Scott Smith: Strong Operating Fundamentals, Favorable Financing Contribute to Positive Investment Outlook
- Jun 24, 2014
PKF Consulting USA, LLC (PKFC)’s recently released results of its annual Hospitality Investment Survey revealed that hospitality investment indices continue to operate at optimal performance levels. According to the survey results, hotel profits are up, debt is more readily available at attractive terms, capitalization rates are stable and values are expected to increase in the near term. Conducted in the spring of 2014, the current edition of the Hospitality Investment Survey tracks changes in investment and financing criteria over the prior 12 months.
With supply growth forecast to remain below the long-run average, the outlook for exceptional returns on hotel investments appears to be positive. The only outstanding question among the respondents to our survey is, “How long can the industry maintain this peak performance?”
Driving the optimistic sentiment is the strong outlook for the major lodging metrics. According to the June 2014 edition of PKF Hospitality Research, LLC’s (PKF-HR) Hotel Horizons®national forecast report, supply growth is expected to remain below the long-run average of 1.9 percent through 2016 before increasing to 2.1 percent in 2017. PKF-HR expects this modest growth to keep occupancy strong and allow operators to increase average daily rates, resulting in robust revenue per available room (RevPAR) growth through 2016.
According to PKF-HR’s 2014 Trends® in the Hotel Industry report, property level net operating income (NOI) increased for the typical U.S. hotel by 10.1 percent in 2013, just below the 2012 year-over-year increase of 10.2 percent. Double-digit annual gains in NOI are forecast to persist through 2015.
Many survey respondents indicated that owners are holding onto high-yielding assets, as the outlook for NOI growth remains strong. As a result, there are a limited number of hotels available for purchase. This has created a competitive environment for buyers, effectively driving up pricing. In response, some investors are now targeting alternative asset classes (i.e., select service, extended stay) or focusing on secondary and tertiary markets.
The vast majority of investors remain bullish on the near-term outlook for hotel investing. Due to the positive outlook for NOI, the overall capitalization rate for hotels decreased slightly to 8.27 percent, the lowest OAR recorded since the inception of the survey. Discount rates (unleveraged IRRs), terminal capitalization rates and equity yields all remained virtually unchanged compared to last year. In our opinion, this displays the comfort level that many market participants have with the current investment environment.
The average expected cash-on-cash return for a hotel investment increased by nearly 1 percent in 2014. This is yet another indication of strong income growth expectations and helps explain the slight increase in the equity yield.
Finally, the survey respondents indicated that the average holding period for assets has increased by approximately six months. Many investors are holding onto well-performing assets a little longer.
The Hospitality Investment Survey asked respondents to provide capitalization rates by property type, offering some insights regarding the preferences of today’s hotel investor.
Luxury hotels and boutique properties continue to be underwritten on lower cap rates compared to typical full-service hotels. Owners have greater flexibility with these types of assets when completing a repositioning or value enhancement project. In addition, these categories are heavily weighted toward properties located in gateway cities such as New York and San Francisco.
Depending on the age of the asset, capitalization rates for full-service hotels continue to vary widely. Full-service properties less than 15 years old had an average cap rate of 80 basis points less than hotels 16 years or older. Limited-service cap rates follow a similar trend with regard to the age of the asset.
Lenders also appear to be bullish on the near-term outlook for the lodging industry and continue to demonstrate increasing confidence by providing debt for hotel acquisitions and refinancing. Debt-service coverage ratios remained below pre-recession levels, while loan-to-value ratios increased 281 basis points compared to last year.
The survey revealed a slight uptick in interest rates; however, on average they remain below 6 percent. Rates for limited-service hotels were slightly higher than those for full-service properties. There was little change in the amortization period, but the loan term (or year of balloon payment) increased by more than one year, demonstrating the enhanced confidence of lenders.
The convergence of positive operating fundamentals and a favorable financing environment makes this an exceptional time for all participants in the U.S. lodging industry. Current owners are benefiting from strong returns and rising values. Meanwhile, new investors are able to take advantage of favorable financing terms and the potential for NOI growth in the near term.
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Scott Smith, MAI, is senior vice president in the Atlanta office of PKF Consulting USA, LLC. The 2014 Hospitality Investment Survey is available for purchase at www.pkfc.com/store or by calling (855) 223-1200. The 12-page report contains tables that show the current and historical averages of a dozen critical investment measurements, including capitalization rates and mortgage terms by property type.