The Western Canadian Lodging Conference was held last week in Vancouver, and the mood was cautiously optimistic, despite increasing economic uncertainty. The sector’s buoyant outlook is being driven by strong top-line performance and lean operating models, which have kept values in line or ahead of pre-pandemic levels. Limited supply-side pressure over the coming two years is also contributing and will help sustain the recovery experienced this year. Meanwhile, the feasibility of some proposed projects shelved early in the pandemic is now being examined and could present opportunities for investors to enter Canada’s resilient hotel industry.
Top-line operating revenue not only surpassed pre-pandemic levels over the summer, but in many places, some key metrics reached record highs. This resurgence, combined with streamlined operating models adopted during the pandemic, resulted in strong operating income. Some examples of improvement to the cost structure included driving productivity in the labour service delivery system through cross-training employees and providing less frequent housekeeping service for stay-over guests. One speaker added that the benefits of efficiencies implemented throughout the pandemic are exceeding cost inflation, which also contributes favourably to the value equation.
Based on the strong fundamentals, the consensus was that values are intact or, in some cases, ahead of 2019 levels. One speaker added that values and pricing in Toronto and Vancouver are also being reinforced by a limited number of owners wanting to sell, combined with a substantial amount of capital chasing hotel ownership to use as an inflation hedge in their portfolios. Throughout the recovery, the sector demonstrated its ability to raise average daily rates ahead of inflation, often considered nightly leases to real estate investors.
Solid fundamentals and resilient values have also gained attention from the lending community, with one lender adding that the overall confidence in the hotel sector from institutions has returned and the appetite to lend is back. Another lender mentioned that the bank had amended its strategy to increase exposure in markets with strong leisure demand drivers, given the rapid top-line rebound in leisure-driven destinations.
Overall, lenders agreed that the focus is now on solid debt coverage ratios and examining secondary liquidity sources from borrowers before issuing a loan. During a different session, a panelist acknowledged the shift, adding that lending was not back in the same way as before and that equity was playing a more prominent role in the capital stack. So overall, this could mean that borrowing is restricted to those with the best covenant.
Even though the appetite to lend is back, there have been limited opportunities for investors to enter Canada’s hotel sector through acquisitions this year, with transaction volume in Canada’s urban centres down in 2022 compared to 2021. Not only have owners benefited from the strong uptick in operating performance, but a panelist mentioned that many of Canada’s hotel owners are generational investors looking for a long-term hold period, which limits available opportunities. Another panelist added that high interest rates would likely keep transaction volume in 2023 subdued, most likely only reaching the same level as 2022 or slightly higher. The panelist added the existing ownership community, which is typically well capitalized, has an advantage of being successful in the bidding process as opportunities do arise.
Additionally, there have been limited opportunities to enter the sector through new hotel development over the past few years. Rooms under construction are now 20% below pre-pandemic levels, as many proposed projects were postponed in the early days of the pandemic based on development costs rising by 20-30%. As a result, proposed projects were made unviable and lenders pulled back on issuing development financing.
But there could be opportunities to develop over the coming years. One adviser is starting to see the feasibility of proposed hotels being reevaluated. And it was mentioned by several panelists that growth in the development pipeline was expected in a couple of years. Somewhat surprisingly, lenders are now more open to originate development financing.
There are several hurdles to overcome for the proposed projects to go ahead. One panelist added that developing new hotels is as tough as it has ever been, citing high land, development and construction costs and securing financing as considerable headwinds. Another added that the highest and best-use studies must be done twice to ensure every square foot is considered to maximize revenue-generating space. For some hotels, this may mean reducing room size. It was agreed across several panels, though, that development costs must decline for the anticipated growth in the pipeline to take place.
On a positive note, the lack of supply-side pressure over the next couple of years, combined with the significant number of rooms that came out of inventory to be repurposed as residential, will help sustain the operating performance recovery in 2023. All told, although the hotel sector is emerging relatively unscathed from what was the worse downturn ever experienced, it is not emerging unchanged.