By Jim Costello on October 11th, 2017
The recent upward trend in hotel cap rates generates concern for commercial real estate investors because in previous cycles hotel cap rates climbed ahead of other property types. Is the upward creep the writing on the wall for the commercial property sector overall or indicative of deeper fears within the hotel sector?
The income trends of the hotel sector are more sensitive to economic conditions than are other property types, which tend to have long-running contracted lease income. Hotel income is determined daily as rooms turn over to new guests. As such, hotel asset values fell and cap rates climbed quickly during the Global Financial Crisis. Cap rates for the hotel sector peaked in 2009, a full year ahead of other property types.
This historic behavior in cap rates has investors concerned but the drivers of the hotel sector are vastly different today. There is no widespread economic calamity in place that will undermine hotel and all property sector income. Job growth is fairly steady and GDP continues to grow, albeit moderately.
The fear about the future income potential of the hotel sector comes from two different sources. There are competitive disruptions underway from the sharing economy. Companies like Airbnb can offer up lower prices for modest accommodations. Looking at the most basic accommodations for limited-service hotels in the Non-Major Metros (NMM), cap rates have climbed 80 bps from 2014 to 2017.
At the same time there are fears over construction as the development of limited-service hotels is on the upswing. Real Capital Analytics tracked the start of 21,000 limited-service hotel units in the NMM in 2016 and 20,000 have started so far in 2017.
An analysis focusing only on these comparatively modest hotels in the NMM excludes any movements in cap rates due to any changes in the sample that might overweight deals in the pricier 6 Major Metros. What it cannot control for, however, is the quality of what is selling in these locales and on this point there is evidence that a change in quality is helping to drive up cap rates.
Smaller hotels are riskier investments. If a hotel has 50 rooms then the aftermath of a visit from a British rock ‘n’ roll band will be more damaging to property income than in a 200-room hotel. All other things being equal, riskier assets should trade at higher cap rates.
We see though that the average size of what has been selling since 2014 has been falling sharply. The average limited-service NMM hotel that transacted between 2011 and 2014 had roughly 100 rooms. There has been a steady decline to something closer to 90 rooms into 2017, however.
Are hotels an operating business facing disruption from sharing economy startups? Or are they real estate investments where brand quality, the facilities, and location determine performance? Why not both?
The upward creep in cap rates is not indicative of future doom for commercial cap rates overall as in the previous cycle. The market trends which drove that increase are not in place today.
Still, it is not to suggest that the increase in hotel cap rates is an anomaly that has no impact elsewhere for commercial properties. The fact that smaller hotels are selling suggests that there is less liquidity today for the higher quality assets in this limited-service hotel sector.