A Mid-Year 2002 Hotel Investment Parameter Snapshot

by: Jeffrey H. Walker, MAI, CHME, and Terry D. Pike

In the wake of the downturn in the hotel industry after September 11, hotel transactions dramatically declined as the perception of value between buyers and sellers widened. However, sales transactions have begun to increase over the past several weeks. In response to this apparent change in the market, we interviewed several market participants the week ending August 25, 2002, including hotel brokers, institutional hotel investors, management companies and corporate hotel owners. Based upon our indication that individuals would not be quoted, the following summary does not attribute quotes to survey participants.

In general, those participants interviewed indicated that a noticeable uptick in transaction activity has occurred since July 2002. One broker indicated that there may have been as much as a 300 basis point spread between the capitalization rate perceptions of buyers and sellers immediately following 9/11. However, that spread has recently shrunk, with perhaps 90% of the difference given up by buyers who had previously anticipated an opportunistic buying scenario. These opportunities in reality presented themselves predominantly in under-performing assets. We did see transfers of these assets over the past year, but many of them defied traditional yield capitalization due to low net operating income levels. But through the first half of 2002, owners of well-positioned assets simply would not entertain the thought of selling their assets in what was perceived as a short- to mid-term revenue trough.

One reason stated by the participants for stability in pricing parameters includes low interest rates, which not only lowered debt service ratios, but also allowed for relatively stable yield and capitalization rate parameters while still allowing for increased equity returns on a leveraged basis. The lower interest rates also kept loan defaults at relatively low levels, at least compared to the crisis of the early 1990’s.

Despite this, the participants did indicate that many asset values have fallen, but that this fall was due more to a decline in hotel revenues and profits than an increase in yield parameters. This is further supported by one participant’s indication that the strong majority of capitalization rate gap has been given up by the buyers. Thus, in the wake of 9/11, there has been only a modest increase in capitalization rates, a trend which was actually occurring prior to the terrorists attacks.

Some participants clearly indicated that income capitalization has not been the only valuation technique used, particularly since revenue and NOI trends have been volatile. The ERRM was quoted as a popular indicator for smaller properties or hotels with historically low NOI. Other methodologies indicated include percentage of replacement cost and leveraged equity rate of return. The methodology also varies with the buyer, with opportunity buyers and smaller owner/operators often looking at ERRM multipliers, while larger institutional investors still tend to rely on unleveraged yield analysis.

So why have transactions recently increased? One survey respondent indicated that there has been “pent-up demand” for hotel sales, and sellers which intended to sell put off that decision until recently. With most market observers indicating the early stages of a recovery, buyers are recognizing that the opportunity window may be closing, and are less demanding in yield requirements. Also, the fall of the stock market has flooded alternative investment markets. While much of this capital has found its way to the perceived stability of net lease and multi-family real estate, it has also been credited with lowering the expectations of hotel buyers. As one broker put it, an opportunity buyer looking for a leveraged return in the upper 20%’s now may see a leveraged return of 18% to 20% as attractive in the wake of stock market instability. One active buyer indicated that leveraged return goals for them are currently in the mid teens.

Another reason quoted for pent-up sales demand is buyers who need to sell for tax reasons hitting a potential year-end window. One hotel buyer indicated he is hearing sellers indicate a strong preference to close by year-end.

In summary, transaction activity of well-positioned hotel assets dramatically slowed after the terrorist attacks of September 2001, but has recently increased. In general, buyers did not find dramatically depressed pricing in the market, and the recent perception of buyers has changed more than the perception of sellers. All in all, this has led to only a modest increase in yield and capitalization rates since 9/11, with value changes much more a factor of market and individual property revenues and profits. At USRC, we strive to utilize the most recent and comparable sales in our analyses, and a recent increase in sales activity should allow us to begin introducing more recent comparable transactions. However, the investor survey does support the use of pre-9/11 sales in analyzing current market value, provided appropriate revenue and/or NOI adjustments are made.