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Weekly UpdatesThe economic turmoil that continues to characterize the environment in all comers of the United States through the first quarter of 2009 has set the stage for what will likely be a record year of contraction for the domestic lodging industry. According to Smith Travel Research (STR), the average U.S. hotel achieved an occupancy level of 60.4 percent in 2008, a 4.2 percent decline over the 2007 level of 63.1 percent and 240 basis points below the twenty-year average occupancy of 62.8 percent. The ill effects of these weak demand conditions are being amplified by the scale of new hotel openings, which represented a 2.7 percent net increase in available supply in 2008. Inventory levels will likely grow by another 2.6 percent in 2009, well above the twenty-year average of 1.9 percent as reported by STR.
The forecasts released by PKF Hospitality Research (PKF-HR) in March 2009 reveal that this disconnect between the property cycle (above-average supply growth) and the business cycle (demand is contracting) will likely result in a 13.7 percent decline in revenue per available room (RevPAR) in 2009 (see Exhibit 1). The magnitude of this top-line decline is expected to result in a 30.1 percent drop in bottom-line profits for the average hotel this year. This would represent the single greatest year-over-year decline in profits for U.S. hoteliers since PKF-HR began compiling data in 1936. Ouch! The implications for hotel property values are clear--and not good.
Where Are Hotel Cap Rates Headed?
A common metric for estimating the value of a hotel is the conversion of the net operating income (NOI) of a property through the application of a real estate cap rate. For income-generating properties like hotels, capitalization rates often give market participants a quick view of the financial integrity of the asset and provide the basis for their investments. Hotel capitalization rates are calculated by dividing NOI after capital reserves by the transacted price.
Throughout most of 2008 and thus far in 2009, hotel transaction activity levels have been at a standstill. Investors appear to share a consensus thought--now is not the time to buy into hotel real estate. The following three factors are primarily responsible for this consensus behavior: (1) declining hotel profits and limited prospects for a turnaround in the immediate term; (2) scarcity of debt at costs that are perceived to be affordable; and (3) heightened volatility associated with (a) the economic decline that is playing out across the globe, (b) the recent intervention of the U.S. government into the capital markets, and (c) the policies of the new administration in Washington that suggest higher business costs are in order for all producers.
A review of data compiled by the American Council of Life Insurance Underwriters since 1965 yields insights into the movement of hotel cap rates through the various cycles that have characterized the industry over the past four decades. These data, which represent the average cap rate derived from actual transactions occurring during the period in question, are shown in Exhibit 2. To quantify the level of risk associated with hotels, we benchmark the average cap rate value (shown in the upper line, percentages on the left scale) against the comparable statistic for risk-free ten-year Treasury Bills (the darker, lower line, also on the left scale percentages). Vertical lines represent the spread (in basis points, right scale).
Select observations from these data are as follows:
The long-run average spread (LRA, the heavy horizontal line, right scale) for the period studied was 417 basis points.
The variation over the past forty-plus years has been significant, with a negative spread of 220 basis points during the high inflation period of 1984.
The all-time-high premium of 785 basis points was realized during the postdot.com, initial recessionary period of the first quarter of 2001.
The low point of the current cycle was a 118 basis-point spread in the third quarter of 2006.
It is interesting to note that, based on historical profit data compiled by PKF-HR, the average annual change in NOI for the three-year period following each of the points identified above was (or is forecast to be) as follows:
* 1985-1987: +0.4%
* 2002-2004: -3.5%
* 2007-2009F: -8.3%
Analyses of these results led to the following observations:
On the surface, the essentially flat NOI growth for the three-year period following the negative hotel cap rate spread experienced in 1984 is surprising. One would have expected above-average levels of income growth. The variation can largely be explained by the tax policies of the Reagan administration of the early 1980s, which served to benefit real estate of all types and particularly hotels. Thus, the economic benefits realized by investors during this period were significantly influenced by legislated, and not market-driven, economic benefits.
The negative income returns realized during the 2002 through 2004 period are not totally surprising, given the economic contraction of the dot.com bust period, which was amplified by the terrorist events of 9/11. The high premium mandated by hotel investors in early 2001 seems to be justified in view of the results actually achieved.
The most recent experience from 2007 to 2009F must clearly be viewed as surprising, as well-below-average risk was ascribed to hotels in late 2006. Perhaps the term "irrational exuberance" applied to the lodging sector, as well as the stock market, during this period.
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The Period Ahead
Three primary factors influence the movement of cap rates: (1) changes in interest rates, (2) expectations for income growth, and (3) perceived volatility in the marketplace. With respect to interest rates, most economists believe that the expansion in the money supply pursued by both the Bush and Obama administrations will inevitably cause increased inflationary pressure, and higher interest rates will evolve.
Net result: upward movement of cap rates.
As noted previously, a major decline in hotel profits is expected for 2009, and the outlook for 2010 remains weak.
Net result: upward movement of cap rates.
The uncertainty concerning both the national and global economies is pervasive as we enter the second quarter of 2009, at this writing. With this uncertainty comes an increased level of volatility.
Net result: upward movement of cap rates.
Risk spreads for hotels in the years ahead may rival, if not surpass, their previous peak.
R. Mark Woodworth is president of PKF Hospitality Research (www.pkfc.com). He is located in the firm's Atlanta, Georgia, office.
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