by Alex White
Over the past few years, hotel investors have enjoyed a period of high transaction sales with all indications that this trend will continue to be strong. However, due to the looming interest rate hike, hotel owners are beginning to face a decision whether they should “hold” their lodging assets anticipating continued ADR growth and increased occupancy demand, or rather, sell their investments before they are affected by these rising interest rates.
No one can know what the future holds, but one can consider where future values are headed by proactively considering what history has taught us about changing market econometrics in the hotel investment arena.
Consider the following scenario: An economy-level, limited-service hotel property that is located in a metro market with good accessibility and visibility. Assume the hotel is in good condition and has 60 rooms, is 65 percent occupied, and commands an $85 ADR. The revenue and income would look like this:
Total Revenue = $1,209,975
RevPAR = $55.25
Gross Operating Income = $859,082
House Profit = $554,133
Net Operating Income = $402,734
For the past couple of years, economy-level, limited-service hotel assets have been trading between a 3.0X and 4.0X based on room revenue. For purposes of this analysis, we have assumed 3.5X room revenue multiplier based on the above-mentioned parameters to estimate value. As a result, I’m assuming that the value of this asset would be approximately $4,235,000 (rounded).
Further, let’s assume that total funds necessary to purchase this asset would look like this:
Purchase price: $4,235,000
Estimated PIP expense: $900,000
($15,000/room to cover franchise transfer fees and refurbishment of rooms)
Closing Cost @ 3 percent: $154,050
Total Use of Funds: $5,289,050
Assuming a buyer’s typical LTV is 70 percent of that value ($3,702,335) at 5.25 percent interest with an amortization over 25 years, the annual debt service would be approximately $266,234. Subtracted from the Net Operating Income of $402,734, the cash flow (before tax) works out to be $136,500 for the first year. That represents a cash-on-cash return for the buyer of 8.6 percent. In Year 2, assuming that the new owner will see an increase of approximately $10 in ADR and a slight increase in occupancy results in a cash-on-cash return jumping to 14 percent.
It should be noted that in today’s market, hotel equity investors are typically looking for a cash-on-cash return on their equity of 9 percent to 20 percent for a limited service lodging asset. A cash-on-cash return is a short-term calculation showing the return on equity during the initial years of investment.
So, the question begs to be asked, “If a buyer has a targeted cash-on-cash return of 10 percent in Year 1, how much more likely would the buyer be willing to purchase this asset if the interest rate were to increase to 6.25 percent dropping the cash-on-cash return to 6.9 percent?”
There would probably be cause for concern since the buyer will see more cash from the net operating income go to service the debt. Additionally, it would no longer be prudent for a buyer to pay a price equal to a 3.5X room revenue. So, how much lower must the multiplier go to achieve the same cash on cash return for the buyer?
If we consider a 3X multiplier cap rate, we’re looking at a 10.2 percent cash-on-cash return being achieved at the now defined 6.25 percent interest rate resulting in the hotel’s value (sales price) decreasing to $3,630,000. In other words, the seller has just lost over $600,000 in value simply with a one-point increase in interest rate.
This brings us to a logical thought when considering one’s investment strategy of selling now versus selling in the future. A seller would need to consider rising interest rates, how high they may go, and whether this would be the new normal for years to come. Remember, interest rates have been at an all-time low since before 2008 – more than 10 years.
When faced with the prospect of rising interest rates, an owner should consider if decreased value can be offset by increasing ADR or improving on occupancy. However, the hotel industry is experiencing high levels of new development (albeit signs are indicating this is slowing down) resulting in more supply and possibly bringing downward pressure on ADR as the added available rooms are absorbed in the market. In other words, one should anticipate for the occupancy to remain flat or even decrease in the near term in some markets.
Often owners will indicate that they choose to wait to sell their property anticipating an improving market and a higher value. But as this analysis shows, ADR and/or occupancy increases must outpace interest rate increases if there is to be a net gain in value. If this is not achieved, then the result might be owners seeing decreased value in their assets.
Consequently, can an ADR increase of 7 percent or more per year be achievable to maintain or increase value if interest rates increase 1 percent or more? What happens if this trend continues into the next year and the FED increases the rates even more? Historically, ADR typically grows approximately 3 percent year-over-year, but can an owner justify a 7 percent or more increase in ADR just to keep pace?
What is the take away from all this? If you believe interest rates will increase over time, values will decline unless income increases keep pace or outpace those interest rate increases. Should we experience a rapid increase in interest rates, it may be improbable that increases in income through gains in ADR and occupancy will be able to offset the negative impact on value.
In short, if interest rates increase significantly, values are likely to decrease. Even if values stay constant in the face of rising interest rates, given the time value of money, an owner may be wiser selling sooner rather than later.