Although the broader U.S. economy defied expectations in the third quarter of 2023 with positive economic indicators—such as a 5.2 percent growth in gross domestic product, softening inflation and resiliency in the job markets—the outlook for the hospitality industry was not as positive. The surge in leisure travel that has driven positive hotel revenues has begun to subside; and the contemporaneous increase in business travel is unlikely to be sufficient to offset increased operating and capital costs, driven by a combination of labor shortages, turmoil in the debt and real estate markets, supply chain constraints and general inflationary pressures.
RevPAR and ADR Growth Slow
Over the past several years, a post-pandemic surge in leisure travel drove increases in both average daily rates and revenue per available room. That leisure-based surge abated in 2023, but increases in group and conference travel and the beginnings of a rebound in business travel allowed RevPAR to remain relatively strong in 2023—with U.S. RevPar anticipated to have increased by 5.5 percent for the year.
While ADR growth remained strong in the first quarter of 2023, the rate of increase in ADR was outpaced by inflation beginning in April. Slackening of the rate of ADR increases may have been inevitable considering the boom in ADR that occurred in 2021 and 2022; however, there are likely additional factors at play that negatively impacted ADR. International travel by U.S. consumers increased in 2023, which siphoned demand for U.S. hotel stays, particularly in leisure stays. Decreases in both consumer confidence and business investment in the second half of 2023 also dampened hotel demand and put pressure ADR.
Although many economists have predicted that the U.S. will avoid a recession in the next 12 months, real gross domestic product (real GDP) is predicted to increase by just 1.5 percent in 2024 (compared to 2.1 percent in 2023). This muted Real GDP increase and possible worldwide economic issues means that the slackening of ADR growth will likely continue into 2024, which will likely also further depress RevPAR growth in that period.
Tight Debt Markets
As with other sectors of the commercial real estate market, the hospitality industry has been impacted by turmoil in the debt markets over the past year and a half. On the one hand, higher interest rates have resulted in an increase in the cost of bank capital (i.e., higher yields on bank deposits) while, on the other hand, higher interest rates have resulted in a decrease in the value of unhedged fixed-rate instruments held by banks as part of their investing portfolios (including, for example, fixed-rate real estate loans). This combination of factors has created significant market pressure on banks and squeezed the profitability margins of many lenders (to the point of failure in numerous notable cases). These market pressures caused regulators to apply increased regulatory scrutiny to capital retention requirements and accounting rules for bank portfolios.
In the face of these challenges, lending institutions have, unsurprisingly, adopted a risk-averse posture, which saw the amount of outstanding commercial real estate debt increase by only 0.8 percent in the third quarter of 2023. This very slight increase reflects lenders’ focus on quality sponsors and quality projects. With few other exceptions, banks have virtually ceased originating other new debt. Until banks fully regain sufficient stability and certainty to resume lending activity, the lack of leverage will continue to be one of the primary bottlenecks impacting the commercial real estate sector, including the real estate-heavy hospitality sector.
There have been some silver linings in the commercial real estate debt market. Life insurance companies and debt funds have taken more proactive stances, filling the gaps in the commercial real estate lending market. Some borrowers have undertaken strategies to create the leverage necessary to make acquisition deals, such as assuming existing in an acquisition or using preferred equity or even mezzanine debt as a means to bridge debt financing shortfalls.
Increased Cost of Equity Capital
The increase in interest rates over the past year and a half has also altered the investing landscape for equity investors in hospitality assets. Depending on the market, opportunistic pockets of equity capital remain ready to deploy, but the cost of that equity capital is increasing. Given that the rate of return on a so-called “risk-free” investment (i.e., treasury bonds) has jumped over others the last several months, the return hurdles in distribution waterfalls for hospitality joint ventures have also begun to adjust upwards to compensate investors for the risk premium associated with these transactions.
Adjustment of Asset Values
The turmoil in the debt markets and the increases in equity costs have created a downward pressure on hospitality asset values. Owners have looked to find a way to increase overall profitability of hotel assets through some combination of increasing operating revenues and decreased operating expenses, but this is a tall task given softening domestic hotel demand, falling ADR, still-present labor and supply shortages, labor cost increases, and rising insurance costs.
Many hotel owners acquired their assets using fulsome valuations; and the recent softness in ADR and RevPAR means that there will be even more pressure on these owners to satisfy the returns demanded by their investors. Likewise, potential purchasers of hotel assets must satisfy increased return criteria demanded by the debt and equity markets and are more likely to attempt decrease the initial acquisition basis. This dynamic has resulted in substantial bid-ask spreads across nearly all asset classes in real estate, and we have seen numerous deals that have been either re-traded or terminated during due diligence or that have died before a purchase agreement can even be signed.
