Capital has been waiting on the sidelines during the COVID-19 pandemic to take advantage of distressed U.S. hotels and make deeply discounted deals.

But the wave of distressed hotel deals hasn’t arrived thanks mainly to federal relief, stronger-than-expected leisure demand and lenders that don’t want to own hotels. That means, however, all that pent-up capital is creating more competition for the deals that do come to market, driving up prices.

The best hotel deals the industry has seen would probably date back to the early 1990s when the Resolution Trust Corporation was wholesale selling off hotel assets or their debt, said Anne Lloyd-Jones, senior managing director and director of consulting and valuation at HVS. The RTC was a temporary federal agency that helped resolve the savings and loans crisis.

People made a lot of money when they recognized this opportunity, she said. Everyone expected similar discounts and revenue-generation opportunities during the downturn following 9/11, but they didn’t get anywhere near what happened in the 1990s. It happened again with similar results in 2009.

“It would take more than one hand to count the number of people having made great deals in ’91, ’92, but by the time you got to 2001, the number of people pursuing those, having recognized what happened earlier, increased geometrically,” she said. “By the time it gets to 2009, it’s increasing geometrically again.”

The value has diminished each time due the growing amount of competition for these distressed deals, Lloyd-Jones said. That’s continuing now because the pent-up capital on the sidelines is increasing the competition for the few assets that do come to market, limiting the discounting that is occurring.

“That doesn't mean that the prices are not discounted, but it does mean that the expectation of the discount is not being realized,” she said. “If you thought you could get something for 30% off, maybe you're getting it for 20% off because that competitive stimulus is driving the market.”

For the first quarter of 2021, the transaction environment was similar to how it was at the end of 2020, said Mike Cahill, CEO and founder of Hospitality Real Estate Counselors. For the latter half of 2021, the number of transactions will likely increase by 30% over 2020.

When hoteliers look back at the state of the industry a year from now, they’re going to say this was “one of the most mixed bags of completed hotel transactions that we’ve seen in the last 20 years,” he said.

The reason for that is there will be some distressed hotels that are put on the market by lenders and servicers, but the volume will be nowhere near what people anticipated, Cahill said. There will also be hotels sold at 2019 prices because they’re located near beaches or other resort destinations and have held up well.

Some discounting will occur through the year, but it’s going to vary, and some hotels will transact without any discounts, he said.

“It's just going to be all over the board, a very diversified bag of hotel transactions,” he said.

The Montage Healdsburg, a 130-room luxury resort in California’s wine country, sold for $265 million in April. That sale represents the highest price per room ever paid for a hotel in California at just over $2 million per room, said Alan Reay, president of Atlas Hospitality Group. The previous record holder was the 201-room Montage Beverly Hills, which sold in 2019 for $415 million and at the time assumed the record from a hotel sale made in 2015.

“Fast forward to going through the COVID pandemic, and to have a deal sell at over $2 million per room, I don’t think there is anyone that could ever have predicted that,” he said.

In talking with prospective hotel buyers, Reay said they were willing to make a deal based on 2019 net operating income, but they want to pay between a 10 and 12 capitalization rate. That means they were looking at assets being discounted anywhere from 40% to 60% of where they traded in 2019, which resulted in only a few deals getting done. A few sellers decided to cut the cord, but most owners in California have held on with few foreclosures and bankruptcies.

With all that money being raised and sitting on the sidelines, those investors are pushing their funds to put their money to work. As a result, the prices for well-located assets are at or higher than what he would have expected in 2018 or 2019.

The 220-room Santa Clara Plaza Suites sold for $72.4 million, less than a 5 cap on 2019 net operating income, Reay said. The hotel industry still needs to recover, and buyers will have to carry that cost until the market comes back while facing numerous challenges, particularly labor shortages.

“So buying something at a sub-five cap of 2019 net operating income, by the time you get back to stabilized, it’s probably getting into the low fours,” he said. “Those are cap rates that we didn’t even [have] in the peak of the market.”

Another complication, at least in California and other states starting this practice, is the government buying up hotels to convert to housing for the homeless, Reay said. California’s Project Homekey bought more than $1 billion worth of hotels across nearly 80 transactions in 2020. The governor has budgeted another $1 billion this year for more conversion deals. The hotels targeted by Project Homekey tend to be budget motels, but some deals have been for extended-stay hotels because they have kitchens in the rooms.

Along with being another buyer on the market, California has been buying these properties at retail prices because that is still less expensive than the state building new residential properties for the homeless, he said.

Even with the increased competition for hotel acquisitions, not every hotel a seller puts on the market will bring in a higher-than-expected price. Buyers are looking for hotels with the right conditions.

A property with recovering cash flows at higher-end, select-service hotels in non-gateway cities that are demonstrating they can outperform will see numbers come back to 2019 levels, Cahill said. The big-box, group hotels in city centers of major urban markets will probably still trade at a discount for another 12 to 24 months.

“It’s going to take a while for a big portion of their business to come back,” he said.

Hotels with ground leases, particularly fixed-payment ground leases, will be much less desirable, Lloyd-Jones said. One of the big issues laid bare is if the hotel has a $300,000 fixed ground rent payment and the net operating income goes from $1 million to a negative $500,000, the hotel still owes the $300,000 lease payment.

“That’s an exposure that hurts,” she said.

Cash flows in most cases are going to be fraction of what they normally would be or even negative, she said. When thinking about an acquisition, a buyer would look at numerous factors, but most would buy based on cash-flow expectations, so in a discounted cash-flow analysis, a negative number in year one is influential on the net present value of the property.

A year later, conditions have improved and many U.S. adults have been vaccinated against COVID-19 and cities are opening back up, Lloyd-Jones said.

“A year ago, we were saying the first year is going to be horrible, but next year will be the beginning of a recovery,” she said. “Then it will recover in the third year, and then the fourth year it should be back to where it was into the general, big-picture paradigm. Now we have the horrible year behind us, and we have evidence of the truth of the recovery.”

Well-located assets in California are entertaining multiple offers, with prices being pushed above list price in certain cases, but that’s not happening across the board, Reay said.

“We’ve got a tale of two different markets, he said.

The sale of the Montage Healdsburg is a reflection of the intrinsic value of the hotel, which took about 20 years from start to finish in a region with high barriers to entry, he said. Inland of California, there are secondary and tertiary markets that do not have anywhere near the kind of interest seen in primary markets.

Owners and outside investors trying to avoid the increased competition are turning to off-market transactions, working out deals with sellers before the assets make it to open market. Host Hotels & Resorts acquired the Austin Hyatt Regency for $161 million in an off-market deal.

Looking at HREC’s current deals, roughly 20% would be considered off-market, matching buyers and sellers before a property is widely publicized as being for sale, Cahill said. That’s a relatively high percentage compared to the past, he said.

In California, Reay is seeing a similar amount. When taking the state government’s appetite into account, off-market deals would probably amount to 25% to 30% of the deals there, he said. Taking the government out of the equation, that amount drops to about 10% to 15%.

For buyers in these situations, though, to secure a deal and avoid price increases through competition, they still have to be willing to pay more than the sale price, Reay said.

The off-market deal may be less of a discount than previously expected, but it could still be less than a buyer would have had to pay years ago, Lloyd-Jones said. Plus, it means securing the deal instead of losing it to a competitor.