Deal Dearth

Credit crunch brings deal flow to a relative trickle; timing of rebound still unclear.

By Jeff Weinstein, editor in chief -- Hotels, 9/1/2008

While the hotel deal spigot has not been shut tight, it has been reduced to a near trickle. Data from Jones Lang LaSalle Hotels (for deals over US$10 million, excluding land deals, JVs and development) shows that global deal volumes in the first half of 2008 totaled US$13.9 billion, down 76% versus the first half of 2007 and 75% versus the second half of 2007, which was already impacted by the credit crunch. “This volume matches the volumes of 2004 and is still well above the last low period (2002-2003), which was immediately after 9/11, SARS and the start of the Gulf War,” says Arthur deHaast, global CEO, Jones Lang LaSalle Hotels (JLLH), London.

Among a few deals getting done recently were Wyndham Worldwide’s acquisition of U.S. Franchise Systems; Strategic Hotel Capital’s US$96 million sale of the Hyatt Regency Phoenix to Los Angeles-based DiNapoli Capital Partners; and Barcelona-based Meridia Capital Hospitality taking a 50% stake (€60 million) in Capital Hospitality Group for a three-hotel portfolio located in Thailand. At the same time, hotel acquisition funds continue to be launched and supported with the belief that the fundamentals of the market are sound and value in the hotel sector remains. For example, the M.A. Kharafi Group, Kuwait, has created Sovereign Hospitality Holdings in Geneva to acquire, finance and develop hotels around the world and the United States, in particular.

“We expect deal volume to settle at more normalized levels last seen in 2004-2005 at around US$30-40 billion per annum.”

-Arthur deHaast, Jones Lang LaSalle Hotels

The questions no one wants to answer, or seemingly knows how to answer, are how deep will the performance slide go; when will credit ease and return to the marketplace; and will the deal pace ever return with the vigor of 2006-2007? Loan-to-value ratios are decreasing, debt coverage ratios are increasing, and the resulting capital stack costs are on the rise. Debt remains very hard to obtain and no commercial mortgage-backed securities (CMBS) has been available since last summer. Yes, illiquidity in the United States, at the very least, still prevails, and appears to be spreading to Western Europe.

“Debt remains a struggle for now,” says Michael Hirst, London-based consultant to CB Richard Ellis Hotels. “If you 'over equitize’ a deal at today’s yield and have an IRR-driven return model, then working on the assumption that there will be a feeding frenzy when the debt market comes back now is a good time to buy. Some financial restructuring will be the name of the game and we see real opportunities to work with banks in providing support and valuation for new financial packages.”

Off the record, some industry observers say there will be stagnation in the investment market over the next 12 months but hotels will continue to trade at profitable levels with very few business insolvencies. Corporate profits will be under pressure due to financing costs and owner-operators will once again be in the ascendency with cash to spend. Any easing in the credit markets will see a spate of hotel deals as those who got in more recently seek to exit. “The fact that investors wait in the wings means that holders of assets can always find a ready home for their real estate when and if holding it becomes too much of a threat to their balance sheet,” says one seasoned industry observer.

However, unlike any previous downturn the industry, owners and managers are now very adept at moving quickly to adjust to market conditions. “Corporate programs, brand standards and consolidation have focused for much of the time on more efficiencies and productivity and cost savings in both capital and operating costs,” says Hirst. “Property owners, using asset managers, have focused on asset utilization yields, construction cost efficiencies and capital improvements. More concentration on branding gives marketing and procurement effectiveness. We are seeing a marked increase in demand for asset management services, which span both operational overviews and evaluation of effective yield from property utilization and capital investment.”

Others believe there are two driving forces at play—one is a recovering economy that will ultimately lead to confidence, increased travel and some sense that we are moving off the bottom. “This will drive confidence among buyers who are blindly looking for a bottom and allow lenders to reallocate to the hotel sector,” says Rob Stiles, principal, Cushman & Wakefield, Sonnenblick-Goldman, San Francisco.

Conversely, Stiles says, further declines could lead to poorer industry performance, a real fall in values and a complete loss of confidence among most lenders. “If we bounce along in today’s environment, with no one convinced we are yet at the bottom, we will go through a prolonged period of stagnant values and very difficult—almost punitive—lending parameters,” he says.

The biggest issue during this deal dearth appears to be the staring contest between buyers who know prices should be adjusted to reflect deteriorating market conditions and sellers who can still show pretty solid cash flows. Yes, smaller deals under US$50 million seem to be getting done, but US$100 million-plus deals that require much more equity are not happening at nearly the rate of even six months ago.

