When conflict broke out in Ukraine in February 2022, central banks around in the world settled in for what would become a two-year-long war on inflation. Rising interest rates on both sides of the pond have since had profound ramifications for real estate investors, who had become accustomed to debt so cheap it barely featured in their calculations.
“When swap rates were lower, the typical all-in debt costs for most European markets were around 100 basis points, which meant leveraged investors could still buy real estate assets even at yields of around 2.5 per cent to 3 per cent,” says Craig Wright, head of European real estate investment research at abrdn. However, he notes that situations where “the cost of debt is in excess of the yield that you’d get on the asset”, have since weighed heavy on the business case for real estate investing.
Indeed, rising interest rates have often meant shinier and easier returns outside property in the last year or so. Investment intelligence firm Morningstar reported that 2023 saw nearly £18 billion invested in UK and US government bond funds. The UK 10-year gilt yield, currently around 4%, peaked at around 4.75% last August. “Very simply, government bonds have gone from being extremely overvalued to attractively valued,” says James Klempster, multi-asset deputy head at Liontrust. "It is not often in the history of fixed income that we can refer to these sorts of yield increases over only a couple of years.”
With bonds offering better yields than some property segments, considerations of risk also come into play. Although many investors dismiss the idea of any investment being without hazard, the risk-free rate thesis usually regards 10-year gilts as an exemplary ‘safe’ investment product with a risk rate equivalent to zero. So, if treasury bonds are outperforming riskier products like real estate – with some market watchers currently placing hospitality investments at a risk-free rate close to 5% – the industry faces a structural problem.
Yet long-term hospitality investors have two counter arguments: the direction of travel for inflation and interest rates in 2024, and the inherent fundamentals of property. Although interest rates might not fall as fast or as far as investors would like this year, there is a clear trajectory for rate cuts in 2024 on both sides of the Atlantic. Secondly, hospitality has been one of the steadiest performing asset classes in the real estate panorama over the past 18 months. “One of the things that sets us apart from other property types is the ability to reprice on a daily basis,” notes Tim Stoyle, head of UK hotels at Savills. “Hence, when considering the increased cost of debt, hotels have been somewhat protected because their income stream can offset a lot of the cost pressures we have seen, and any softening around capitalisation rates. Some parts of the hospitality industry have seen very significant rises in average daily room rates.”
Stoyle also argues that the best hospitality assets look set to maintain their relatively low-risk status. “We have seen that hotel occupancy rates and returns aren’t just connected to a post-pandemic boom but are now responding to a more persistent demand from international leisure and business travellers.
“As a consequence of that demand, owners have tried to move pricing – also in relation to operational costs – and have met limited resistance to rate rises.”
A further factor protecting the inherent value of hotels is the lack of distress in the sector. “Covid-related distress never happened, largely because governments moved to protect business owners,” Stoyle says. “At the same time, any expected distress relating to refinancing events still seems contained. We are hearing that some lenders – particularly the newer ones – may be looking to get their money back at the end of 3-5 year terms, rather than rolling it over. This may prompt some sales but assets that have inherent value will meet a stampede of prospective buyers.”
Cautious lenders monitoring aspects of risk remain a potential hurdle for the industry going forward. With a few exceptions involving quality sponsors and quality projects, many banks slowed in originating new debt over the last 18 months. However, alternative lenders often filled the gap, and it is likely that myriad financing options will remain going forward. Charlie Bottomley, a director in the debt advisory team at Savills, thinks that the market has passed its lowest point. “Last year, with the increases in interest rates, debt funds were able to price competitively whilst offering a bit more leverage than the banks, and therefore came to the fore in terms of serving hospitality assets. This year, they are having to take the downward shift in the SONIA curve into consideration which may affect their competitiveness. Conversely, banks, which were very cautious last year, are already showing appetite to deploy more capital in 2024.” Bottomley sees continuing appetite to lend against hospitality’s “winning” segments, including city centre hotels serving business and leisure travellers, and select luxury hotels.
Stoyle thinks it could also be a positive year for hospitality funds looking to raise capital. “I expect to see opportunities for hospitality funds this year not least because the fund management industry – which employs a lot of people – needs to spend money to deliver returns. So that should support further transactions.”
He suggests that interest rate contraction is now in sight. “All the indicators are pointing towards a significant reduction in inflation and as a consequence, the Bank of England will start to reduce rates, with at least two or three rate cuts likely in 2024. We will wait for the US to blink first and there is the issue of elections both sides of the pond, but governments will want to deliver some better news before citizens reach the polling booths.”
In turn, he thinks that there are signs that hotel values could finally rise. “We haven’t seen values decline but equally they haven’t risen to reflect recent trading conditions,” Stoyle notes. “The principle of hotel valuations is a multiple of profits, but we haven’t seen much of the price inflation on room rates translate into asset values. Prices in London, for example, have gone up significantly – room rates have increased 50% in the last year. Some may be stuck in a pre-Covid mindset, but the reality is that hotels are generating higher profits and that should be reflected when deals take place.”