As an increasing proportion of the population gets vaccinated, there are clear signs of growing consumer confidence and strong desire to travel. Transportation Security Administration checkpoint volume has been increasing steadily, hotels’ weekly revenue per available room has been recording impressive triple-digit growth from the same periods in 2020 and groups and social events are gradually being confirmed. While we are not “out of the woods” yet, understanding what drives hotel valuation as recovery continues will help investors, stakeholders and market participants chart their path forward.
While many factors drive hotel valuations, three key factors stand out in the current dynamic environment.
Since the cost of debt generally is lower than the cost of equity (with some exceptions, such as rescue capital), using leverage could enhance the return on investment and increase accessibility to larger assets; therefore, the availability of debt capital has always been a critical factor in transaction pace and volume. The debt availability was immediately shut off when the pandemic hit in April 2020 and remained so for the rest of the year. As such, hotel transaction volume plunged 75 percent last year.
However, the appetite for hotel lending has significantly improved in recent months. The Federal Reserve continues to hold the benchmark interest rates near zero, a strategy that is widely viewed to remain in place over the next few years as the economy recovers. The low interest rate environment and greater liquidity offered by the debt markets, combined with an abundance of capital wanting to enter the hotel real estate space, are boosting investors’ confidence. As such, competition to acquire good quality and highly defensive assets will be increasingly fierce. Justified by the recovery trajectory and upside, this is driving hotel valuations to higher levels in certain markets and segments, particularly those with compelling leisure demand and drive-to feeder markets as well as luxury, iconic assets.
The pandemic also paused many planned hotel projects due to the lack of construction debt, uncertainties in forecasting recovery and challenges in valuation. In fact, hotel construction spending has declined 32 percent since its mid-2019 peak—the largest decline among all commercial real estate sectors.
While stimulus packages boosted infrastructure spending, they, along with a booming housing market, also exacerbated the cost of construction materials. Led by a pricing surge in lumber, copper, brass and steel, construction costs in early 2021 rose 7.6 percent over 2020.
The increases in construction costs, coupled with lingering hotel closures, project delays and labor and material shortages, will limit new supply this year. Over the immediate term, construction financing will largely only be available for lower-risk projects with the best sponsors. Hotel supply pipeline will be curtailed until the debt market reopens for new construction lending. Additionally, there are markets that are experiencing permanent hotel closures for redevelopment or conversion to nonhotel uses. These phenomena would provide relief for certain markets by reducing some of the competitive pressure.
As such, markets that have inventory reduction or limited new supply coming online in the near term could see their recovery accelerate. Hotel values in these markets would fare better than those that are still weighed down by new supply entering the markets.
3. Hotel Product
At the onset of the COVID-19 pandemic, hotel owners were suddenly strapped for cash and hit with liquidity issues. Executing capital plans or completing property improvement plans was the very last thing on most owners’ to-do list. Instead, owners received leniency in using their furniture, fixture and equipment or PIP reserve funds to cover working capital. Hotel brands also allowed PIP deferrals of 12 to 18 months.
As markets continue to recover, PIPs that were deferred will need to be completed later this year or next to satisfy brands’ requirements. Additionally, travelers are becoming increasingly discerning and well-informed and the hotel marketplace is increasingly competitive with many options to choose from. Hotel brands need to constantly upgrade their products to win market share. As such, it is important to know whether hotels are meeting the current brand’s standards. If not, a capital cost deduction will be required to arrive at the net value of the hotel because the burden of executing the renovation often rests on the shoulders of the hotel owners or franchisees. However, properties that were able to complete renovations during the pandemic are better positioned to catch the wave of recovery with newer, fresher product offerings.
There are many more asset- and market-specific factors that drive hotel valuations. It ultimately comes down to the hotel’s cash flow generating capability and its longevity. As market conditions change, investors and owners should keep themselves abreast of the hotel capital movements, supply inventory shifts and new brand standards needed to formulate a value-preservation strategy.
Charlotte Kang is Jones Lang LaSalle Valuation Advisory Group managing director, national practice lead - hotels and hospitality.