Research

Hospitality real estate valuations in for a bumpy ride


Article by Alexander Sassen
Research fellow in Finance and ESG
at Hotelschool The Hague


“2024 will most likely be the year for brave investors with strong balance sheets” Published by React News


Read more about Alexander Sassen

The commercial real estate sector had a rough time in 2023 in both the US and Europe. Due to rising interest rates on the back of higher inflation and fears of a recession, lenders are demanding higher interest rates at a lower loan to value levels than before. So how will 2024 look like now that the interest rate environment seems to be turning? And within commercial real estate, how well will European and American hotel real estate perform?

Commercial Real estate taking a beating

The news flow in 2023 for commercial real estate was far from positive, and so far in 2024, things seem to get worse instead of better. Especially so for office real estate. In the US, office vacancy rates in Q4 2023 stood at a record 19,6% and this is weighing on valuations. For example, an office building next to Penn Station in New York that was built in 2019, sold for $16 million while the development costs were $90 million and in San Francisco, a prime office building that sold for $121 million in 2013, was sold for only $60 million in 2023. In Europe, real estate giant Signa filed for insolvency as they could not service the 5 billion euro of debt on their balance sheet. These are just a few examples of how bad things are in parts of the commercial real estate sector. In part, this is due to the work from home trend which has hit the office real estate hard. But that is not the whole story.

Looking at the lending side of the equation, conditions are tightening; meaning higher interest rates, lower collateral values and lower loan to value conditions (LTV; debt/value of the real estate). While current conditions cannot be described as a credit crunch as credit is still available, tightening of credit standards often proceed a credit crunch due to its propensity of being self-fulfilling.

Source: ECB Lending Survey 2024

The ECB published its lending survey in January, in which it states that lending conditions for commercial real estate will get even tighter, due to continued refinancing risk. So, to see things improving quickly in 2024 in Europe, might be overly optimistic. “Banks assessed credit quality risks for firms on average as contained, but there were pockets of deteriorating quality in certain segments, such as commercial real estate or construction” and “credit standards and terms and conditions continued to tighten most in the commercial real estate sector (CRE), reflecting higher financing costs, falling house prices and structural changes in the CRE segment in the aftermath of the pandemic”, according to the respondents to the ECB Lending Survey.

The situation in the US is hardly any better, as most loans to commercial real estate are provided by the embattled regional banks. Due to an outflow of deposits to Money Market Funds, these banks were forced to sell, at a significant loss, US treasuries they had in possession. Up until mid-March, the Fed had a Bank Term Funding Program (BTFP) in place to allow banks to postpone selling these positions so that the losses on paper (the unrealised losses stand at around $685 billion at the moment!) do not get realised. But now the BTFP program is closed, while the deposit flight from the US regional banks is far from over.

Even with a resumption of the BTFP, commercial real estate in the US will face a trifecta of issues: lower collateral value, lower loan to value conditions and higher interest rates (compared to previous financing rounds). Currently, according to report by researchers at the University of Southern California, Northwestern University, Columbia University, and Stanford University, an estimated 14% of all CRE loans and 44% of office building loans are in negative equity territory (loans>value of the real estate). The Deloitte Commercial Real Estate Outlook 2024 survey of US real estate investors also confirmed the bleak outlook for commercial real estate in general, with respondents indicating that cost of capital (50%), capital availability (49%) and property prices (35%) will worsen in the next 12 to 18 months.

Hotel Real Estate

But how did hotel real estate perform? Operationally, looking at the excellent data provided by HVS on 2023, the hotel market saw improvements across the board in revenue per available room (RevPAR), but the picture per region was quite different with Asia performing strongly and the US less so for instance. The Middle East showed very strong performance on both occupancy and average daily rates (ADR). Europe performed better than the US, with the big Northern European cities like Amsterdam, Paris and Brussels doing very well on RePAR. But the northern European market was also heavily impacted by rising operational costs (mostly linked to labor). Southern Europe showed a strong operational performance as RevPAR increased considerably in most markets, while labor costs did not rise to the same degree, according to HVS.

