With valuations for select-service, extended-stay and drive-to resort properties pushing above, in many cases, 2019 levels, we believe that investors will soon turn their attention to full-service and group-dependent hotels that can still be acquired at below pre-pandemic levels. In particular, over the next 12 to 24 months, the “big box” hotel market should offer some of the most interesting opportunities of this cycle.
By way of context, according to STR, there are 360 U.S. urban hotels with 400 rooms or more. These big box urban properties, often affiliated with convention centers, represent massive investments. This makes them some of the largest and potentially most valuable assets of the hospitality sector, especially as their substantial costs are often offset in part by large public economic development incentives. Once built, barriers to entry for potential competitors are substantial. Historically, these properties have been darlings among institutional investors and lenders.
Regardless, we witness time and again how these properties can fall out of favor and experience wild swings in asset valuations during times of high stress in the economy or capital markets. No time like the present.
However, these properties are not now without near and longer-term risks. Near term, profitable lodging demand has yet to return in the larger meeting and group segment for which urban big box hotels are designed. Longer term, there are existential concerns over how much video conferencing might permanently replace “in person” business meetings and conventions, as well as inflationary cost concerns for most every operating line item, ranging from labor and capital expenditure expenses to insurance and property taxes.
“We witness time and again how these properties can fall out of favor and experience wild swings in asset valuations during times of high stress in the economy or capital markets. No time like the present.” – Stephen O’Connor
These considerations add to the volatility in net cash flow from hotel operations and risk of default at stressful times like the present. However, the seesaw nature of the daily occupancy rates and the continual re-pricing of rooms inherent to hospitality means that even a few bookings of large meetings and group events can result in a dramatic increase in operating revenue, profitability, and asset value.
Couple this with cyclical booms and busts of liquidity in the debt and equity capital markets that can result in both a virtuous cycle of value creation during good times (simultaneously improving NOI, financing terms and compressing cap rates) and a vicious cycle of value destruction during bad times (simultaneously worsening NOI, financing terms and widening cap rates). These natural trough-to-peak swings in liquidity for hotel investments in capital markets are further amplified for big box properties, given their complex operating characteristics.
Go for it
We have seen numerous occasions in past economic cycles where large, big box hotels trade on a “price per pound” basis as values are bottoming out and a sophisticated operating partner with opportunistic private equity behind them comes in to execute a renovation, often coupled with a change in brand and management. Then, in a recovering market, the cash flows ramp up dramatically and the investor can recoup their capital in a cash out refinancing or exit the investment altogether with the property valued at an attractive cap rate.
“The seesaw nature of the daily occupancy rates and the continual re-pricing of rooms inherent to hospitality means that even a few bookings of large meetings and group events can result in a dramatic increase in operating revenue, profitability, and asset value.” – Douglas Hercher
Given the risks in this class, markets with potentially large upside for big box assets include cities with broad tourism attraction to complement business travel like Nashville, Las Vegas, New York, Orlando, San Diego or New Orleans; major airline hub cities that allow corporations to easily gather staff from multiple locations like Chicago, Dallas, Atlanta or Los Angeles; primary and secondary markets attractive to large state associations like Boston, New York, California, Texas, Illinois or Florida; and cities with well-funded, award-winning Convention and Tourism Bureaus like Louisville, Raleigh, Las Vegas, Salt Lake City or Denver. Take your pick.
Overall, we believe it’s hard to bet against properties that have such outstanding commercial, entertainment and tourist locations in major U.S. cities; or that pent-up human demand to gather and meet in person won’t re-assert itself.
So, to the extent that urban big box hotels go “on sale” at material discounts to pre-COVID valuations during this next phase of the cycle, well-capitalized investors with a sufficiently long-term investment horizon stand to realize outstanding returns on investment.
History very well could repeat – or at least rhyme.
Contributed by Stephen O’Connor and Douglas Hercher, principals and managing directors, RobertDouglas