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The Momentum of Hotel Transactions in
the Current Low Cap Rate Cycle
By Anwar Elgonemy, Vice President, Jones Lang LaSalle Hotels, San Francisco
December 2004

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.


Source: Lodging Databank, RERC and Jones Lang LaSalle Hotels


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:
 
 

  • Window of opportunity: strong competition for deals, with lots of money chasing limited product.
  • The "gamesmanship" factor: unsatisfied buyers who haven’t made all their buys, especially since the anticipated foreclosure activity post 9-11 didn’t happen.
  • Cheap debt driving pricing and volume: competition among lenders to place capital has led to sharply contracting LIBOR spreads.
  • Quality hotel assets are fetching good proceeds with attractive LIBOR spreads. This level of proceeds is being driven by: strong DSCRs, valuations below replacement cost, LTVs of 70-75 percent and improving market conditions, making such loans relatively less risky than other types of real estate.
  • Significant CMBS issuances continue to drive leveraged buyers.
  • With mezzanine debt, LTVs are higher at 85 to 90 percent.
  • Lenders have become more cautious in assessing the risk accompanying a particular hotel asset at a particular time.
  • More information is available now than in previous cycles, permitting more scrutiny and discrimination among hotel deals.
  • Equity markets are still extremely volatile and bond markets offer the dubious combination of low yields and high corporate credit risk.
  • Real estate in general is becoming a highly sought-after asset class, with hotels becoming more alluring in the minds of investors.
  • Better pricing and recovery story compared with other real estate sectors.
  • Consumer lifestyle trends and the "Midas Touch" of residential real estate (investors are looking more into buying condo-hotel units and fractional interests). 
  • Limited new supply risk in most major markets.

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.
 


Source: RERC and Jones Lang LaSalle Hotels

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


 
 
 
Contact:


Anwar Elgonemy
Vice President
Jones Lang LaSalle 
One Front Street, Suite 300
San Francisco, CA 94111
Direct: (415) 456-1709
Cell: (415) 699-3347
Fax: (415) 421-7736

 
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


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