But while topline performance improved for the hotel sector, transactions took a nosedive; down 35% and 30% compared to 2022 for the US and Europe respectively, according to HVS. Compared to 2019, transactions in Europe declined by 60%! This did have a dampening effect on the value development of hotel real estate. After the first Corona lockdowns, value per room increased by 20,7% in 2021 and by 47,6% in 2022, settling at 8,2% for 2023, according to Penn State Index of US Hotel Values. So clearly, things are not in the negative now, but the trend of increasing values is slowing rapidly, and with lower transaction volumes, one could argue that there is no proper price forming taking place at this stage and that the worsening outlook is not yet reflected in hospitality real estate valuations.

There are several reasons for this development, one of them is subsiding revenge spending. But the elephant in the room is the sharp rise in interest rates.

It’s the interest rate, stupid!

Especially the US and Europe were, and still are, vulnerable to rising interest rates, as this happened from a very low base. For example, refinancing a property at 9%, while it was financed at 7% will hurt, but a lot less than if the refinancing happens at 5% while it was financed at 3% (it is both a 200 basis point rise in interest rates, but the percentual rise of the rates is 29% versus 67%).

This can become life threatening for some (hotel) real estate owners. For example, if a property of $1 million was financed by 80% debt (so loan to value, or LTV, 80%) at an interest rate of 3,5%, and the required yield by investors on the property was 4,5%, then rental income was $45.000 (4,5% of $1 million) and interest expense was $28.000 (3,5% of $800.000). Ignoring all other costs and taxes, the result would be a positive $17.000. But if interest rates rise by let’s say 250 basis points to 6%, the interest expense rises to $48.000, while the rental income stays at $45.000, thus giving a negative result of $3.000. The interest expense become so large, that it overwhelms the operational income.

In reality, most real estate buildings have been financed at a lower loan to value than in the above example and inflation of course allows for rising rental income too, but it should be clear that violent rise in interest rates will have a significant negative impact on property valuations. With the American Federal Reserve rate (the federal effective funds rate, the risk-free rate on which al credit is priced) having risen from 0% in 2022 to 5,33% in 2023, and the European equivalent, the ECB deposit rate, having risen from 0% to 4%, it is obvious to all that the (hotel) real estate sector finds itself in the middle of a storm.

And the effect is not just on interest expenses, but also on the discount rate used in discounted cash flow analysis by valuators (this discount rate often moves in tandem with beforementioned interest rates). While not operational in nature, the discount rate can have a much bigger effect on the value of real estate. But that discount rate depends again on the outlook of the risk-free rates (amongst others). If one expects the risk-free rate to remain elevated, the valuation impact will be significantly more negative than if one expects elevated levels of interest rates to be only transitory.

Market in deadlock

Because of diverging views of what the proper discount rate should be, most commercial real estate owners are not willing to sell at current implied (much lower) valuations, while prospective buyers are not willing to deviate from the new (read lower) price indicated by their valuation models. Most transactions that did occur, concerned parties that had to refinance. So, in essence, there is currently a battle between buyers and sellers on where interest rates will go (and if the economy is going into recession or not, which is interlinked with both interest rate levels and operational performance). This explains why transaction volumes in both the US and Europe have fallen of a cliff.

While further interest rate rises from the Fed and the ECB (and the Bank of England) seem to be off the menu, a drop in interest rates is far from assured in 2024. At the end of 2023, investors were banking on 4 or more interest rate reductions by both the Fed and the ECB. Now, these expectations have been lowered significantly due to macro-economic figures showing it is too early to significantly lower rates in 2024. Still, investors are not in agreement on when and by how much interest rates will change in 2024 and beyond. This causes significant differences in the valuations of commercial real estate.

But risks sometimes have a funny way of playing out in financial markets. For example, a recession is another risk for US hotel (and other commercial) real estate assets, but at the moment, this risk is low, according to some economists. However, that is mostly due to enormous deficit spending by the US government and, ironically, this huge spending spree ($200 billion in the last two months alone!) and the already elevated debt levels of the US (currently $34,4 trillion and rising by a trillion every 100 days!) might force the Fed to lower interest rates sooner rather than later in order to “save” the US government from even higher debt servicing costs. According to the Committee for a Responsible Federal Budget, the interest payments on US debt will be larger than the defense budget by 2025 and will become the second biggest government programme by 2026. This puts a lot of political pressure on the Fed to lower interest rates to avoid the US debt becoming unsustainable.

