Mixed Signs for Hotel Sector in Global Capital Markets

By Michael Fishbin, Global Leader, Ernst & Young Hospitality Services Practice: In the wake of continued economic and political uncertainty, real estate capital markets have displayed mixed results, and there are signs of pent-up investor demand.

By Michael Fishbin, Global Leader, Ernst & Young Hospitality Services Practice

In the wake of continued economic and political uncertainty, real estate capital markets have displayed mixed results, and there are signs of pent-up investor demand. While expectations for returns have decreased, investors continue to seek high-quality assets with higher yields in stable gateway cities with consistent cash flows. However, a significant increase in transaction activity is not anticipated until there is greater constancy in the credit markets. And without any clear market direction, the current sell versus hold sentiment is expected to last. If an asset does not have to be sold, it appears to be better to hold off until another time and, without pressure from lenders, owners will keep waiting for top-dollar prices while investors are still looking for bargains. The ongoing deleveraging of commercial real estate is also expected to change leveraged yield expectations.

There is a notable divergence in markets with investors first targeting investment in global gateway cities with major urban centers and next, everywhere else. According to global services company Jones Lang LaSalle, as of the Third Quarter 2012, the 10 largest countries in the world accounted for 82 percent of all commercial real estate transaction activity, with more than 50 percent of all activity concentrated in just 30 cities globally. Although hotels continue to attract considerable investor interest, the economic uncertainty has shaped how investors target their investments, as they focus on cities with strong leisure and corporate demand drivers. As of October 2012, one-third of all hotel transactions were completed in just 10 gateway cities. Of these, half are located within the U.S., representing approximately 19 percent of all global hotel investments. London remains the most attractive city in the world for cross-border commercial real estate investment, and inter-regional commercial real estate transaction activity has continued to be characterized by larger portfolio deals involving pension funds and sovereign wealth funds.

In the EMEA region — Europe, the Middle East and Africa — hotels remain an attractive alternative investment, while in the Asia-Pacific region, there have been fewer transactions in key gateway cities compared with last year and, instead, greater activity in the resort and destination markets. As of September 2012, the top three countries for hotel investment in EMEA were the United Kingdom, France and Germany, while the top three countries for hotel investment in the Asia-Pacific region were Australia, China and Thailand. In keeping with the trend of investors focusing on global gateway cites, London, Paris, Sydney and Hong Kong have been the cities in their respective regions with the most hotel transaction activity in this same period.

While international investor demand for hotels in key European cities remains, actual transaction activity last year was below 2011 levels, likely due to international investors’ concerns regarding investment in the eurozone. In contrast, the Asia-Pacific region, Australia in particular, experienced several record-breaking deals and has seen considerable transaction volume, comparable to peak 2007 levels. In fact, investment funds and private equity groups are currently raising additional capital in view of the strong growth outlook for the region.

As the real estate markets recover, capital is expected to return to riskier markets and poorer performing assets, as investors look for additional opportunities to maximize returns and diversify holdings. According to a recent Urban Land Institute report, an estimated U.S.$300 billion of refinancing of maturing loans over each of the next three years will affect lenders’ ability to originate new loans. With stringent underwriting standards widely anticipated to remain in effect in 2013, non traditional lenders such as private equity funds and insurance companies expanding into secondary debt positions are expected to partially fill a gap in financing.

Hospitality-focused public real estate investment trusts (REITs) will likely continue to benefit, as investors look for alternative places to put capital while maintaining certain yield levels. These REITs are also likely to continue acquiring high-quality, stabilized hotels with a competitive edge in strong markets, due to a lower cost of capital. Finally, initial public offerings are still seen by some real estate companies as a growth strategy and an alternative method of accessing low-cost debt through the corporate bond markets.

During all phases of the real estate cycle, real estate as an asset class is anticipated to keep attracting investors’ attention and capital. This will ultimately help the underlying markets continue to recover and move toward a new equilibrium. Investor frustration about opportunities and lower levels of return will potentially be offset by the attractiveness of the asset class as an income generator and a potential inflation hedge.

Excerpted from Ernst & Young’s Global Hospitality Insights: Top Thoughts for 2013. To view the complete report, visit www.ey.com/realestate.