In the Americas, the “hold” sentiment is the dominant investor strategy for the first time in five years—at 38.1%, according to JLLH research. Investors intending to hold their assets are followed closely by net buyers—representing 37.1% of respondents. “Investors are deploying renovation strategies now to improve their position for future trading and wait it out during this period of illiquid debt and perception gaps in pricing,” says Kristina Paider, senior vice president, research and marketing, JLLH, Chicago. “Many investors are taking this opportunity to upgrade their assets and improve performance.”

In search of the accurate climate reading for hotel deals around the world. HOTELS’ Investment Outlook interviewed several brokers, hoteliers and consultants to take the pulse and consider the future and timing of hotel deals heading into 2009. And with so much uncertainty, are we in unchartered waters?

“Investors and sovereign funds from these territories (Eastern Europe, Africa) plus those from Russia, China, India, Israel and the UAE are keen to redeploy capital into hotels in Western Europe.”

-Michael Hirst, CB Richard Eliis Hotels

Off the record, one industry observer considers this downturn different than others. “If oil, food and commodity prices stay high then recovery will be long in coming with profitability moderating and margins being squeezed,” he says. “Equally credit markets will remain cautious for some time and we may return to more traditional lending criteria. All in all, I except trophy properties prices will ease and I think the down cycle will last longer than previous downturns.”

JLLH’s deHaast says, “I don’t think any cycle has been the same as there are always different factors that have come into play to cause a downturn whether that be economic slowdown, excessive supply growth or a major demand shock such as 9/11 or SARS. This down cycle is being driven by economic factors more than perhaps the ’01 -’03 cycle but is not that dissimilar to the ’90-’93 down cycle which was largely economic driven and was also accompanied by weakness in the banking sector.”

When asked about the global nature of this cycle, deHaast says while there is some truth to the theory of global deal cycles, he points to those economies driven by commodities and food exports. “We are still seeing strong development and increasing investment activity in markets such as the Gulf region (UAE, Saudi Arabia, Qatar and Oman in particular), Russia, Australia, Canada (especially west) and most recently Brazil,” says deHaast. “China, although a net importer of commodities and thus more dependent on manufacturing and export, has such a large domestic market that has its own momentum and will also be less affected by the global downturn.”

CBRE’s Hirst adds, “While some areas of Western Europe are undoubtedly feeling the effects of the downturn there are many growth areas where new developments continue unabated such as Turkey, Russia, former Russian Republic States, CEE States, The Baltics, UAE, Central Europe and Africa. All these economies are on the up or where higher returns are currently available.”

Hirst says hotel investment led by local investors is very much the name of the game. “Similarly, investors and sovereign funds from these territories plus those from Russia, China, India, Israel and the UAE are keen to redeploy capital into hotels in Western Europe. Equally, several new investment funds are being set up to concentrate on hotel investment.”

While deHaast points to the GCC as a hotbed of development activity, a recent report by JLLH says room supply growth across the Middle East and North Africa from 2007 to 2015 likely will be about 200,000—around 35% less than proposed. In addition, expect serious delays in completion of those projects with JLLH forecasting as many as 40% of the projects due by 2015 being delayed due to increased competition for resources, rising costs and tough financing due to global credit crunch.

Looking globally at the transaction pipeline, the Americas were down over 80% in the first half of 2008, but at US$6 billion, deHaast says, was still the most liquid hotel investment market of the three regions tracked by JLLH.

“We believe many sellers are waiting for post summer and early fall results before proceeding with a sale mandate, which could result in many more assets being brought to market by the fourth quarter.”

-Bill Stone, Colliers International

Europe, Middle East and Africa deals declined 59% to US$5.8 billion in the first half of 2008 with the UK most affected, and France and Germany least impacted. Asia Pacific was also badly affected with the deal pace off 67%, according to JLLH data.

“We have also seen a big change in deal size with only one transaction over US$1 billion in the first half of 2008 (compared to a dozen in H1 2007) and deals over US$100 million down from 87 in first half of 2007 to only 32 in first half of 2008,” deHaast says.

DeHaast also points to a significant shift in main buyer group away from private equity toward hotel operators who are using their own balance sheets or traditional low leverage financing to complete deals.

