Some segments of the market, such as smaller, drive-to leisure hotels, have seen an uptick in demand. Others continue to struggle.
by Sebastian Obando, National Real Estate Investor
Nick Plasencia was interviewed for this Q & A article published on August 10, 2020. The article is also available on the National Real Estate Investor website.
The hospitality industry has been one of the hardest hit commercial property sectors during the pandemic, so what can prospective hotel investors expect in the coming months?
Hotel operators are bracing for a recovery that’s likely to be longer and more difficult than the one that took place after the Great Recession. Most of the hotels that remained open in 2020 despite the COVID-19 crisis are generating very little revenue at the moment. Many face difficulty meeting the costs of mortgage payments, property taxes and insurance, according to real estate services firm CBRE.
NREI spoke to Nick Plasencia, managing director at The Plasencia Group, a commercial real estate advisory firm that focuses on hotels and resorts, about what investors can expect when examining lodging investment opportunities in the current market, how to bid competitively and what owning a hotel asset in this environment ultimately entails.
Can now be a good time to invest in the hospitality sector? Why?
The lodging sector is struggling with a temporary liquidity crunch which has created unprecedented investment opportunities. While demand has returned in some segments of the market, many properties are still suffering historically low occupancies. That means that there is often not enough cash flow at most hotels to cover mortgage payments and pay fixed overhead expenses, such as insurance and taxes. Many borrowers, as well as lenders, are looking for sources of fresh investment capital to cover such costs until demand improves. For well-capitalized investors who can afford to ride out the storm, material discounts to 2019 asset values are available. Historically, investing in the lodging sector during market resets such as the one we’re in at the moment has been a profitable venture.
How much do you see the sector rebounding and within what timeframe?
We have already seen an uptick in some corners of the industry, particularly in drive-to leisure markets. Improved property performance is highly dependent on the specific location of the asset. A beachfront property in Florida, for example, may be meeting their budget for the year, while a property a few miles inland could be still struggling to make ends meet. As our asset management team has learned, leisure markets with outdoor demand generators (i.e., beaches, mountains, lakes, etc.) have been very quick to rebound, especially in drive-to destinations, as families that have been cooped up seek a change of scenery. Typically following this rebound in leisure travel, we start to see a pick-up in corporate business travel, followed lastly by a return of group business (conventions, association meetings, weddings, etc.). It’s a little bit different this time around in that many corporations are still hesitant to send their teams out on the road. It will take a proven therapeutic or vaccine to really allow the industry to fire on all cylinders, especially with meaningful corporate and group demand.
Are there certain types of hotels (full-service vs. limited services, for example, or luxury vs. motel) that are better bets than others right now?
A general rule of thumb for today’s demand environment is that the smaller the property, the better. Economy hotels and extended stay properties, particularly along highways, have fared much better than larger, full-service hotels in urban metros. They have lower overhead costs to fund, and having fewer rooms has allowed them to achieve higher occupancy percentages and to maintain some level of integrity in ADR [average daily rates]. While many resorts are often found in attractive outdoor, leisure-oriented markets, most have been forced by local regulations to significantly scale back their amenities (e.g., restaurants and spas). Today, they also face fierce competition from nearby properties that never offered such amenities, but are able to cover their overhead, even with lower room rates.
Which markets should first-time hotel investors be targeting right now?
Our investment advisory practice is getting this question on a daily basis. The distress is really widespread at this point, and there are opportunities to place money across the entire spectrum of assets. Ultimately, the answer depends on the risk profile of the investor. There is an opportunity today to acquire properties that are generating cash flow, but where the owners have a liquidity need. Many owners who have sought our assistance are willing to trade some or all of their equity in their hotels at a modest discount, thereby allowing them to stay afloat with fresh capital. There are also much more distressed situations, including larger, full-service and convention hotels that are really hurting. In some cases, these larger properties have not yet reopened. The discounts available there may be more profound, but any investors acquiring such hotels must have strong conviction in their ability to eventually return to normalcy and be willing to carry debt service and overhead costs possibly for an extended period. Many first-time hotel investors prefer to invest in simpler hotels, where there are fewer moving pieces (no restaurants or spas and a limited reliance on group business), but the investment return profile of larger properties may prove more compelling at this point in the cycle. Our team is now working with a number of first-time hotel buyers to help them identify the asset profile that best suits their capital and return thresholds. We also help them navigate through the entire acquisition process.
What kind of a return timeframe should they be counting on and what are your estimates for eventual return on investment?
This question really gets to the heart of the risk profile of the investor. There are opportunities today for investors to come in with short-term investments to help existing owners meet their immediate liquidity needs, and through financial structuring come in with preferred equity or mezzanine debt. This essentially allows the investor to capture an above-market interest rate for a short period of time and exit the investment in a matter of months or a couple years. On the opposite end of the spectrum, investors who have the financial wherewithal to stay in for the long haul can capture discounted asset prices today with the hopes of even more substantial increases in asset value appreciation as the hotel industry recovers and eventually surpasses the 2019 peak. Typically, following recessions, the return to peak has occurred within four years.
What should investors pay attention to when examining a hotel investment opportunity?
Hotel investments are very unique and unlike most other real estate asset classes. At the end of the day, you have a very human-intensive operating business, with dozens or even hundreds of employees on property. You also have what amount to one-night leases. Fortunately, this also allows hotel owners and operators to capture demand upside rapidly as the economy improves, and also raise their rates on a nightly basis to take advantage of improving market conditions. Our asset management team typically keeps a close watch on property expenses, as well as optimizing revenues, perfecting the business mix at the property. Additionally, our development management consultants are constantly looking for ways to deliver renovations in a timely manner while seeking high quality materials and labor. Investors should pay close attention to the small items that, when added together, can be very meaningful. Keeping an experienced eye trained on revenue generation and expense reduction is critical to exceeding return on investment expectations.
It might currently be difficult for investors to travel to examine the properties due to quarantines and reinstated lockdowns. Should investors even consider buying a property they have not inspected in person?
We would never recommend that an investor acquire property that has not been inspected in person. It is worth hopping on an airplane or getting in a car to tour a property before making a sizable investment. It is also important to have a qualified team of experts review the operational and physical aspects of a hotel before acquiring it. For example, our development management and asset management teams have found that it is incredibly important to spend the proper amount of time investigating physical and operational aspects of an acquisition candidate. It is incredibly important to ensure that hotels are inspected from top to bottom and inside out before investments are made.
How many hotels are you seeing come on the market and how many bids are they getting?
There is more capital coming into the market today than there has been in a long while. This will eventually serve to buoy asset values, despite the unprecedented downturn. TPG has actually created a platform, TPG Lodging Capital Nexus, to help pair investors looking to enter the hotel space with those in need of capital. It is evident that many investors, including ones who are new to the space, realize the tremendous opportunity in the lodging sector today. That said, there have been fewer transaction opportunities available since the pandemic began simply because owners have been more focused on stabilizing operations and negotiating relief from their lenders than they are on selling.
Additionally, lenders have pulled back from issuing new hotel loans as they wait for clarity, making it difficult for most would-be-buyers to finance an acquisition. Many of the transactions that have occurred since mid-March have been completed mostly on an all-cash basis or with corporate-level debt. As PPP proceeds are coming to an end, and as initial mortgage forbearance agreements are expiring, we expect to see more owners turn to outside investors to shore up their capital stacks. The good news is that many investors view this credit cycle reset as a great entry point into the lodging space. Many disposition and financing processes that our firm has orchestrated have been extremely competitive, with investor interest actually exceeding pre-pandemic levels, often because of the current scarcity of high-quality assets.