NEW YORK — Though hospitality in the U.S. is still an attractive investment opportunity for Wall Street banks, the hotel industry faces challenges that are expected to turn down the heat.
During the “Wall Street Outlook” panel at the ALIS Summer Update 2022 conference in New York, investment bank executives spoke about how rising costs will affect financing hotel deals and the strategies hoteliers employ.
Interest Rates
Much of what will drive the market for at least the next six months to a year will be tied in with the inflation outlook and the cost of borrowing, said Croft Young, managing director of real estate, gaming and lodging at Morgan Stanley.
His company recently refinanced on a 30-hotel portfolio of select-service and extended-stay properties with major global brands, he said. They came through at 70% loan-to-value at blended cost and the commercial mortgage-backed securities market blended cost of the Secured Overnight Financing Rate +5.5%.
The cost of borrowing is now close to 7.5% when many loans were at 4% or lower, Young said. Inflation is going to push owners' net operating income beyond the SOFR curve.
“I think we’re in a bit of a flux right now,” he said. “That’s going to put a damper on transactions in the near future.”
The ones that are going forward are legacy deals put together earlier and currently in motion, Young said, citing his company’s advising of the Watermark Lodging Trust deal as an example. The deal hasn’t closed but has committed financing.
Goldman Sachs is a little more contrarian on interest rates than the overall market, said Taylor Williams, the company's vice president of investment banking. Rates are projected to continue to increase and then fall next year over recessionary concerns. The investment banking company’s economists believe rates will stay where they are through the end of the year and that there is a 50% chance of recession over the next few years.
“I think that speaks to the fact that there is a lot of uncertainty right now,” he said. “When people are thinking about value, it’s really hard to come up with a view of what that is, whether it’s a buyer or a seller or someone you’re trying to finance an asset for.”
One person’s 60% or 65% loan-to-value could be someone else’s 70%, Williams said. That mismatch will make it difficult to complete deals.
“What we need is a period of just greater certainty, even if rates are higher, before transaction activity will come back,” he said.
Over the past three to four weeks, the messaging from banks has changed to hit the pause button on financing, said Anand Jobanputra, head of public lodging division and hospitality finance at Wells Fargo. His company had a high volume of loans in the first half of the year, including financing part of the Watermark deal.
“You see a lot of these banks write these bridge loans, and there’s no CMBS take out for these loans, so they’re out holding a lot of paper, and so banks are being cautious about financing today,” he said.
Newer deals are becoming more difficult, and the problem sometimes is the buyer falls out because rates and SOFR have gone up, Jobanputra said.
New Strategies
The markets have shown they like a separation of asset ownership and fees, Young said. When the C-corps do break from their asset-light model to acquire a property, it’s strategic and not necessarily a long-term hold. If they can buy a property, they need to develop it the way they want and do it their way, but overall, it’s not a common occurrence.
The other end of the spectrum has companies such as Sonder in which the model allows the company to scale faster, but they take on operating risk when the brand isn’t as well-established. It also requires an owner to be willing to give the company space to take that risk.
“You have to establish yourself, then you can start converting to manual contracts,” he said.
That said, the C-corps are trying to reach new customers, and much of that has been through expansion into the all-inclusive resort space and a renewed interest in extended-stay hotels, Young added.
“You're going to see them reaching into different pockets to try to find new ways to address customer needs,” he said.
On the real estate investment trust side, many of these companies are getting out of troubled markets, Jobanputra said. Pebblebrook Hotel Trust has sold a few hotels in San Francisco and acquired several resorts.
“I never thought Pebblebrook would buy Margaritaville, but it’s performing really well,” he said. “In their portfolio, they’re getting rid of the bottom 10% and moving to more high-growth-type hotels.”
One of the new sources of capital that blended into the market in the past several years has been the non-traded REIT, Young said. It’s a heavy flow of retail capital moving into institutional capital allocators, and they’re spending a lot of time in the market.
Some of that has entered the public markets, such as the acquisition of Extended Stay America, and there is a tremendous need to put that capital to work, Young said. Hotels generally are a small piece of the pie in broad real estate portfolios. When scaled to a certain point, they can only do so many hotels, but now those are scalable, he said.
Prior to the most recent recession fears, the top four or five capital raisers in this space were raising about $4 billion a month and levering that up, Young said. That equated to about $10 billion a month of capital that needs to be put to work buying real estate and commercial real estate.
“With the recession, those inflows are going to really pull back, but those are the things that could drive a market,” he said. “As they scale even bigger, and they’re looking to balance their portfolio, they’re looking for things on the margin. They will become bigger and bigger players in the hospitality space.”
If those companies ever get to investment grade ratings, that would have major implications, Young said. Right now for the hotel space, there’s financing through things like the public market, CMBS loans, and balance-sheet lenders.
“If they can get to be an investment-grade company and raise bonds with a lot cheaper financing, that is a game changer,” he said.