5 things shaping U.S. hotel investment

Investment in smaller markets is hot—investment in the Carolinas increased more than 20 percent during the past 12 months ending in June. Photo credit: Pixabay/12019

The United States economy is holding steady, with growth exceeding 4 percent during the second quarter of the year and strengthened by consumer confidence along with business investment, according to Marcus & Millichap’s "Midyear 2018 Hospitality Outlook" report. That spells good news for commercial real estate such as the hotel sector, with continued growth on the radar throughout next year.

Investors continue to remain interested in U.S. hotels thanks to strong performance, but that doesn’t mean there are no clouds on the horizon, especially as all eyes watch what the Federal Reserve will do next.

Here are five things from Marcus & Millichap’s report that need to be on the industry’s radar through the rest of the year and heading into next.

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1. Tax Reform Brings Change

The new tax laws have helped to bolster the industry. The reform did keep three of the most important rules for real estate investors: tax-deferred exchanges, real estate depreciation and the mortgage interest deduction. But beyond those rules, the changes also created three things that investors should know about, according to Marcus & Millichap.

First, investors using pass-through entities such as limited liability companies need to be aware of the new 20-percent deduction, which has restrictions based on income and asset base but also offers upside for entities that qualify.

Related Story: Corporate tax-law changes drive hoteliers to rethink their business classification

Second, the bonus depreciation provision will phase out after 2023, but for now investors can expense personal property in real estate assets acquired after Sept. 27, 2017.

Finally, investors need to be mindful of the new restrictions on business interest deductions. Under the new law, companies with average annual gross receipts of $25 million or more are limited in overall interest deductions. That means that the sale-leaseback model can be more beneficial because leases are still a deductible expense, according to the report.

2. Supply Remains Lofty

Demand for hotel rooms has risen, and that means hotel construction has followed suit in order to keep pace. By the end of 2018, Marcus & Millichap expects that U.S. hotel supply will have increased 5.5 percent since 2015, when looking at STR data. That’s the largest three-year gain since 2010.

Related Story: U.S. hotel supply expected to grow 2.5 percent in 2018

But growth in supply could begin to affect occupancy—which has hit a 30-year high in the U.S.—in some markets. That would mean average daily rate and revenue per available room would start to slow in those markets. For example, Los Angeles has increased its supply more than 3,500 rooms during the past 12 months ending in the second quarter. Demand, meanwhile, has not kept up, causing occupancy to decrease 120 basis points to 79.5 percent in June. Other markets that are increasing supply at a fast clip could sing the same tune.

Overall, U.S. hotel construction is up 2 percent year over year with almost 180,000 new rooms in the works as of June. Most of that construction has been in the upper-midscale and upscale segments.

3. Small Markets Are Big Winners for Investors

Transaction pace increased about 4 percent during the past 12 months ending in June, and much of that activity happened in smaller markets, according to Marcus & Millichap.

Related Story: 5 issues that should be on hotel investors’ radar

Specifically, the Northwest, Southwest and the Carolinas were huge for investment, growing more than 20 percent in each region. Strong demand is likely to maintain investors’ interest in these regions moving forward, according to the report.

4. Hoteliers Adapt to Changing Guest Preferences

Home-sharing services are still top of mind for the hotel industry because many hotel guests have flocked to these accommodations. That has caused hoteliers to adapt in order to win customers. And while many hotel companies are creating millennial-centric brands, owners are looking to independent properties.

Related Story: Millennials, other travelers cooling on home-sharing

Likewise, many investors are discovering opportunities in older independent properties by renovating around themes and expanding amenity packages appealing to the experience-oriented traveler, according to the report. Average first-year returns for these hotels can be found in the high-8 to low-9 percent band.

5. Lending Could Tighten

Although the 10-year Treasury swelled at the beginning of the year, it’s been hovering near 3 percent since. But depending on what will happen next, potential rapid interest-rate increases could create headwinds, according to Marcus & Millichap.

Related Story: It’s a challenging time to operate a hotel in the U.S.

Capital is abundant now, but lending could tighten quickly if interest rates rise fast. For example, in late 2016 the 10-year Treasury increased more than 80 basis points in 60 days and then it jumped 60 basis points at the beginning of 2018. Because these rapid gains happened twice in the last two years, Marcus & Millichap cautions that borrowers will benefit from taking a guarded approach and locking in financing quickly with their lenders.