Hotel investors rethink battle plans as interest rates rise

The era of free money is over forcing investors to redraw their battle plans as central banks look to tame inflation by raising interest rates. It's made it increasingly difficult to get deals done as hotel buyers and sellers try and find a happy bid-ask medium.

Indeed, it's getting rough out there. According to Hospitality Insights' latest Investor Sentiment Index, 50% of respondents noted that the competition to acquire assets has increased and that the time to close a deal has protracted. Still, there is an ample amount of money on the sidelines searching for deals, with 93% stating that their unallocated capital was now the same or higher than the previous quarter. Meanwhile, 27% expect a rise in prices with 40% expecting a decline. The difference of opinion is going to make it tough for advisors over the coming months when it comes to working out what a fair offer is.

Current asset owners seemingly are in the driver seat, with revenue from operations hitting record highs. In Europe, RevPAR in July was up to €159, the highest level it’s been in three years, and 17% higher than in the same time in 2019, according to data benchmarking firm HotStats. It’s a similar trajectory for the UK, where RevPAR has reached its highest level in almost four years.

The top line is padding the bottom line, but as expenses creep back up, profit is being threatened. Gross operating profit per available room (GOPPAR) has been on a similar course, but has leveled off as costs begin to eat into the top line. It hit €94 in July, according to HotStats. The good news: It’s almost €20 higher than in July 2019, but down versus the previous month. The trajectory is still strong: GOPPAR is now up 1,935% since January 2021. The bad news: expenses are showing their teeth and biting into the impressive revenue gains, which have been fueled by strong rate growth that is 43% higher than at the same time last year.

A worrisome portion of the expense jump is attributed to a rise in utility costs, which are now at €8 on a PAR basis, a full €3 higher than at the same time in 2019. The largest portion of that are electric costs, which are soaring throughout Europe, due in part to the war in Ukraine and its impact on natural gas prices. Electricity at Europe’s hotels is now more more than €5 on a PAR basis, its highest level ever recorded and €2 higher than at the same time in July 2019. 

Interest in Interest Rates

Every investor has its eyes on how central banks are handling still intense inflation. The biggest tool to quell inflation is raising interest rates as a way to suppress demand. Higher interest rates make it more expensive for potential buyers to acquire assets. The ECB raised rates by 50 basis points to zero in July to fight inflation—the first time its raised rates in 11 years—and the Governing Council expects to raise rates again in September. 

Just four months ago, the landscape was drastically different. But in May, inflation rose significantly, mainly because of surging energy and food prices, including due to the impact of the war. They've intensified since.

At the International Hospitality Investment Forum, in May, in Berlin, investors and lenders were rosy about the future of investment. Michelle Weiss, head of hotel properties at Aareal Bank, said the bank is "very committed in the hotel industry. We have a €10 billion book or a third of our portfolio are hotels. So the bank is very much committed. What has changed is our underwriting; we're looking at it on a more conservative basis. But we remain committed to the hotel industry."

Russell Kett, chairman of the London office of HVS, has seen many cycles and is not scared off by the current inflationary environment. "We have been able to cope with inflation," he said. "I recall times when inflation hit double figures and stayed there; I can remember the times when interest rates were well into double figures. The industry worked their way through it and in a way inflation helped the industry through because you were able to raise rates, and you were able to maintain margins, and you were able to move on. Ultimately, you were paying back whatever loans you had in inflated euros, pounds, dollars, whatever currency you borrow them. So the inflation bailout turned out to be quite a good thing. Now as long as we haven't forgotten how to deal with inflation, I think we're going to be alright."

As optimistic as some are, Coley Brenan, partner and head of Europe at KSL Capital Partners, was less cheery, and that was before inflation and interest rates accelerated. "Underwriting for new opportunities and thinking about what the top line and cash flow look like for the next year or two, there is always a margin of error and today that margin of error is massive," he said.

Yield Chase

Chasing yield has long been a point of emphasis by would-be investors when interest rates are at near-zero levels. That was the case prior to the pandemic. 

While quantitative easing was used in 2008 to counter the effects of the Great Recession, the volume of QE used in 2020 pushed bond yields toward zero or, in some places, into negative territory. With risk-free interest rates, investors take on more risk or face the possibility of negative returns, a scenario often referred to as "chasing yield." Investors chase yield when they go further out on the risk spectrum in search of better returns than, for instance, traditional bonds.

In commercial real estate, hotels can fill that gap, as investors weigh many variables, including cap rates, cost of capital and IRR.

According to Savills' July European Hotel Trends Outlook, investor appetite remains high, but softening economic indicators and the rising cost of debt could temper transactional activity. European hotel transaction activity improved in 2021 with volumes of €16.14 billion, 61% above 2020, but still 36% below the €25.32 billion reported for 2019. The momentum in transactional activity seen last year continued into the first quarter of 2022 with Q1 2022 volumes at €3.54 billion.

A big shift in the investment market last year that has carried into 2022 is that Spain now outpaces Germany in terms of transactional activity, with a YOY increase of 211% in Spanish hotel transaction volumes in 2021. The UK remains the largest transactional region, accounting for almost half of all deals in Q1 2022.

Further from Savills: "While total European activity remains relatively subdued against pre-pandemic levels, there remains significant capital targeted at the sector, highlighting its strong longer-term fundamentals. As a result, where we would have traditionally seen a flight to safety, the weight of capital has meant the shift to secondary markets has been much quicker than usual. This has already been seen in the UK with private equity money looking beyond London to grow their platforms, albeit this has also been supported by quicker operational recovery in some regional markets, particularly those with a significant leisure demand component. This has heightened competitive tension, meaning we are seeing more potential buyers at every asset value point, placing downward pressure on prime yields in some parts of the market."

The aggressive buying could be subdued by the aforementioned rate hikes and ensuing debt costs. "Investors are likely to take a more considered approach resulting in a mismatch between buyer and seller expectations, slowing transactional activity," Savills wrote. "Reduced activity could place upward pressure on yields in some parts of the market, but considering the weight of capital still targeting hotels and the appetite to spend this by the year end, could mean we see a very strong final quarter and the resumption of yield compression."