: “It is much more difficult to underwrite new deals that meet our return expectations. Construction prices, land prices and entitlement demands continue to increase dramatically. Most cities are incredibly busy, which has increased the time required for the process. Operating expenses and the cost of capital continue to increase. All of these factors combined with slowing RevPAR growth often lead to an underwriting result that makes new development much more challenging.”
Murphy: “There are more headwinds today as a result of the absolute math of slower growth, skepticism on the part of some equity investors in the asset class and nervousness on the part of lenders, who have one eye on the markets and the other on their regulators. The result is that lending on development projects is exponentially harder to place than it was two years ago. Acquisition financing remains very viable at the 60% to 70% range, maybe five percentage points behind where loans could be sized two years ago. Re-financings remain tricky based on valuations and the size of loans that have to be replaced.”
What can make a project attractive for investment even if you expect to see a downturn in the near future?
Stiles: “For an existing asset, there has to be either a really strong and stable demand source that has created a good in-place and therefore sustainable yield or a turn-around story, often involving some investment in rebranding, renovating and repositioning in an otherwise strong market.”
Arps: “As mentioned above, deals with many levers that are not dependent on market growth—the opportunity to improve the property’s market position. Pricing needs to allow for returns that work given a downside scenario where the market is underwritten to decline.”
Yazbeck: “We have secured consistently strong returns by focusing mainly on making sure that we have the right assets in the right locations and with the right management teams in place to get the job done, rather than relying on market improvements. We like hotels for many reasons—a stabilised hotel business (which is normally the end-game for us after we have implemented the business plan) becomes a favoured asset class for buyers, where the medium term outlook for profit increases is normally strong. Hotels act as a hedge against inflation, and they provide diversification in a commercial real estate portfolio, meaning the sector remains attractive. For us, an attractive investment is one where there is an opportunity to add value, improve cash flows and stabilize profits through best-in-class management partners and refurbishment or improvement initiatives. We look carefully at RevPAR/RGI differential to other properties in the local area and seek out opportunities to improve it through asset management. We look at cost-improvement and revenue-generation measures, opportunities to reposition via targeted capital expenditure, more keys and management improvements. We also analyze whether we are working with the right local partners to make sure interests are aligned, synergies and upside potential are understood, platforms and bolt-on deals can be created and environment performance and forecasts, cap rates and investment cycles are all improved. We also think about how we might exit before we buy, with our strategy tending to involve selling to investors who will continue to reposition the assets or to long-term holders who see hotels as yield cash-on-cash generating assets.”
Oakes: “We let the math speak for itself, and always model an investment period that attempts to mirror the actual development timeline and operating period. In our experience, we’ve seen a lot of bad investments move forward because of a belief that things would just get better. In reality, markets follow the facts. Our projects stand on their own, meaning the hotel has to make sense as an individual investment. Other developers may have a larger project with multiple asset classes where the hotel is necessary to produce returns on the entire development that justify the risk, or they may have a financial model that can handle a downturn to meet their return expectations. We often see too many projects don’t fully underwrite the risk of negative results across a number of factors. We attempt to do this with some sensitivity analysis where negative results on a number of variables are contemplated.”
Murphy: “An asset with the wrong brand or with bad management, leaving opportunity for keen-eyed investors to spot turn-around chances. Assets that are in the path of revitalizing urban areas but have weak brands or are suffering from lack of capital.”
Do you expect to be a net buyer or net seller in 2017?
Stiles: “I think a lot of owners will believe the sale market is not strong enough and will instead look to take some money off the table with higher leverage financings, which will in turn bring additional higher yield capital to the battlefield.”
Arps: “For 2017, we expect to be net buyers. We will have properties with our capital partners on the market next year, as we did this year which have produced excellent returns. We had a record year in acquisitions and think that 2017 will be another record year. Acquisition growth will come from full-service opportunities along with boutique and lifestyle, which continues to blossom. We are seeing excellent opportunities for Pivot Hotels, our boutique and lifestyle division.”
Yazbeck: “Having been net sellers in 2016, we are moving into being net buyers in 2017. Having recently raised €949 million ($986 million) for our fifth fund, we have the financial firepower to invest in around €3 billion ($3 billion) of assets and are actively looking for opportunities across Western Europe. We like hotels for many reasons: a stable hotel business, which is normally the intended outcome for us after we have implemented the business plan, is a desirable asset class for buyers, where the medium-term outlook for profit increases is normally strong. Current market conditions and global political events mean there are opportunities out there, and we will certainly be looking to capitalise on them.”
Murphy: “As an intermediary, I am neither, but I expect to see steady buying and selling going into the new year. Despite overall slowed growth, there are numerous markets that have not yet peaked, many assets that are underserved by their owners, and managers and many buildings that are wrongly branded. Sharp-eyed developers and operators will find these deals, and they will get financed.”
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