Persistent turmoil in the debt and equity markets continues to impact the hospitality industry. This article addresses the state of the hospitality market as we enter into the final months of 2023 and look forward to 2024.

The Post-Pandemic Hospitality Industry

The challenges faced by the hospitality industry during and after the pandemic (e.g., shelter-in-place and lockdown requirements, increased materials cost due to supply chain disruption, lack of flight availability, and shortages in availability of labor) have been well chronicled and, at this point, have, for the most part, subsided. The summer of 2023 saw a spike in leisure travel, as consumers were finally able to take trips that had been postponed by the pandemic, but business travel continued to remain low.

During this period of transition, sustained increases in average daily rates (ADR) strengthened operating fundamentals, despite weak business travel demand. Increases in ADR, in turn, drove a continued rise in revenues per available rooms (RevPAR) which in turn buoyed gross revenues.

As we look forward, RevPAR growth is predicted to slow to 0-2% for 2024, as a result of slower US economic growth and as the spike in post-pandemic leisure travel subsides. On the bright side, however, anecdotal evidence may indicate that business travel has started increasing (although not yet to pre-pandemic levels) which could help sustain occupancy rates.

Increased Cost of Equity Capital

The increase in interest rates over the last 18 months have materially 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 other 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. The practical effects of this change are discussed below.

Debt Markets Are Tight

The lending landscape for lenders has changed materially as well over the last 18 months. On the one hand, higher interest rates have resulted in an increase in the cost of the 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). The combination of these factors has created significant market pressure on banks and squeezed the profitability margins of many lenders (to the point of failure in the case of Silicon Valley Bank, Signature Bank, and First Republic Bank). These market pressures have not gone unnoticed by regulators, who have applied renewed regulatory scrutiny to capital retention requirements and accounting rules for bank portfolios.

In light of these challenges, the lending community has, unsurprisingly, adopted a risk-averse posture. With a few exceptions for target lending activity for quality sponsors and quality projects depending on the market segment, many banks have ceased originating new debt. Until banks regain enough stability and certainty to resume lending activity, the lack of leverage will continue to be one of the primary bottlenecks holding back transactional activity. With that said, however, we are seeing insurance companies and debt funds take a more proactive stance to fill in the gaps in the lending market.

In situations where it is possible, borrowers are being resourceful and creative in attaining the leverage necessary to make acquisition deals pencil. We have seen borrowers assume existing debt as part of the acquisition. Where available, borrowers are also using preferred equity and, occasionally, even mezzanine debt as a means to bridge financing shortfalls.

Adjustment of Asset Values

The practical effect of the matters discussed above is to create downward pressure on hospitality asset values. Borrowers appear to be attempting to satisfy the increased return criteria that investors are now demanding by, primarily, seeking to either: (1) increase profitability of the hospitality asset through some combination of increased operating revenues and decreased operating expenses or (2) decrease the initial acquisition basis. In many cases, it is not possible to meaningfully increase profitability sufficiently to satisfy the increased return criteria, so purchasers and developers of hospitality assets are pushing for lower initial acquisition basis in order to make deals pencil.  

The issue here, however, is that prospective sellers have purchased hospitality assets at fulsome valuations over the last several years and now are sitting on paper losses. To the extent that these market participants are not in default of their loan, 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. This dynamic has resulted in substantial bid-ask spreads across nearly all asset classes in real estate, and we have seen several deals that have been either re-traded or terminated during due diligence.

With respect to borrowers under non-recourse loans that are either in default of the loan (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 (REO) properties.

Other Market Considerations

The cost of low strike rates on interest rate caps for legacy debt continues to be a severe pain point for the borrowing community. The cost of these caps has skyrocketed, in some cases 10-15 times the cost of the original cap, to the point that the cost of these caps is nearly prohibitive. In some instances, we have seen lenders accommodate this concern by exchanging a higher strike rate on the cap for either a new debt service reserve or a guaranty, but this is a negotiated provision in each deal and not all lenders will agree to this.

In certain markets (like Florida), the cost of insurance has also skyrocketed to the point of becoming a dealbreaker. The increase in premiums is driven, in large part, by continued insurance losses arising out of hurricanes and other adverse weather.

The Big Picture

Putting these pieces together to look at the big picture for the hospitality industry over the next year: market headwinds have certainly slowed transactional activity and we are more likely than not beginning to enter into a countercyclical period as higher interest rates and loan maturities loom. With that said, however, the outlook for any individual hospitality assets will depend on variety of asset-specific factors such as operating fundamentals, capitalization, and market positioning. For this reason, there are still pockets of upmarket activity as quality deals are still penciling and managing to close.