With respect to borrowers under non-recourse loans that are either in default (including maturity default) or are otherwise out-of-the-money on their investment, we are beginning to see such borrowers hand possession of the hospitality asset back to the lender. This creates further distress in the market, as lenders will ultimately need to dispose of these assets, likely at a loss, after acquiring them.
The typical drivers of institutional sellers are the end of a fund lifecycle or an inability to rollover debt upon maturity. As the higher interest rate environment continues to persist and outlasts fund lifecycles and upcoming financing maturity dates, we can expect to see bid-ask spreads tighten sharply in favor of buyers. In response to this dynamic, we have begun seeing sponsors start opportunistic funds to take advantage of distressed and real-estate owned properties.
Transaction Volume Remains Low
To the extent that current owners are not under immediate pressure to sell as a result of defaults on their financing, they have two options: (1) either sell the assets at the best price they can get and try to minimize their losses or (2) continue to hold the assets in hopes that asset values will recover. It appears that most hotel owners have opted for the latter of these two alternatives, as sale transaction volume for 2023 consistently declined from 2022.
In the third quarter of 2023, hotel transaction volume was down approximately 25 percent from the previous year. This continued a trend of year-over-year declines in transaction volume shown in the first and second quarters of approximately 20 percent and 35 percent, respectively. The continued slowness of the hotel transaction market mirrored softness in the general commercial real estate market, where mismatches between buyer and seller expectations on property values, the continued increases in debt and equity interest rates, a pullback by banks from real estate lending, and rising insurance costs continued to hinder transactions.
Although the volume of sales was down, the sale price per room actually increased year-over-year in 2023 from the third quarter of 2022 by approximately 7.5 percent. This continued a trend from the second quarter of 2023, where prices were up year-over-year by approximately 3.5 percent; and was in contrast to the first quarter, where prices decreased on a year-over-year basis by approximately 9 percent. Perhaps this trend shows signs of the value of hotel assets stabilizing as the year progressed. However, given the other market factors at play, it seems more likely that this trend reflects the trend in the larger commercial real estate industry where standard sale transactions have become focused on the highest quality assets and the lower quality assets have difficulty generating interest from purchasers.
Recent Action by the Fed
The Federal Reserve’s recent pauses in interest rate increases and its signaling of multiple cuts in the coming year served to rally stock and bond markets. The consecutive quarters of rate pauses coupled with the likelihood of coming rate decreases may serve to thaw the commercial real estate debt markets and allow purchasers to more easily predict their cost of capital when modeling their offers, which may in turn allow hotel transactions to proceed apace.
One interesting note is that the Federal Reserve is contemplating rate reductions despite the fact that year-over-year inflation for November was approximately 3.1 percent. Although the trend shows decreasing inflation rates—3.2 percent in October and 3.7 percent in both September and August—this is still well above the Fed’s stated inflation target of 2 percent. A frequent refrain of economists is that “the last mile to price stability may be the most challenging,” which makes the affirmative signaling of interest rate decreases—a move that is likely to spur the overall economy and potentially spur inflation—a curious decision.
With between $1.4 trillion and $930 billion in commercial real estate loans scheduled to mature in the coming year and values and fundamentals of most all asset classes on shaky ground, perhaps the Federal Reserve’s decision to decrease interest rates reveals that it is more concerned about the economic effects of a looming crisis in the commercial real estate market than the effects of continued inflation.
Many stories have been written of late that laud the Fed for achieving a “soft landing” of the economy by tackling high interest rates without pushing the U.S. economy into a recession. However, the final verdict on that soft landing likely has not been rendered, as we must see whether debt and equity markets are able to absorb the volume of loan maturities over the next year and how impacted real estate values and hotel demand will be by increasing economic headwinds, both in the U.S. and abroad.
Charles B. Ferguson, Jr. is a partner at law firm ArentFox Schiff LLP, where he is co-chair of the firm’s hospitality industry group. He represents publicly traded REITs, investors, developers, and other owners of hotel assets and other clients in the acquisition, development, financing, ground leasing, and space leasing of real property, condominium conversions, financing transactions, and related management, licensing and corporate matters.
Ankit Shrivastava is a partner at law firm ArentFox Schiff in the firm’s real estate practice. His wide-ranging practice focuses on hospitality transactions, among other things. He regularly counsels multinational corporations, private equity funds, investment banks and other market participants in all aspects of their hospitality investments and has deep expertise across all tiers of the capital structure. Shrivastava is also a member of the hospitality, ESG, and long-term care & senior living industry groups.