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Along with changes in NOI come fluctuations in capitalization rates, or cap rates, which are calculated by dividing a property’s NOI by its
current market value. The cap rate is an industry risk tool and floats with the economics of any cycle. As the cap rate drops, due
to a robust portion of the real estate cycle or
a positive burst in the larger economy, the
value of a hotel asset increases.
If this cap-rate reduction coincides with a
strong business environment, the value of a
hotel can increase significantly in a short period
of time. This is one of the great attractions of
the hotel business but, unfortunately, the
reverse scenario is true as well.
In 2008, the hotel industry was at a peak after
six solid years of growth. Cap rates were low
and recent years had witnessed significant
growth in NOI. Hotels were the sweetheart of
real estate at that moment — until, suddenly,
they were not.
In 2009, cap rates began a steady climb,
lowering the values of hotel properties at
the same time NOIs also were decreasing.
This created an implosion of profits for many
hotels and their owners, who were unable
to refinance or sell and lost their assets to
banks and servicing companies. This condition lasted for about two years and then
began to correct itself.
The next seven years proved very strong,
with the annual growth of RevPAR (revenue
per available room, which is a major index
for judging hotel values) steadily increasing,
including double-digit increases in some
markets. As risk factors diminished, cap rates
also settled down and hotel values began
to rise. Solid growth during this seven-year
period put the hotel real estate market —
along with the stock market — in strong positions right up to the start of 2018. And then
the cycle slowed again. This is an example of
why all industry players should be aware of
RevPAR in 2017 was relatively flat compared to 2016, and 2018 estimates are looking
relatively flat compared to 2017. Lenders,
mortgage brokers and investors can expect
this trend to continue into 2019 and maybe
2020. Investors who did not understand the
cyclical realities of the industry may see their
investments looking softer than forecasted.
In many cases, just before cycles cool
down, there are record sales because investors believe the trend will continue. The
reality is, there are always downturns. Savvy
investors can ride these waves successfully.
And the changes in cycles can create value-add
opportunities for real estate assets.
Commercial lenders — and, consequently, mortgage brokers — need to be in tune
with the hotel marketplace. This is not too
hard to do as there are plenty of sources to
compare notes with in order to understand
what is happening. You should be cautious
about listening to real estate brokers or others with a vested interest in a robust cycle.
Even if the market is crashing, they usually
will not acknowledge it. This makes sense as
their livelihood relies on a healthy market.
During the run-up to these downturns,
investors often make the most egregious
errors and acquire assets with too much basis in costs. Although these investors may
be well-capitalized and, as such, are less
risky to lend to, they can be the first victims
of a downturn. Mortgage brokers should
be aware of the market and read the signs.
Knowing when you are in a midcycle point
between hot and cold, for example, is critical to helping lenders and borrowers make
the right decisions.
The basis cost, or the original amount
invested, is the critical component of investing wisely. Remember that a hotel is a dual
product combining hard real estate and
operating-business elements. The asset’s
NOI, when mixed in with the prevailing cap
rate, can dramatically change the value of
the property. It can be discouraging to see
the market cool, the cap rate rise and — as in
present times — an increase in interest rates
for debt. It’s a double whammy. Consequently, the amount being invested becomes
critical and is something likely to be studied
carefully by lenders.
Value-add real estate transactions are those
in which an asset can be acquired at a significant reduction in cost compared to the
replacement cost. Consider, for example, a
hotel that was producing $1 million of annual
NOI. The cap rate at that time, reflecting the
strong part of the cycle, was 7. 5 percent.
The property would have a value of
about $13.3 million So, an investor pays that
amount to purchase the hotel. When the deal
was underwritten, there may have been a
rationale to increase the NOI by 5 percent
annually, based on the hotel’s historic economic
growth, while also assuming a steady cap rate.
Now, imagine what happens if the cap
rate rises to 9. 5 percent and the NOI only
increases 2 percent. The hotel suddenly loses
more than $2 million in value. And, even more
troubling, the debt-service-coverage ratio in
the loan agreement is now in jeopardy.
The value-add part of this scenario comes
when the investor, seeing the value of his
asset deteriorate and being required by his
bank to add equity, decides to sell the hotel
as quickly as possible. A hotel that was
worth $13.3 million at one point may now