For the rest of 2008, deHaast says JLLH expects little change—with the exception of Continental Europe where they foresee greater reductions in volumes countered by some pick up in Russia, the Middle East and emerging Europe as developers start to sell almost- or recently completed hotels. “In past few weeks (early July) we have closed on a nearly completed Moevenpick in Dubai and a recently opened Park Inn in Russia,” he says.

In the first half of 2009, JLLH predicts a continuation of the present low level of transaction volume. “But as owners start to feel greater pressure from falling incomes (to date this pressure has been modest as RevPAR has generally held up although in some markets modest RevPAR growth has been more than wiped out by cost increases) we expect more will bring assets to market, and at more realistic prices that will start to meet buyers’ expectations,” deHaast says.

When the market does turn upward, there is still a significant amount of equity available to invest in hotels. However, deHaast does not foresee volumes coming back to anything like the levels of 2006-2007. “Rather, we expect it to settle at more normalized levels last seen in 2004-2005 at around US$30-40 billion per annum.”

In the United States, capitalization rates are expected to continue to rise and hotel values, in the short term, should decline. Owners with good quality assets and not forced to sell will not, especially at a discount. Experts expect quality owners in the states to hold for dividend yield and wait for the next cycle to sell.

“Although floating and fixed interest rates remain attractive, the required rate of return on a larger portion of equity and the increased cost of mezzanine financing results in upward pressure on capitalization rates,” writes Scott Smith, senior vice president PKF Consulting, Atlanta, in a recent report. “Additionally, where there may have been a potential of 10 or 12 debt/equity participants for any given transaction in 2007, now there are only three or four participants actively seeking each transaction.”

“If we bounce along in today’s environment, with no one convinced we are yet at the bottom, we will go through a prolonged period of stagnant values and very difficult—almost punitive—lending parameters.”

-Rob Stiles, Cushman & Wakefield, Sonnenblick-Goldman

Smith adds, “It will be up to the sellers to determine if they want continued dividends (hold) or redeploy capital (sell). As investment bankers have exited the market, traditional commercial banks and institutional money will provide the majority of capital for hotel investors. This will limit the size of any one transaction forcing portfolio and large dollar (US$50 million-plus) transactions to occur in late 2008 or 2009. Property appreciation, as seen during the past several years, is not expected to be realized in the short term.”

North of the U.S. border in Canada, the hotel business has been on the rise for the past 24 months with an oil- and gas-based economy doing quite well in the west. “There remains strong demand for assets located in primary Canadian markets. However, the slowing economy and a surge in new hotel construction has led to some price erosion in some secondary and tertiary markets,” says Bill Stone, managing director, Colliers International, Toronto. “We believe many sellers are waiting for post summer and early fall results before proceeding with a sale mandate, which could result in many more assets being brought to market by the fourth quarter.”

Stone adds that the impact of fewer American travelers (overnight visitation has declined some 11% during the past three years) and a Canadian dollar that has risen more than 50% against the American dollar since 2002, have already been priced into the market and are reflected in the yields. “Debt continues to be the most significant influencer on the volume of deals coming to fruition and pricing,” he says.

Hotel profits in Australia, New Zealand and the Pacific are at their highest levels in 20 years, according to John Smith, managing director, Horwath HTL Australia, Sydney. Even better, the outlook for continued outstanding performance looks good for another one to three years.

At a recent industry conference in Sydney, hotel investment sentiment remained high with over 70% of delegates suggesting a capitalization rate for Sydney 5-star hotels of below 7.5%, and over a quarter of delegates suggesting a rate of below 6.5%. The preferred investment sectors according to conference delegates, 4-star hotels and serviced apartments, while 3-star hotels also scored well. Resorts were voted the highest risk category, followed by 5-star hotels.

A panel of capital providers at the Sydney conference, including Ben Keeble, a senior executive from CVC (that recently secured a controlling interest in Stella Hospitality Group) confirmed that while increased challenges now existed for raising equity and debt for future acquisitions, investor appetite nonetheless remained and deals would continue to be done.

JLLH’s Mark Durran reported that foreign investor interest had returned to the Australian market and one investor on the transaction panel, Mark Etherington (Australian Property Trust) who only recently had begun to invest in the industry, confirmed that opportunities still existed to acquire assets for upgrading and repositioning to improve revenues, profits and values.

The big question remaining is whether the party is over for the foreseeable future or if the downturn is going to be short-lived. Either way you want to look at it, there is a positive to take out of the current state of the hotel business: moderate increases in supply and pressure in construction costs will temper development. As a result, once the credit crunch moderates, market fundamentals should rebound faster and the cork in deal pipeline should be popped once again.