Narrowing of Bid-Ask Spread To Result in Record Hotel Sales, Plus Six Other Predictions for 2023
After being decimated by the plunge in business and group travel in 2020 and 2021, the hospitality industry has demonstrated a strong recovery and record profitability as it recovers from the pandemic. While there are significant capital market challenges in the backdrop of a slowing macroeconomic environment, hotels are expected to continue to offer attractive risk-adjusted returns for investors in the year ahead. Here are some additional predictions for hospitality real estate in 2023:
1. Short-term interest rates will increase and put additional pressure on hotels with floating-rate debt.
Inflation is expected to continue to be a sticky issue for the economy for some time. As a result, the Federal Reserve is expected to continue increasing the federal funds rate even after the latest 50 bps increase at the Fed meeting in December 2022. Interest rates will move upwards from the current 4.25%. Higher interest rates in 2023 will put additional pressure on properties with floating-rate debt, and capitalization rates will increase substantially.
2. Capitalization rates will increase up to 150 basis points.
As the Fed increases short-term interest rates, cap rates for hotel transactions will rise and the average cap rate for hotel sales will increase up to 150 basis points. With a recession anticipated in 2023, underwriting will be stressed – this, combined with higher interest rates and continued high inflationary cost pressures, will drive cap rates up between 100-150 basis points.
3. The bid-ask spread for hotel transactions will begin to narrow; deal volume will grow year-over-year.
The bid-ask spread in pricing for hotel transactions continued to widen in 2022, with sellers seeking cap rates of 4.0% to 6.0% on trailing 12-month price-to-cash flow and buyers offering cap rates of 7.0% to 8.0%+. The bid-ask spread is expected to narrow significantly in 2023, as sellers become more realistic regarding their asset values in an environment of continued high-interest rates. The narrowing of the bid-ask spread will lead to more transaction activity this year, with total hotel transaction volume in 2023 surpassing the $48.6 billion in total transactions closed in 2022.
4. Loan maturities will lead to defaults, foreclosures and some workouts.
Debt capital available for refinancing hotel properties will be highly selective. This, combined with higher interest rates, lower asset values, and a slowing economy, will cause a sizeable increase in hotel defaults and foreclosures. Some assets will be candidates for workouts, which will require owners to infuse more equity to keep the investment afloat. Loan-to-value and debt-service coverage ratios will be negatively affected as a result of lower values and higher interest rates. The distress expected in hotel capital markets since the onset of the pandemic will finally occur in 2023. Well-capitalized buyers with specific expertise in different components of the capital stack will be best positioned to acquire distressed assets.
5. Hotel values in urban markets will stagnate; resort values will continue the upward momentum.
Values of urban hotels are expected to be generally stable this year, however, asset values will decline in certain markets that continue to experience a delayed recovery, for example, San Francisco, Minneapolis, Washington D.C., Portland and Detroit. Low office utilization, high crime rates, and low quality of visitor experience will negatively impact values in these markets. Resorts will continue to be highly sought after by investors, particularly in high barrier-to-entry coastal markets, pushing per-key values up and lowering resort cap rates even further.
6. Fixed costs will continue to exert downward pressure on margins and cash flow.
Property taxes and insurance costs are forecast to grow at double-digit rates in 2023, putting additional pressure on hotel profit margins and cash flow. Hotels in Florida and California will likely see the most significant increases in insurance costs. Jurisdictions where property tax increases are not capped will also see significant increases in real estate taxes, as cities and counties aim to make up budget deficits exacerbated during the pandemic.
7. Hotels will be a highly favored commercial real estate asset class.
The U.S. lodging industry has demonstrated remarkable resiliency during the COVID-19 pandemic, the worst downturn the industry has experienced in decades. It took the industry 26 months to get back to pre-pandemic levels of revenue per available room, or RevPAR, which has greatly accelerated recovery compared to the previous two down cycles in 2001 and 2008. Certain sectors of the industry, such as luxury resorts and select service hotels, are achieving record profitability. With record amounts of commercial real estate investment capital waiting to be deployed, hotels will be a highly sought-after asset class since they offer protection against high inflation. Increasingly higher levels of sophistication in revenue management enable hotel operators to price their rooms to outpace inflation while optimizing RevPAR. Despite current headwinds, unlevered returns in lodging continue to outperform levered returns in other commercial real estate asset classes, a trend that will likely continue in 2023.