This twisted way of seeing things, gives rise to some investors expecting rate cuts, even if the economic figures do not warrant it. But just like the buyers and sellers of CRE are not in agreement on values, on “Wall Street” too, opinions vary; equity investors and bond investors seem to expect different things. For example, credit markets are expecting interest rates to remain at elevated levels (see for example the graph below of the US 30-year yield) (German 30-year yield shows exactly the same pattern). The 2year interest rate, for both countries, also show an upward move since the beginning of 2024. This while equity investors are celebrating all-time highs in the large equity indices. Something has to give…

Source: St Louis Fed

Different takes, different strategies

With the divergent views in financial markets, investors show different investment strategies.

There are investors that are looking to buy distressed hotel properties (that have to refinance now, for example), finance at the current higher rates for 3 years or so. Idea is then to improve operations and thus operational profit and refinance the debt once interest rates have dropped and/or sell the property at a big premium. That is, if interest rates will be significantly lower in 3 years’ time than they are currently and no recession takes a bite out of operational results…

But, obviously, there are also those investors that think that interest rates will remain elevated for longer (or even rise again). The FT recently published an article on debt issuance by high grade borrowers, and it shows a big rise at high volumes. If the expectation would be for significantly lower interest rates, then why would borrowers (that can wait), especially the high-quality ones, refinance such large volumes at the current elevated levels? These borrowers thus likely have a rate outlook which differs from the one of the previously mentioned investors.

This makes for interesting market dynamics. Specifically, the longer interest rates stay elevated, the more CRE loans will come up for refinancing at the currently unfavorable conditions, revealing the chilling reality of low or even negative equity (debt higher than the value of the real estate), lower LTV conditions and higher refinancing rates. Either this forces the owners of these properties to sell their best performing properties in order to shore up enough own capital to refinance the bad ones, or to opt for bankruptcy. Either way, more properties will hit the market at significant discounts, further exacerbating the situation. Those investors that moved in too early with too aggressive financing profiles (financed too short term as per example above), might then find themselves in trouble in a few years’ time; the choice of debt maturity profile will be the make or break decision in this case.

If rates do not come down soon, 2024 will prove to be another painful year for American and European commercial real estate. While hospitality real estate weathered the storm relatively well in 2023, it will have a hard time to repeat that feat in 2024 if rate cuts do not materialise soon enough.

In that light, it would be catastrophic if a prolonged recession (two consecutive quarters with negative GDP growth), hitting both business and leisure segments, would occur. So far, the view is that the US will avoid a recession, but for Europe recession seems only a heartbeat away (it just about avoided an “official” recession in the fourth quarter, as GDP growth was not negative but flat).

However, and ironically, any sign of a possible (prolonged) recession, might prompt central banks to start cutting rates sooner and more aggressively. So, while the economy will hit operational results, at least the lower risk-free rate could have a positive impact on valuations via lower discount rates. This might help out some but not all CRE investors, as the rise in risk premium due to the recession (simply put, the interest rate on a loan is the risk-free rate + a risk premium) might negate in part or even overwhelm the cuts in the risk-free rate by central banks. This will further amplify the valuation gap between low quality and high-quality real estate assets (with solid underlying operations).

It seems that hospitality (and other commercial) real estate is trapped in the twilight zone between rate cuts and a possible (prolonged) recession; with the latter depending on the timing and size of the former. For CRE in general, and hospitality real estate in specific, 2024 will most likely be the year for brave investors with strong balance sheets, solid cash flows, and favorable refinancing profiles; the rest is looking frail and might become easy prey if central banks decide to delay and or lower interest rates too slowly.

In the end, it all depends on the Fed, the ECB and the Bank of England; central banks will make or break European and American commercial real estate in 2024. And although hospitality real estate has fared better and, at the moment, has better fundamentals than office real estate, it will be hard pressed to avoid feeling the heat.