the Current Low Cap Rate Cycle
|By Anwar Elgonemy, Vice President, Jones
Lang LaSalle Hotels, San Francisco
The momentum of hotel transactions comes into play from an iterative relationship between demand and supply factors; this, coupled with money flows in the capital markets to both equity and debt, constantly impacts the lodging sector’s yields.
Current Low Cap Rate Environment
Required yields, as measured by initial cap rates, continue to decline. While many expected that cap rates would start to rise as soon as the Federal Reserve began to increase interest rates, this has not been the case so far. The sense is that it is still early in the game, and we will have to see how the investment market reacts to the total 100 basis-point increase in short-term rates that have been expected by December 31, 2004.
Hotel asset pricing has become more aggressive as investors take advantage of the "debt party" and an improving operating environment, resulting in a low cap rate cycle. The current low cap rate cycle indicates that investors are paying more for each dollar of underlying NOI, and are targeting lower IRRs.
Reflecting the weight of capital in the market and the much lower interest rates, cap rates in the U.S. have fallen by almost 125 bps since 2003. A similar compression is occurring with IRRs; since 2003, IRRs have shifted downwards by over 100 bps.
Listed and unlisted REITs are acquiring hotels at EBITDA multiples of 9 to 12x, mirroring the appetite that public capital has for the lodging sector. The emergence of public companies and private equity and opportunity funds is also shifting the buyer landscape and is contributing to the current low cap rate environment.
Given what has been transacted, along with what is known will sell and how transaction activity typically flows during a year, it is anticipated that total 2004 transaction volume will hit the $11.5 billion mark. That’s a nearly 70 percent lift over the 2003 level of $6.7 billion and more than three times the 2002 volume. The average price per key is also projected to increase to approximately $140,000, up from $120,000 in 2003, or by 17 percent.
|The average cap rate on 25 of the largest U.S. transactions as of October
2004 was 6.5 percent. In comparison, the year-to-date 2004 transactions
executed by Jones Lang LaSalle Hotels had
a lower overall average cap rate of 5.9 percent (or close to $17 paid for
each dollar of underlying NOI).
Why the current low cap rate (high NOI multiple) environment? The following
are some of the contributing and inter-playing factors:
Yield Premium: Hotel Cap Rates vs. 10-Year Treasuries
The yield premium, or spread, over 10-year Treasuries that investors demand to own hotels continues to be at an all-time high, indicating that the lodging sector is competitively priced. Since 2001, the hotel cap rate spread has averaged close to 600 bps, above the historical norm (since 1990) of 510 bps.
However, higher economic-trend growth in the U.S., assuming it is here
to stay, should increase government bond yields. Assuming a 3.0 percent
real trend growth rate and a 2.0 percent implied inflation target, and
adding on a risk premium, equilibrium nominal 10-year Treasury yields are
probably closer to 6.0 percent than the current 4.2 percent. This means
that the spread is likely to narrow in the short-term before the hotel
cap rate pendulum eventually swings upwards once again.
Based in San Francisco, Anwar Elgonemy draws on over 10 years of hospitality investment experience. Since joining Jones Lang LaSalle in 2001, he has been involved in major hotel advisory, transaction and debt placement assignments. Anwar holds an MBA from Thunderbird and a Bachelor of Science from The Glion School in Switzerland.
Jones Lang LaSalle Hotels, the world’s leading hotel investment services group, provides clients with value-added investment opportunities and advice. In 2003, its success story includes the sale of 12,429 hotel rooms to the value of US$2.4 billion in 59 cities and advisory expertise on 119,814 rooms to the value of US$18.8 billion across 281 cities. Jones Lang LaSalle Hotels’ services include transactions, mergers and acquisitions, financial advice and capital raising, valuation and appraisal, asset management, strategic planning, operator assessment and selection and industry research. Jones Lang LaSalle (NYSE: JLL) is the world’s leading real estate services and investment management firm, operating across more than 100 key markets on five continents. www.joneslanglasallehotels.com
Jones Lang LaSalle
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San Francisco, CA 94111
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|Also See||Profile of Hotel Ownership in the San Francisco Bay Area / Anwar Elgonemy / January 2004|
|Anwar Elgonemy Appointed by Jones Lang LaSalle Hotels to Northern California Post / Jan 2003|
|Debt Financing Alternatives & Debt Restructuring Strategies in the Lodging Industry / Anwar R. Elgonemy / Sept 2002|
|Concrete to Cash: Real Estate Sale-Leasebacks in the Lodging Sector / Jones Lang LaSalle Hotels / March 2002|
|The Dynamics of a Hotel Deal in Mexico / Jones Lang LaSalle / July 2002|