Cost of Capital and Bid-Ask Gap Slow 2023 Hotel Deals

At $800 million, the sale of the 1,002-key JW Marriott San Antonio Hill Country Resort & Spa was one of the biggest U.S. hotel deals in 2023. (CoStar)

By Bryan Wroten
Hotel News Now

Expectations Rise for Acquisitions in 2024

Hotel transaction volume fell in 2023, and while there are myriad reasons why, the higher cost of capital is a main driver.

Through the end of the third quarter, JLL Hotels & Hospitality has recorded a 40% year-over-year drop in hotel transaction volume this year, said Kevin Davis, Americas CEO for JLL Hotels & Hospitality.

To put it in perspective, however, 2022 was one of the stronger years relative to 2019, which was not a particularly robust year, Davis said. Compared to 2019, this year is down about 8% to 8.5%.

“The bottom line is we’ve certainly seen a decline relative to 2021 and 2022 but also a less severe decline relative to ’19,” he said.

The capital markets dislocation, the Federal Reserve’s tightening process and raising fund rates roughly 500 basis points compared to March 2022 have driven up the cost of debt, Davis said.

“That’s what’s driven down what buyers are willing to pay for assets, and in many cases, it is below where sellers are willing to sell, hence a fairly sizable bid-ask gap and also the significant reduction in transaction volume,” he said.

The third-quarter hotel sales survey produced by LW Hospitality Advisors, which records hotel deals over $10 million, reported 88 single-asset hotel sales representing roughly 14,000 rooms. The deals totaled about $3.2 billion, at an average per-key price of $228,000. In the third quarter of 2022, the survey recorded 119 single-asset sales with 17,400 rooms, totaling $3.7 billion and averaging about $212,000 per room.

Surveys for the first two quarters of the year reported a 36% year-over-year decrease, with total dollar volume dropping by 50% and price per key dipping 4%. During the first quarter, there were 83 single-asset sales totaling nearly $3.5 billion. In the second quarter, there were 84 deals for $3.1 billion.

As of Dec. 20, preliminary year-to-date numbers from LWHA for the fourth quarter show 68 individual sales, a 36.4% year-over-year decrease, with 11,587 rooms, a 24.3% decrease. The total dollar value of these deals came to nearly $2.6 billion, a 36.5% drop, with the price per key falling 16.2% to $223,000.

From the same set of preliminary numbers, the year-to-date data shows a total of 323 individual sales, a 32.8% year-over-year decrease, representing 50,219 rooms a 35.9% decrease. The total dollar volume of these sales amounts to $12.3 billion, a 37.6% year over year drop. The price per key only dipped 2.8%, however, to $246,000.

The market has clearly slowed down, said Daniel Lesser, president and CEO of LWHA. Pricing depends on each property and the location, but some hotels’ valuation is staying flat while others are eroding 25% to 50%.

That’s a broad generalization, but the varying valuations that buyers and sellers each want are causing enough of a spread to cause this drop in sales, Lesser said. If a seller doesn’t need to sell, then they won’t.

This doesn’t apply to trophy assets as they continue to trade at healthy levels, he said.

“There’s never a shortage of capital out there to chase down one-of-a-kind assets,” Lesser said.

Investor Sentiment

The cost of capital is significantly higher than it was in early 2022, Davis said, and the market wants clarity and, ideally, reasons to be optimistic.

Currently, there’s more clarity looking ahead than there was previously, and there’s generally a view that the Fed has inflation under control, so the tightening cycle may be over, he said.

“That’s certainly one element that enables investors to start making some decisions,” he said.

Davis said the labor market continues to be strong, which will support consumer spending and the underlying strength in the economy.

But “that generally puts upward pressure on inflation,” he said.

Sources of Capital

Private equity will continue to be active buyers of hotels, even in lower-transaction-volume markets, Davis said. This segment of buyers continues to be the largest investor in the hotel space, even though they’re investing less.

More high-net-worth investors are diversifying from other asset classes and looking to move into the hotel space, he said. Investors can generally get a risk premium on their capitalization rate relative to other asset classes, and the fundamentals continue to be incredibly strong, he said.

International buyers had largely been on the sidelines through the pandemic and the recovery, but there has been a pickup that JLL expects will continue to grow as the world opens up further, Davis said.

Hotels have always been perceived as “sexy investments,” so there’s no shortage of ego capital that gets interested in the sector, Lesser said.

“They’re dipping their toes in the water when it comes to hospitality and, and I think part of the current drive into hospitality is the inflationary environment that we’re in and the ability to change room rates,” he said.

