Interest coverage ratio is increasingly becoming the litmus test for hoteliers servicing debt. Before, the prime test was a property’s loan-to-value ratio.
Interest coverage ratio displays a firm’s ability to pay interest on outstanding debt or, put in another way, how many times a firm can cover interest payments with earnings.
At a webinar titled “Deals or Distress for the Hospitality Sector” hosted by business consultancy HVS, hoteliers said a different set of economic factors emerged from the COVID-19 pandemic against a backdrop of stubborn inflation and higher interest rates.
“Wage inflation overtook general inflation in the second half of 2023, which means more money for guests but also more operational costs for hotels. Add to that increased interest rates, which have moved up significantly and increased the cost of debt financing,” said Graeme Smith, partner and managing director of travel, hospitality and leisure at business advisory AlixPartners.
“Outside of hotels with real pricing power, cost inflation has largely offset revenue increases, and capital expenditure costs have increased. Interest rates can absorb a significant proportion of free cash flow, but that leaves little for shareholders or to pay down debt, which creates business fragility. … When fixed rates roll off, hoteliers might be in breach of interest-cover loan covenants,” he said.
He added a firm’s refinancing position is a key issue due to the significant level of debt set to mature over the next 24 months.
Charles Human, president of HVS Europe, said he remains optimistic, even if interest rates stay elevated.
He said only the most distressed hotels will be forced to transact, and those likely had problems before.
“If interest rates remain high, hoteliers who cannot grow profit margins will eventually face distress, either when debt matures or through the steady erosion of cash reserves,” Smith said, adding some hotels’ pre-COVID-19 debt has been extended and created a “wall of facilities maturing over the next two years.”
Human said banks are better able to assess risks, hotel trading is stable and interest rates seem to have peaked.
Hotel cap rates increase when interest rates do, he said, affecting leased hotels more but also relatively reflective of the entire market.
He added local lenders are becoming particularly competitive, especially in Spain, which points to why there is so much activity in that market.
He said he expects increased transaction volumes for good hotel stock, but it will largely be non-distressed.
“Sellers are adjusting their price expectations, which is leading to more activity, and there will be more disposals from institutional investors. If interest rates come down mid-year, expect an increase in activity in the second half of the year,” Human said.
He predicts approximately €3 billion ($3.26 billion) of hotel transactions this year in the U.K. and a return to the long-term average in Europe of between €14 billion and €15 billion.
“We see interest rates as being pretty much plateaued,” he said.
“Luxury looks to be softening, but group and MICE business is recovering, which is benefiting full-service and midscale” hotels, he said.
Industry Needs More Mediterranean
One thing that could tip over the apple cart is the holding of general elections in both the U.K. and U.S., he said.
Russell Kett, chairman of HVS London, said statistics underline that Americans do not travel as much during an election year.
“The U.K. election will have very little effect on our sector,” Human said.
He said 2023 transaction volume in Europe totaled €10.8 billion, 19% below 2022 levels and 60% below 2019.
“There were €1.5 billion of trophy assets, which appear unaffected by the headwinds. Actually, boosted,” he said, noting sales such as the Westin Paris Vendôme, Six Senses Rome and Mandarin Oriental Barcelona.
“Spain and France drove almost 50% of the 2023 transactions market [in Europe],” he added.
Human said more hotels will trade this year, but the U.K. and Europe have not caught up yet with trading in 2019.
Hotel transactions volume in the United Kingdom was down 68% year over year in 2023.
Human said it is the “lowest level for quite some time, I believe, and the other theme is there being quite a reduction in core-investor acquisitions activity. That sector has seen the greatest asset-value decrease in the last 18 months.”