302 | Value Judgment: Hotel asset pricing in COVID-19 age is different from previous recessions

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Xenia Hotels & Resorts of Florida in December sold the Commonwealth Hotel in Boston’s Kenmore Square to Ohana Real Estate Investors for $113 million. That’s $23 million less than Xenia paid for the hotel four years ago. The month before, Xenia disposed another asset at a discount when it sold its Renaissance Austin Hotel to Axton Group for $70 million, which was $23 million less than its appraised value. Xenia is not the only investor to sell off assets at discounted prices. Many assets that traded in 2020 saw their market valuation decline amid the pandemic recession.

Investors’ pre-COVID strategies ‘should radically change’ as pandemic drags on, says analyst

HVS, a hotel appraiser and broker, has assessed the market values of more than a thousand hotels since the start of the coronavirus pandemic a year ago. In that mix are 140 properties that HVS has tracked since 2017. The company reported in November the subset has lost 24 percent of its pre-COVID value, falling from $6.6 billion to $5 billion.

All is not lost, however.

HVS notes it re-assessed the hotels’ values at the low point of the COVID-19 cycle and it expects the assets will eventually regain their pre-pandemic values.

Rod Clough, partner and president of the Americas at HVS, recalled that a year ago hotel businesses were charting years of strong performance with high occupancy levels and stable average rate. Investors viewed hotels as a good place to park their money.

“At the beginning of 2020 there weren’t alarm bells going off, like this is about to end,” he said. The hotel transaction environment was “frothy.”

“There were plenty of buyers and not enough sellers. So sellers who did bring their hotels to the market were really able to obtain a lot of good offers. They were able to pick not always the highest price [but] they picked the best price that would get them to closing.”

READ: READ THE REPORT: Rod Clough, partner and president of the Americas at HVS, co-authored a Nov. 5 report, “COVID-19’s Impact on Values,” that looks at the variations in the value of hotels.

Nearly a year into the coronavirus pandemic and the subsequent economic recession, hotel valuation is a mixed bag. Not every hotel has seen its market value eroded.

“What we’ve seen is this incredible range,” Clough said.

For example, some budget-priced extended-stay hotels have seen average daily rate decline by only 5 percent and occupancy hasn’t declined at all. “So those values, we haven’t really seen a decline because a buyer would anticipate having a recovery in that rate in the coming year,” Clough said. “And if they’re buying the asset off of the next five to 10 years’ worth of cash flow, and you have a fully recovered cash flow, then asset values in part of that sector, aren’t declining.

“On the flip side, there are some assets where we’ve seen that the blow to NOI be so significant and the outlook for recovery might not be for another two to four years, in some cases maybe longer than that. For those assets, if the owner isn’t able to hold and keep their asset through the downturn, then that’s where you see the asset’s value declining pretty significantly.”

VALUE CHANGE: HVS research reports: “By chain scale, all tiers have been affected when reviewing the data on a weighted average basis, but the weighted percentage decline has been less so in the lower three tiers versus the higher three tiers. This is to be expected, as these tiers rely less on group and convention demand and are also less reliant on high-volume, corporate-account travel.” Read the entire report, “COVID-19’s Impact on Values” here.

Any hotel’s market value depends on the asset type and its location. Clough pointed to Sunstone Hotel Investors’ sale of the Renaissance Los Angeles Airport Hotel in December for $91.5 million or $182,300 per room. Its capitalization rate of 6.8 percent was based on 2019 net operating income – 2020 performance is an aberration.

“That’s a very strong cap rate,” Clough said, adding the buyer obviously viewed the deal as a smart move because it could not build a new 500-room full-service upscale asset at that price.

“There are still buyers out there for those types of assets,” he said, noting buyers of airport hotels like the Renaissance LAX usually have a long-term investment view that even if it takes a hotel three years to recover to 2019 performance there is no competitive threat now nor in the future.

“There are markets like LAX, markets around the country that are highly sought after and so those values may not have declined much at all,” Clough said. “Then there are other markets where maybe the buyers aren’t as frothy and there’s just not as much interest in the market. Maybe the risk profile is too high. And so for those hotels, we have seen some assets decline in value, pretty significantly.”

GOOD DEAL: Sunstone Hotel Investors in December sold the 500-room Renaissance Los Angeles Airport Hotel for $91.5 million with a capitalization rate of 6.8 percent, a good return amid the pandemic recession, say analysts.

Hotel Values Static

Early in the coronavirus pandemic, Long Live Lodging interviewed Daniel Lesser, president and CEO at LW Hospitality Advisors, who said it was too early to determine how significantly the crisis would affect hotel values. We got back with Lesser this month to find out what he thinks now.

“You know, it’s interesting, many folks have asked about, well, how has valuation changed compared to pre-COVID? The reality is it hasn’t changed at all.”

