The recent turbulence in the broader capital markets has created a slowdown in overall lodging transaction activity, particularly in the summer months as inflation and interest rates accelerated. Despite the capital markets volatility, hospitality fundamentals have exceeded 2022 expectations and 2019 levels for most hotels. Fears of recession and the rising cost of labor have offset some of the enthusiasm surrounding rapid revenue growth, but hotel cash flows in general have an upward trajectory. Among the biggest challenges in this environment are the increased cost of debt and the rise in the forward interest rate curves, however, this has also helped slow new supply. The combination of these factors has in some instances contributed to a widening in bid/ask spreads.

Despite inflationary impacts and recessionary fears, investor sentiment for hospitality remains highly positive. Lodging historically has been a favored sector during rising rate environments and has been the top performing real estate asset class during the past four Fed rate-hike cycles. We are seeing a rotation of capital from other asset classes into lodging and an appetite from existing investors to increase exposure, which are both trends that bode well for the US hospitality transaction market.

Investors view slower supply growth as a notable tailwind for hospitality investment, especially when balanced against a forecasted increase in demand. Escalating construction and labor costs are expected to further slow the pace of new supply, while construction financing for hotel projects remains challenging as well, creating additional barriers to entry. Increases in replacement cost and very moderate supply pipelines are providing support for per key metrics and placing a premium on newer build assets with limited future capital requirements. On a national basis, hotel performance growth has typically outperformed during periods of slow supply growth.

The lending market for lodging is open and functioning with active new loan originations from select banks, debt funds, life companies, CMBS, and alternative sources. For the right deals, we’ve seen increased lender depth on recent acquisition financing assignments.

Lenders remain disciplined and are more focused than ever on in-place cash flow, quality of sponsorship, a strong business plan, and limited asset-level encumbrances. Some of the larger money center banks are currently constrained for new originations, which has created a challenge to fill the more senior portions of capital stacks or lower leverage whole loans with efficiently priced capital.

Given the perceived risk profile of hospitality, credit spreads for hotel loans have historically priced at a premium to other asset classes. With credit spreads relatively flat over the past two to three months, the rise in benchmarks has forced borrowing rates for moderate leverage (~65% loan-to-value) floating rate loans into the high single digits. For perhaps the first time ever, lodging has emerged as a favored asset class for lenders compared to traditional office (a segment of the market that historically represents the largest concentration on lenders’ books). 2023 could present an environment where credit spreads may tighten, potentially opening a window for more attractive all-in rates.

The CMBS market remains a viable option for specific portions of the lodging market, namely large transactions ($250 million+ loans) in the form of floating rate single asset, single borrower securitizations, as well as smaller balance loans ($10-75 million) for fixed rate CMBS conduit pools. Compared with pre-pandemic levels, CMBS spreads and all-in coupons are significantly wider today. The CMBS market is very sensitive to the broader capital markets. We’ll likely need to see spread tightening in other portions of the credit market (namely investment grade corporate bonds) to see a notable improvement in all-in CMBS coupons, and we could see certain CMBS lenders look to be opportunistic in 2023 to fill voids in the current lending market.

Over the past few months CMBS lenders have successfully sold a backlog of recently originated loans off their balance sheets to the end user bond buyers. This has created some new confidence and lending capacity as evidenced by a few new large CMBS loans originated over the past two months and has provided additional visibility on loan pricing during a period of volatility.

Over the past two years, the most sought-after acquisition targets have been destination resorts, well positioned select-service, and assets in Sunbelt markets with favorable demographic and employment profiles. While growth in lodging fundamentals is moderate in these markets and valuations in many instances are well above pre-COVID levels, we would expect these segments to continue to make up a large chunk of the transaction market given the very attractive yields and more favorable operating environments.

The out-of-favor markets – including urban, corporate transient, and big box hotels – have become more appealing as they have enjoyed more rapid growth over the past six months and are now on much firmer footing. We see very compelling opportunities to buy these assets at attractive per keys and yields based on prior peak years. If the recovery continues in these markets, we are expecting additional “contrarian” bets followed by a more normalized level of trading. While this trajectory is dependent on return-to-work and business travel recovery and will not apply to all urban markets, we expect that hindsight could prove attractive acquisitions were made in the first half of 2023.

At Eastdil Secured, our connectivity across asset classes and culture of collaboration is one of our key differentiators. I’m often involved in broader discussions with my office, multi-family, industrial, retail and debt colleagues with investors that target many different product types and geographies. Multi-sector investors often ask, “why invest in hotels” and “why now”? Importantly, many of these investors are focused on finding a place with current income and inflation protection given the global instability. We are quick to point out that lodging represents a safe haven with the ability to effectively mark-to-market overnight (versus long-term leases) and adapt to rapidly evolving market conditions.

In terms of the transaction market, the ongoing labor shortage has created a larger subset of investors who are keenly focused on opportunities in markets with business-friendly environments and policies. We expect this trend to continue into 2023 and perhaps become magnified in certain markets in the event specific ballot initiatives are passed and the projected labor shortages persist.

Hotel operators have proven to be nimble and creative in responding to these challenges, including implementing strategies that have increased profit margins. In some instances, profitability levels are at record highs and prompting buyers to carefully study their long-term sustainability when underwriting transactions.

While broadly discussed, we still believe labor represents one of the most critical challenges for the future of the industry. Restrictive immigration policies and declining labor participation rates are likely to continue to exacerbate the current issues. The challenges are most acute in older, full-service hotels within urban markets that tend to utilize a more mature labor pool.

However, the lodging industry has pressed forward over the past two decades in the face of these challenges, and we are confident they will continue to find creative long-term solutions. One silver lining to a possible recession would include a rebalancing of the labor market, which could serve to course correct this ongoing trend.

The opportunity to invest in high-quality assets and cultivate relationships within leading global innovation hubs remains highly under-appreciated. More specifically, key West Coast markets, such as Seattle, San Francisco, Silicon Valley, and Portland, have fallen down the list rather dramatically as priority target markets for institutional investors. While understandable given lagging post-COVID growth and, at times, difficult regulatory environments, these markets are poised to be long-term growth engines and attract some of the best talent worldwide with a corresponding long-term appreciation in quality real estate.