PHOENIX — As financial conditions continue to press on hotel owners, the recent decision by the Federal Reserve to cut interest rates was seen as the start of something they hope will continue.
During the "View from the CEO Perspective" session at the Lodging Conference, hotel company chief executives said the Fed's decision was welcome news, but the initial cut itself isn't enough to move the needle much.
Aside from debt maturities, owners are also having to contend with brand-required property improvement plans, either within their own portfolios or for the properties they're considering acquiring.
Lowered rates
Transactions have been muted over the last two years, and that’s partially due to interest rates rising so quickly, said Greg Friedman, president and CEO of Peachtree Group. There had also been a degree of uncertainty over where interest rates were going to settle long term.
“I think there’s starting to be a little bit more consistency of thought that’s allowing pricing discovery to hopefully start to take place, especially as rates are coming down,” he said. “I think a lot of people are starting to believe rates truly stay higher for longer, even though it’s coming down, and that’s going to allow for hopefully pricing to come in a bit.”
The 50-basis-point cut was great, coming in at about 25 basis points more than expected, said Kevin Davis, Americas CEO at JLL Hotels & Hospitality. The cut on its own doesn’t change the internal rate of return math that much, but it changes the psychology. With meetings of the Federal Reserve scheduled for November and December, Davis expects interest rates may drop another 50 to 100 basis points over the next six to eight months.
“At that point, at 100 to 150 basis points total easing relative to the peak, that has a real impact on the math,” he said.
On the psychological side, people are expecting higher rates for longer, but the potential path forward set by the Fed could have the federal funds rate between 3% and 4%, Davis said. That may be a catalyst for transaction volume. The combination of lowering rates, brand-mandated property improvement plans, maturing debt and the end of fund life cycles will result in a tremendous year for transaction volume in 2025.
“I actually think you're going to start to see it pick up this fall, maybe surprisingly, on the other side of the election,” he said.
Looking at the market generally, the rate cuts have already been priced in, Friedman said. That gives some optimism, letting people be more assertive and potentially buy hotels. On the other hand, the long-term rates, specifically the 10-year Treasury rates, have gone up since the Fed’s rate cut.
“The 10-year’s up close to 4%, so it’s risen close to 50 [basis points] since rates have dropped, and to me, that’s a bigger impact because that really impacts the long-term debt costs,” he said. “The long-term debt cost is actually rising.”
There may be some spread compression over time, but even if the federal funds rate does settle in the 3% range, that’s still three times higher than where the industry was a decade ago before the pandemic, Friedman said, referring to the period of recovery after the Great Recession.
“That’s going to have a really strong headwind against just values,” he said.
Next year will be a more active year due to the wall of debt maturities, Friedman said. The big banks in general, which make up about 50% of the commercial real estate lending market, have a lot of fatigue where they’ve been extending loans, but much of that is coming to an end as the market sells out.
“There’s a little bit more predictability to where rates are going to be, and I think that’s going to help really jump-start the transaction market as well,” he said.
Brand standards and legacy
The hotel brand companies have had to be flexible with property improvement plans during the pandemic and recovery as everyone was fighting for survival, said Greg Juceam, president and CEO of Extended Stay America. Then once the pandemic passed, interest rates “went through the roof,” he added.
“So, any owner who even wanted to invest capital into his or her hotel was having a hard time finding cash flow to do it, so the brands were very flexible,” he said.
Each brand will have its own requirements, but many brands, including Extended Stay America, have been reasonable, Juceam said. The company has lowered insurance requirements, knowing how costly it has become, especially in locations such as Florida. There are still COVID-19 accommodations in place at its core brand, reducing weekly housekeeping to biweekly.
However, the pendulum is starting to swing back, Juceam said. The thing to keep in mind in, above all the other factors, is that hotel guests are the ultimate arbiter of where they want to stay.
“They don’t have to stay in a hotel,” he said. “They could go to home sharing. They could rent an apartment. So, at the end of the day, social reviews, how much capital is invested, how we care for guests in our industry matters. Otherwise, we’re vulnerable to disruption from our industry.”
As an owner, the brand-required property improvement plans feel like full-fledged construction projects, said Lisa Lombardo, president of Ark Holdings Group. When acquiring a hotel, because renovations have been delayed, deals now come with unforeseen preventative maintenance as well. This extra work adds about 20% to 30% to the per-key cost, not to mention the disruption to operations.
There are a lot of things hoteliers can’t see in the hotel's walls until they get started, she said. Her team said that three out of four deals now require a “hefty PIP.”
“I think right now, there's a lot of that coming to market, and if you are willing to go down that path, it's a way to get a deal done, but just to know what you're signing up for and what truly the cost of that project is going to be,” she said.
Along with the renovation costs, owners are concerned about the proliferation of hotel brands and how that affects the value of legacy brands, said Miraj Patel, chairman of the Asian American Hotel Owners Association and president of Wayside Investment Group. For example, the extended-stay segment that did so well during the pandemic has seen multiple new extended-stay brands launch within recent years. Not that long ago, there were a handful of hotel brands in operation; now there are more than 1,200 for travelers to choose among.
“Now, that not only confuses the consumer, but that confuses also the developers,” he said. “Many of the developers are thinking out loud that well, with all these brands coming out and all these legacy brands, when it loses its value, are we adding too much supply in certain markets as well?”
There will always be new brands, said Larry Cuculic, president and CEO of BWH Hotels. The brands create them based on consumers creating them.
“We see consumers, we see locales create these niches, and then we as brands feel we need to create that brand that satisfies that consumer demand for something special and different,” he said.
The extended-stay segment had always been thought of as a stepchild, but during the pandemic, everyone saw the demand for it, Cuculic said. Consumers wanted the product, so everyone rushed to the patent and trademark office to create new brands.
“I wouldn’t agree that brands create them,” he said. “I think consumers create them, and we try to meet that demand of something that’s new, experiential. We continue to evolve, and we will always evolve as an industry.”