LISTEN: GET CAUGHT UP: Lodging Leaders’ previous podcasts reporting on the pandemic recession’s impact on hotel values and transactions include:

Episode 261 – Let’s Make a Deal: Coronavirus crisis alters hotel transaction landscape

Episode 268 – Peaks and Valleys: COVID-19 crisis cuts hotels values and creates opportunity

Episode 281 – Rescue Capital: Hotel financiers seek opportunities to invest in distressed assets

Hotels are income-producing real estate, Lesser said. And post-pandemic, lodging will recover with gusto. That outlook is the true value hotels bring to investors these days.

“It always was; and still is today; probably always will be in the future [about] cash flow, cash flow and more cash flow,” Lesser said. “Obviously today there’s not a whole lot of cash flow.

“Assets are being underwritten by very smart, sophisticated investors who know and understand the space is very akin to looking at a brand new hotel that’s opening up for the first time.”

Whether a hotel has been open and operating at low occupancy or it has been closed, when the pandemic is past, business will return to January 2020 levels, Lesser said. Transient demand will revive and ADR will increase with it.

Lesser advises owners against selling their hotels if they don’t have to. Still, he expects a significant number of hotels to come to market in the first half of this year.

Looking at the pace and volume of the sale of hotels priced more than $10 million, Lesser sees the transaction market getting active. In the second quarter of 2020, just six hotels changed hands. The number of transactions increased in each subsequent quarter – 12 in the third quarter and 32 in the fourth quarter.

“So the point is that as time is going on, we’re definitely seeing the transaction market heating up. And it’s only going to continue for each of the next couple of quarters,” Lesser said. “There is really little question about that.”

LISTEN: VALUE JUDGMENT: Hotel appraisers and brokers expect distressed assets to come to market as the pandemic recession continues into 2021. But commercial asset pricing in COVID-19 age is different from previous recessions, say analysts featured in Episode 302 of Lodging Leaders podcast.

Lesser said there will be some distressed sales taking place this year. But, for the most part, selling a distressed asset in a pandemic is not the same as a buying mortgage that’s in distress because of poor management.

“One of the key decisions is maximizing proceeds,” he said. “Obviously, sellers want to maximize the amount that they can achieve for their assets. And so there are going to be a number of questions that are going to need to be dealt with.”

Timing is key, Lesser said. “Is this really the right time to be selling an asset? I think in the not too distant future it will be a very compelling story for assets that have gotten beaten down because of the pandemic but are fundamentally good properties with very good locations that have good stories behind them.

“There’s so much money on the sidelines looking for these kinds of opportunities that I trust that over time we will definitely see those shortages of distressed transactions. But because of all the money out there, the compelling opportunities will get bid up. And while a transaction may be distressed, it will not necessarily reflect distress pricing.”

Cap Rates Stagnant

John Chang is senior vice president and national director at Marcus & Millichap Research Services. The real estate broker and investment firm is very active in the hotel sector, selling more properties than any other real estate company.

Chang said although the hotel industry’s business performance was healthy pre-pandemic, hotel capitalization rates were relatively stagnant.

“Prior to the pandemic, hotels were selling at some of the highest prices on record. Good full-service hotels were trading in the $230,000 per door range and limited-service hotels were trading in the $90,000 per door range. The prices were high but this was really tied to the operational metrics. Occupancy levels, ADR and RevPAR were all at or near record levels, and that drove values. Cap rates really hadn’t moved that much. They were still in that 7 percent to 10 percent range, depending on the asset, the tier of service, their flag, their location, et cetera. So the values were really being driven by demand from tourism and business travel for hotel space. And that was supporting the underlying values.”

UPS AND DOWNS: Marcus & Millichap charts the sales volumes over the past 16 years, including the Great Recession in 2008. The commercial real estate firm expects the hotel industry will begin to recover this year and the volume of sales will follow pace as it has in previous downturns.

Long Live Lodging asked Chang to explain why a capitalization rate behaves the way it does.

“A cap rate is simply a matter of yield on a property. At a 7 percent cap rate, you’d get a 7 percent return on your money. So the returns that investors are looking for on the hotel properties really didn’t change that much. But because the underlying revenues changed so dramatically, it really affected the valuations of those hotel properties.”

The higher the cap rate, the greater risk for investors. And Chang has seen cap rates increase since the onset of the coronavirus pandemic.

The trend makes for interesting price negotiations.

“The cap rate represents how much risk the buyer’s willing to take and how much the seller is willing to let it go for,” Chang said. “Some properties, of course, are trading at a much higher cap rate if they’re in distress; they have some problems. They need some work on them if they weren’t cared for; if the owner didn’t have enough capital to support that property. [But] some are still trading at relatively low cap rates because those properties have performed better than others during the downturn.”

Many hotel owners have sought forbearance from banks on mortgage payments and most franchisers have deferred fee payments during the coronavirus crisis. But the temporary hold on payments cannot last forever and investors may be forced to unload properties to settle those accounts.

