While the current labor shortage and rising labor costs are continuing to grab headlines, another potentially larger issue could limit the value of hotels in the years ahead.
Rising interest rates are likely to lead to less aggressive bidding by hotel investors while higher returns from bonds and other asset classes are likely to lead to rising capitalization rates — or cap rates — over time. How this affects value will depend on how quickly fundamentals improve versus when and how much cap rates rise. Hotels that usually trade at lower cap rates are most likely to see limited value growth.
On the fundamental side, despite labor and other cost headwinds, the outlook is positive. In addition to a strong demand outlook, I suspect we will see a steady slowing of new hotel deliveries in the years ahead.
Demand growth might not be uniform — while I am bullish on leisure demand, I am more optimistic for low- and mid-priced leisure travel than for the very highest-end luxury resorts. Those resorts have experienced strong occupancy and nearly inelastic price sensitivity, leading to strong rate growth. As international travel opens up in the years ahead, very high-end customers might go outside the U.S., spreading that demand around the world, rather than concentrating it in domestic U.S. destinations. Nonetheless, I expect record leisure travel demand this summer. As strong as last summer was, it still largely coincided with the delta variant of COVID-19. Unless the current variants explode in the next couple of months, summer should be a busy time.
We are already seeing growth in business travel and the beginning of a return of group travel. I suspect these trends will continue for several years. Having worked remotely since 2006, I continue to believe that some level of remote work is here to stay and that this will stimulate more travel as workers scattered over many locations need to get together for a variety of reasons.
Rising construction costs, lack of available trade labor and rising interest rates should all slow new additions to the hotel supply pipeline in the U.S. Combined with strong demand, this should lead to excellent occupancy growth for several years, barring yet another demand shock.
All investments ultimately compete with each other for a share of a finite pool of investable dollars. Money flows to hotel investments when the returns look strong relative to the risk involved. With interest rates rising — reflecting the supply of money, inflation expectations, and investor appetite for risk — all risky assets have to provide a higher return to compete with risk-free and lower-risk assets.
Numerous factors influence the asset value of investments, including the growth prospects of the asset or asset class, the perceived risk involved, the cost and availability of debt financing, and the cachet that ownership of an asset might bring to a buyer. Cap rates, or the return provided by a given amount of cash flow — before debt service — reflect investor assumptions about all of these factors.
Cap rates are calculated by dividing net operating income by the value of the investment. For example, if a select-service hotel has NOI of $8 million, and the value of the asset is $100 million, that implies an 8% cap rate. If investors are finding lots of less risky opportunities at higher rates of returns — such as bonds, savings and money market accounts, or investments in other real estate assets — they might decide to require a 9% return. If NOI is still $8 million, the value at a 9% cap-rate asset would be $88.9 million — eight divided by .09. This means that a 100 basis point — "bp," or 100th of a percentage point — rise in cap rate decreases the asset value by 11.1%.
The lower the cap rate, the bigger the impact on value from a rise in cap rate. What if the $100 million asset is a luxury resort valued at a 4% cap rate, meaning it generates $4 million of NOI? If the cap rate goes up 100bps to 5%, that asset would be worth $80 million, down 20%.
In order for these hotels to hold their value, NOI has to increase by twice as much at the luxury hotel than at the select-service hotel — 25% versus 12.5%. The value headwinds for low-cap-rate hotels will be much greater than for higher-cap-rate hotels.
Most investors have not seen an extended time of rising interest rates. Ten-year treasury yields declined fairly steadily from September 1981 until August of 2020. According to the St. Louis Fed1, the yield on the that bond declined from 15.84% to 0.52% during those 39 years and is around 2.8% as I write this, after rising to greater than 3.1% in early May. I don’t think rates will climb back to 15% — let’s all hope not — but it seems realistic to assume that the era of “lower for longer” has come to an end. This has major implications for the value of all assets. Cap rates tend to trail changes in interest rates, but over time they follow the same general trajectory.
For hotel investors, the trade-off to watch will be how quickly property cash flow rises relative to the pace of increases in cap rates. Higher-growth assets are likely to get lower cap rates, but lower-cap-rate assets have the most to lose from rising rates, regardless of growth. Let’s hope that cash flows continue their rapid growth trajectory for several more years.
1St. Louis Fed: https://fred.stlouisfed.org/series/DGS10 10-year constant maturity yield
After a 30-year career as a stock research analyst, David Loeb created Dirigo Consulting LLC, which advises on capital markets, strategy, and communications issues. Clients have included REITs, brands, and private equity investors. He also served on the board of directors of CorePoint Lodging (NYSE: CPLG) prior to its successful realization for shareholders. He can be reached at davidloeb@earthlink.net.
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