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Capital stack changes impact property values
January 11 2013

The U.S. hotel industry has potential for epic appreciation and is poised to increase ADR above inflationary levels.

  • The looming threat of substantial capital gains tax increases had the market poised to see a huge spike in transaction volume in the fourth quarter.
  • U.S. hotel values declined roughly 38% off peak levels during late 2008 through late 2009.
  • Hotel pricing increased 21 basis points to an approximate 17% decline from peak.

The much anticipated U.S. presidential election is decided, but the need for a credible plan for reducing the national deficit still exists. Geopolitical issues throughout the world and the recent destructive consequences of global climate change are some of the significant challenges that continue to confront the nation.

Dan Lesser

Although there is no shortage of negative news and events, the fundamentals in the U.S. hotel sector are strong. Hotel debt capital markets, while not as robust as might have been hoped for, are clearly coming back. With all types of equity aimed at the space, there is tremendous investor interest in the sector. While extremely modest, the U.S. economy today is expanding. Demand for U.S. hotel rooms is increasing and achieving record levels, while new hotel supply growth is muted. Finally, as most notably occurred in 1986, changes in tax law often spark activity as market participants rush to beat the impending deadline. The looming threat of substantial capital gains tax increases had the market poised to see a huge spike in transaction volume in the fourth quarter.

Deal volume and pricing of U.S. hotel assets is rising and gaining momentum as investors who were able to hang on during the downturn now bring assets to market, and sponsors who acquired properties at the bottom of the market execute exit strategies to cash out and realize robust returns. Dramatic examples of recent rapid price appreciation are evident by two recent transactions:

  • HEI Hotels & Resorts acquired what was the Doubletree Guest Suites in Waltham, Massachusetts, in November 2009 for $20.2 million. The property went through an extensive $12-million brand conversion to an Embassy Suites in 2011. In November 2012, HEI sold the property to RLJ Lodging Trust for $64.5 million or roughly double its basis in the deal. Appreciation of the asset equated to 50% per annum.
  • Loews Hotels & Resorts announced earlier this month an agreement to purchase the Madison hotel in Washington, D.C., from Jamestown Properties. The reported sale price is $145 million for the 356-room hotel, which recently underwent a $23-million renovation. It is interesting to note Jamestown acquired the hotel and an adjacent 95,000-square-foot Class A office building in January 2011 for $123 million. Jamestown’s net proceeds of $122 million ($145 million sale price less $23 million renovation cost) is roughly equal to what they originally paid 24 months ago for the hotel and office building.

An analysis of the variability in the amount and cost of hotel equity and debt combined with fluctuations in net operating income further illustrates the recent rebound in values. During the past five years, changes to a typical hotel capital structure coupled with varying return requirements for debt and equity impacted hotel prices as exemplified in the following table.

Click image to enlarge.

The top part of the chart demonstrates the fluctuation of the weighted cost of capital and highlights that hotel capitalization rates bottomed out in early 2007 when typical loan-to-value ratios were upwards of 80%. Coupled with the availability of sub 6% interest-only financing and single-digit equity dividend rates, hotel capitalization rates dropped significantly from 2005 and rose dramatically during 2008 and 2009 only to ease back closer to where rates stood during the last peak.

Measuring the implied value of $1,000 of NOI throughout each point in time illustrates that merely through changes in typical hotel capital stack structures between debt and equity, and the required returns for each position, U.S. hotel values declined roughly 38% off peak levels during late 2008 through late 2009.

With the recent loosening of the credit markets, although hotel cap rates are down from the dramatic peak of 2008 and 2009, values continue to be roughly 13% off the peak based merely on changes in hotel capital stack structures and returns. Thus far, the analysis does not factor in any changes in NOI.

The following table layers into the analysis positive and negative changes in NOI at increments of 5 percentage points to determine the implied value of $1,000.

Click image to enlarge.

The third table again illustrates that simply for the change in the capital stack structure and the returns for each position within the stack (with no change in NOI), hotel pricing bottomed out during late 2008 through late 2009 at roughly 38% below peak levels. More recently, hotel pricing increased 21 basis points to an approximate 17% decline from peak. Layering into the analysis modest increases in NOI as experienced by most hotels during the recent past, an asset that hypothetically experienced a 10% increase in profits, combined with capital stack changes, resulted in a rebound in value to only 9% below peak. The table further illustrates that if the same asset’s NOI is roughly 20% higher today than the recent bottom, based upon current capitalization rates, the property value would be roughly back to peak levels.

Click image to enlarge.

The upcycle in the hotel space is clearly underway with potential for epic appreciation. The national hotel occupancy rate is approaching peak levels again. And this, coupled with record demand for U.S. hotel accommodations and a muted level of new supply, positions the industry to increase average daily rates above inflationary levels.

The inflation adjusted national average rate is still below peak with a lot of runway for growth during the next several years. The investment thesis in today’s hotel sale transaction market is that, as revenues rise above inflation and expenses increase at underlying inflationary levels, profits and property values will dramatically increase during the next 24 months to 36 months.

However, risks abound including but not limited to: worldwide and/or global regional conflicts; continued divisiveness of U.S. government for the next four years; natural disasters, including effects of continued climate change; risk of U.S. economy slipping into recession once again; or a continued tepid recovery of U.S. economy resulting in a lost decade or decades, similar to what occurred in Japan.

With everything said, the outlook for the nation is bright, as the U.S. has always and will always be the safest, most secure nation on the planet in which to invest. Overseas capital and visiting foreigners will continue with net inflows to the U.S. Natural resources are being exploited whereby the U.S. is anticipated to be energy independent by 2030. Finally, with a longstanding tradition of American creativity, the U.S. is an oasis of technology and innovation and a beacon the rest of the world looks to as a standard bearer for a free, entrepreneurial and market capitalist society.

During the past thirty years, Mr. Lesser has specialized in real estate appraisals, economic feasibility evaluations, investment counseling, and transactional services of hotels, resorts, conference centers, casinos, and timeshare properties on a worldwide basis. He provides services to corporate, institutional, and individual clients and municipalities on all facets of hospitality real estate including: litigation support and expert testimony, site evaluation, highest and best use analysis, appraisals for mortgage, acquisition, and portfolio management, workout strategies, operational analysis, property tax assessment appeal evaluations, economic impact studies, deal structuring and fairness opinions. He is President & CEO of LW Hospitality Advisors. Previously he served as the Senior Managing Director-Industry Leader of the Hospitality & Gaming Valuation Advisory Services Group which he established at CB Richard Ellis Hotels. For eleven years prior to joining CBRE, Mr. Lesser founded and led the Hospitality & Gaming Group at Cushman & Wakefield. Mr. Lesser was a member of the original team at HVS International when it was launched, spending thirteen years there expanding the firms practice. Prior to his hospitality advisory and transactional experience, Mr. Lesser held operational and administrative positions with Hilton Hotels Corporation and Eurotels-Switzerland. Mr. Lesser can be reached at 212.300.6684 X 101 or

The opinions expressed in this column do not necessarily reflect the opinions of or its parent company, STR and its affiliated companies. Columnists published on this site are given the freedom to express views that may be controversial, but our goal is to provoke thought and constructive discussion within our reader community. Please feel free to comment or contact an editor with any questions or concerns.


1/11/2013 10:51:00 AM
Dan's article is a "Masters Class" in valuation. Well done
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