“If they decide to sell the property then they’re going to need to cover those expenses, those deferrals,” Chang said. “Whether that deferral is from the franchise, whether that deferral is from the bank. They’re going to have to cover those expenses and bring it current in the process of selling their property. Of course, that’s always going to depend on the individual agreements that have been made, but just as a general rule of thumb they’re going to have to bring their accounts current when they sell the property. And so that’s going to take some of the income from the sale out of the deal.”

Chang said many owners and investors are preparing to sell their properties. The reasons to go to market are varied.

Some are selling in an effort to get out from under a distressed mortgage. Most hope to at least “break even against their debt,” he said. “They’re OK with that in certain situations. It just really depends on the situation.

“The owners who are going to be selling are owners who were not able to get a deferment from their bank. Maybe they had a CMBS loan and they just really haven’t had any ability to work with the lender to set up some sort of a deferment.

“There are also investors who simply need liquidity. Maybe they are selling one property in order to build up a cash reserve to support other investments that they have.

“And then there are investors who are simply deciding to cut bait because they could take the loss on the sales price or they can try to carry the asset until the market revives, but they don’t know how long that will be. So they may do the math and say, ‘Well, you know, my burn rate is this and I can still get 50 to 80 percent of the original value of this property. So I’ll take my loss in the sale rather than in the burn rate for an unknown of length of time.”

Question of Financing

Clough of HVS expects the sales market to soon start churning as long as the financing is available and the two sides can negotiate a realistic outcome.

“There are so many opportunistic buyers out there right now wanting to pick up assets,” he said. “I think more and more buyers that are able to come to the table with financing in place is going to be key.

“There always needs to be that meeting of the minds where sellers are maybe able to come off of the price 15, 20 or 25 percent of what their market value was in 2019. And buyers are able to come in with enough financing to make that happen. That’s what we need to have assets start trading.

“If sellers stay resistant and thinking that their assets are worth what they were worth in 2019, they’re going to need to wait until that NOI recovers,” Clough said. “We do think assets will again be worth what they were in 2019, for sure, but in the moment if trades are going to happen then sellers have to be willing to come off of that a little bit.”

While there may be a lot of dry powder in some private equity kegs, prospective investors will have to seek debt financing to complete the deals.

“Another big component of it is can you even get financing to pick up one of these hotels? So that’s the big limiting factor,” Clough said.

Joseph Yi is chief financial officer at Real Hospitality Group, a third-party manager that also deals with acquisitions, development and the investment process.

He watched as lenders closed their doors for the first few months of the coronavirus pandemic. “Somewhere about between March and let’s say June lenders were very far in between,” he said.

As with the previous recession, lenders who were making loans were working with investors with whom they had relationships. “These were generally smaller regional banks or commercial banks that are lending to best-in-class clients just to preserve that relationship.

“But off the street, you’re not getting good financing in the market. That market has opened up from July to October with just a handful of players. Primarily, debt funds are filling the void,” Yi said.

Private equity or hedge fund groups that have a lot of capital and depth can buy into the hotel sector, but those loans are more expensive than conventional lenders. Yi estimates the interest on private money is around 6 percent to 8 percent above LIBOR, which is below one half of a percent at this time.

Loans for new construction are hard to come by, said Yi, noting they’re usually the last part of any economic recovery.

CMBS is another story. Yi said about a third of Real Hospitality Group’s portfolio is tied to CMBS debt. CMBS debt pricing relies heavily on trailing 12 month revenue to underwrite the loan. “The trailing 12 revenue is incredibly weak. It’s almost negligible. That part of our financing market has completely, of course, now disappeared,” Yi said.

For this year, only about 70 percent of the lending market will be available. And many of those lenders have not yet returned. “They’re looking to get a little bit closer to the light at the end of the tunnel, before they will finance,” Yi said. “But the financing that are available happened on deals where the lenders have very good confidence that the collateral or the value of the property before COVID is well above what they’re lending to. So if the discount to the acquisition is 30 percent, if you will, lenders, while they’re not seeing cash flow to support the debt, with the proper insurance and interest reserve, they have been lending.”

Hotel Investment Outlook: Joe Delli Santi of MCR Hotels was a panelist during a Dec. 11 webcast organized by Marcus & Millichap titled “2021 Hospitality Investment Outlook.” John Chang of Marcus & Millichap moderated the discussion. View the webcast via this link.

Rethink Investment Strategy

Overall, any hotel owner or investment group considering whether to sell or buy in 2021 should consider several key elements, said Chang of Marcus & Millichap.

“Owners of every commercial real property type should be taking this time to reevaluate their strategy – their investment strategies and their portfolio – and determine which assets are still going to represent value for them going forward and which ones are maybe not the best to hold.”

The coronavirus pandemic has changed America, Chang said. “There have been a lot of structural changes to society as a by-product of the pandemic. So we’re advising investors to take this time – now that the dust is starting to settle; now that we have at least a limited ability to see forward into the future – to sit down and re-imagine your investment strategy for your real estate. Because your plans from two years ago should be radically changed. Those things that don’t make sense anymore? You should get rid of them. You can allocate those resources into something that has a stronger growth outlook.”

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