By Hans Detlefsen
Introduction
For the past seven years, hotel capitalization rates (cap rates) have generally declined, according to investor surveys. The last time hotel cap rates increased for consecutive survey periods was in 2008, as the investment community realized the U.S. economy was in the early stages of a severe economic recession. From 2008 through early 2010, hotel cap rates jumped roughly 150 to 250 basis points, depending on which survey and hotel chain scale you observed. Since then, hotel cap rates have declined roughly 200 to 300 basis points, according to the same surveys.
At the beginning of 2017, hotel cap rates stood at historically low levels. However, research by Hotel Appraisers & Advisors (HA&A) shows that hotel cap rates are beginning to increase, reversing a multi-year trend. In this article, HA&A summarizes our recent research about hotel cap rates, based on a review of more than 400 hotel transactions and listings. We also discuss implications for hotel owners who may be considering near-term exit strategies.
Is It Time to Sell?
Is it a good time to sell hotels? Data from late 2016 and early 2017 show hotel cap rates recently reached historically low levels. According to many investors, there is only one direction cap rates can move from here — up. Indeed, recent research conducted by HA&A shows that capitalization rates for hotels appear to be inching up in certain markets. When hotel cap rates increase, the value of a hotel’s income stream decreases. So, if cap rates are higher at the end of 2017 than they were at the end of 2016, then market participants will be willing to pay less for an identical hotel income stream at the end of 2017 than they would have paid in 2016.
As revenue growth projections decelerate and as more investors voice uncertainty about the national economy, we expect hotel cap rates to increase eventually. This reversal in cap rate trends appears to be occurring in certain hotel markets around the U.S. already. It may be too early to conclude whether this is a broad, national trend. However, for our clients who are considering near-term exit strategies, this may be a good time to evaluate options.
Recent Data Trends
Over the past 18 months, researchers at HA&A analyzed hundreds of hotel listings and transactions from across the United States. Our research focused on national and local trends in hotel cap rates. We studied cap rate trends for all chain scales and brands as well as independent hotels. At the end of 2016, the weighted average hotel cap rate was 7.5%, based on chain hotels in our data[1] sample. This figure has risen to 7.7% based on year-to-date data through May 31, 2017. Since large transactions in the top markets tend to skew these national average cap rates downward, we also evaluated median cap rates. We also studied several matched pairs of comparable transactions in seven local market.
The 2016 year-end median hotel cap rate in the U.S. was about 8.4%, according to our research. Based on year-to-date 2017 data through the end of May, the median hotel cap rate held steady at 8.4% nationally.
While national trends may provide general guidance about certain trends in hotel cap rates, there is no such thing as a “national average” hotel transaction. All hotel sales are local. So, HA&A evaluated transaction data in several local markets where we could identify two similar hotels selling at different times. That is, we searched for markets in which one hotel sold in 2016 and a similar hotel sold in 2017. By focusing on these matched pairs of similar hotels in the same markets, we attempted to gain a better understanding of whether cap rates are changing.
HA&A evaluated matched pairs of hotel sales in seven markets around the U.S. The following descriptions summarize our local cap rate findings.
- Chicago – Unchanged
- Denver – Up
- Los Angeles – Up
- San Francisco – Up
- San Jose – Up
- Seattle – Down
- Washington D.C. – Unchanged
Four of the seven markets we evaluated exhibited an upward shift in hotel cap rates. One market showed hotel cap rates declining. Two markets indicated unchanged cap rates.
Most of these cap rate changes were small and should not be considered in isolation. Moreover, one or two matched pairs is not sufficient evidence to draw conclusions about overall cap rate trends in any of these individual markets. But, in contrast to recent years, our cap rate research is showing some mixed results in 2017.
What Causes Cap Rates to Change?
A cap rate is simply the ratio between a property’s single year of income and its market value. The process of applying a cap rate to a hotel’s income to estimate its value is known as direct capitalization, when applied to a single year of income data. The Appraisal Institute[2] provides the following definition of direct capitalization:
A method used to convert an estimate of a single year’s income expectancy into an indication of value in one direct step, by dividing the net income estimate by an appropriate capitalization rate.
What causes hotel cap rates to change? Many factors, such as hotel revenue trends, expense trends, regulations, labor market conditions, credit market conditions, property tax trends, market risk, geopolitical risk, and investor sentiment can all affect hotel cap rates. To simplify this incomplete list, we can think about two key investor considerations: (1) how are hotel income streams expected to change; and (2) how much uncertainty do investors ascribe to these expected changes in income?
When investors expect hotel incomes to increase rapidly, like in recent years, they may be willing to underwrite acquisitions based on lower cap rates. On the other hand, when investors perceive heightened risk and uncertainty in the market, like in 2008 and 2009, their underwriting typically requires higher cap rates. When investors are concerned that income growth may decelerate or hotel incomes may even decline, hotel cap rates generally increase. Similarly, when investors perceive that their hotel income projections are subject to increased uncertainty and more risks, hotel cap rates typically increase.
Conclusion
Moderate evidence is beginning to emerge that indicates hotel capitalization rates may have bottomed out in recent months. National data is inconclusive. Although weighted average hotel cap rates are higher in 2017 than they were in 2016, the median national cap rate has remained unchanged for chain hotels. Local research is also mixed, as we observed matched pairs in seven U.S. markets that revealed differing results about cap rate changes. However, the trend of the past several years that showed broadly declining hotel cap rates in the U.S. appears to have ended.
As transaction volumes slow nationally, HA&A is closely monitoring a combination of national and local hotel cap rate trends. We expect hotel cap rates to eventually increase, and this appears to be happening slowly, at least in certain markets. Clients who are considering selling hotels in the near future may want to evaluate options and priorities at this time.
This article is for discussion purposes only and is not intended to be construed as investment advice.
[1] Data sources include Real Capital Analytics and HA&A interviews with brokers, buyers, and sellers. [2] The Appraisal Institute, The Appraisal of Real Estate, 13th Edition (Chicago: The Appraisal Institute, 2008), 22-23.