It’s a compelling story for investing in hotels, but the notion cuts both ways, Lesser said. In a down market if demand goes away, then pricing collapses.

“It’s risk and reward, and that’s fundamentally why hotels are in fact riskier than office buildings with long-term leases,” he said. “A lot of of investors see opportunity to deploy capital into the lodging sector with the ability to push revenues because of the ability to raise rates in a rising market.”

Expectations for 2024

There are some large hotel trades that are underway right now that will close in the first half of 2024, Davis said. Outside of those deals, he said he expects transaction volume will generally be muted because there’s still a lot of uncertainty, at least in the early part of the year.

“A big driver of transactions in 2024 will be the debt and what happens with existing debt,” he said.

Most hotel capital structures were built for 4% to 5% cost of debt, but the prevailing rates now are 8% to 10%, he said. As a result, a lot of borrowers with maturing loans will be forced to refinance at a higher cost, bring on a partner or sell.

Lesser predicted a faster recovery in transaction volume, with numbers picking up by the second quarter, if not in the first, due to the approaching debt maturities.

“We have seen distressed deals, but not necessarily induced by poor operating fundamentals,” he said. “Rather, it’s stress vis-à-vis rising debt costs. We will see more ‘distressed activity’ as we go into ’24.”

These opportunities will have compelling stories around them because of the money flowing around the world that’s chasing commercial real estate in the U.S., he said.

All that competition for distressed deals, however, will increase bid prices, Davis said.

“What will happen is distressed-induced transactions may very well not reflect distressed pricing,” he said.

Cities that have struggled, particularly San Francisco, should see more interest from buyers, Lesser said.

“I think now is the time to get into San Francisco,” he said.

New York is another city that has hit its bottom and is moving back up, Lesser said. When MCR and Island Capital Group bought the Sheraton New York Times Square in April 2022, the price of $373 million broke down to about $210,000 per room, a 13-year low in Manhattan, according to MCR.

“You couldn’t replace that asset for multiples of that amount, right?” Lesser said. “If I had to guess, the property’s worth more than $200,000 a key today because New York from an operational perspective — the city is just humming.”

Select-service and extended-stay tend to be the “Steady Eddies” of the industry compared to the full-service hotels that may have a fantastic location but have some kind of physical or functional obsolescence, Lesser said.

Many buyers are looking to add value to their hotels. “When you buy a hotel, you’re buying the dream, right?” Lesser said.

These value-add opportunities tend to arise more with larger full-service hotels, compared to select-service hotels that have about 150 keys and are a rooms-only operation, he said.

“It’s not that one’s better than the other,” he said. “It’s just a different investment profile.”

An Owners Perspective

In February, a joint venture of Trinity Investments with Credit Suisse Asset Management bought the 1,000-key Diplomat Beach Resort for $835 million from Brookfield Hotel Properties. The hotel is undergoing a brand conversion to fly Hilton’s Signia flag.

The Diplomat was a desirable property for several reasons, Trinity President and CEO Sean Hehir said. The company loves larger destination-type hotels, typically 400 rooms or larger, so the 1000-key count hit the sweet spot. Plus, the hotel has the big group-meeting space. Trinity prefers to invest in brand-managed properties, and it brought Hilton on to operate the hotel.

Since closing the deal, the hotel has been performing as expected, if not better, Hehir said.

“We’ve seen such a strong resurgence in group travel, plus we’ve got the compression with the leisure traveler,” he said.

Looking at how the financial environment has evolved over the year, Hehir said his company is as confident in its investment as it was back in February. The joint venture paid $835 million for 1,000 rooms on a beach in South Florida, and the property connects by a sky bridge to another 10 acres on the Intracoastal Waterway.

“That type of real estate is truly irreplaceable, so we feel very good about the investment,” he said.

As a buyer looking at deal opportunities in the U.S. and Europe, the financing situation is roughly the same all over, Hehir said. It used to be that when a buyer sought acquisition financing, 12 to 16 banks would show up. Now, it’s about four to five banks, but they’re quality banks, he said.

“It all comes back down to relationships and reputation and having the right business plan buying in at the right basis and having been known to do what you say you’re going to do,” he said.

Sellers want surety of execution and to know they’re dealing with a credible, capitalized buyer, he said. Demonstrating this reliability to a seller is more important than ever, he added.

There are some situations where cash flow is slipping, and acquisition debt is more difficult to come by, Hehir said. Some discussions have turned to seller financing or earnouts from the seller’s behalf. More creativity is needed in these cases to put a deal together, he said.

With the Diplomat, for example, the joint venture knew it would close the deal but needed more time, so it negotiated that into the agreement as related to extensions, he said.

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