Hotel investors: Counting dollars while watching pennies - by James O'Connell

October 20, 2017 - Front Section
James O’Connell
HREC Investment Advisors

Slow and steady wins the race. It’s a pretty boring existence. However, if you are a hotel owner seeking a view into the crystal ball, one can take comfort in knowing that nothing in the immediate future will skew hotel performance. Nothing dramatic, just a slow steady digression to the flat line…for revenues. Costs on the other hand will increase. At a projected rate of over 5% per year. 

Between rising standards from brands, employment issues, health care, minimum wage increases, reduction of J1 and H2B work visa’s, IT expansion, carbon foot prints and global warming, hotel owners have to cinch their belts tighter once more and decide whether or not they want to stay in this race. I have failed to mention that ugly side effect of the great hotel bull market; new hotel room supply. New supply has crept into every market in the northeast. Starting with Boston to Bangor, to the Berkshires in Mass., Burlington, VT, New Britain, Conn. and everywhere in between has one or several new hotels opening or in the works.   

When Boston fills, every hotel on Rte. 128 to I-495 benefits from its market compression. However, according to a study done by Pinnacle Advisory Group of Boston, 2018 will be a down year for citywide convention business. Nationally, negotiated room rates for group bookings in 2018 are also projected to be minimally increased over 2017.  In order to fend off companies such as AirBnB and the third party booking engines Marriott, Hilton and all of the brands are taking steps to sweeten their honored guest programs. This is expected to cut into the market share of the OTA’s, however, the honored guest programs then become more expensive for the hotel owners.

Adjustments have to be made to projections that were done in 2014, 15’ and 16’. RevPAR projections remain positive. But with the rise in costs, management has to really dig deep for profitability. According to Hotel AVE, hotel revenue performance tracks Gross Domestic Product (GDP). The GDP for 2018 is projected to be +/-2%. The proposed health care repeal and replace effort has failed. Tax reform looks to be diluted and at best, not in effect until mid-2018.  However, the Federal Reserve is grasping for good news so that it can claw back the giveaway’s caused by artificially low interest rates. 

An interest rate rise of 50 basis points (.05%) would cause capitalization rates to rise and hotel values to decrease. $5 million in hotel net operating income at an 8% direct cap projects a value of $62.5 million. A 9% cap on the same cash flow reduces the value to $55,555,555. Essentially a $7 million drop in value without one penny of reduced cash flow.  If the hotel was purchased for roughly 25% equity, this equates to a loss of almost 50% of the equity invested. 

It is an excellent time to perform a portfolio review with a hard look at the next eighteen to twenty-four months. It may be much more prudent to liquidate those hotels that are at greatest risk to new supply and rising costs. It may be best to redeploy capital into secondary and tertiary markets supported by non-cyclical demand generators such as hospitals or universities. Markets where labor is plentiful and investors have a better opportunity to control costs and one brand doesn’t control 80% of the guestrooms.

2010 to 2015 were the gravy days of hotel investment. 2016 and 2017 is the period of realization that the good times now come with hard work and difficult decisions. 2018 and 2019 are going to be the days of shoulder to the wheel and nose to the grindstone. Every dollar counts. It is all positive. There are no shock waves. Slow and steady. It also could be worse. Like having to perform an alternative use study on your suburban shopping mall. 

James O’Connell is principal, ISHC  at HREC Investment Advisors in Boston. 

Over the past 25 years, Jim O’Connell has earned a reputation for succeeding on the toughest assignments by assembling all of the moving pieces within a transaction that has stretched to both coasts.  

He gained his national contact base while advising workout professionals and managing the ORE hotel portfolio of the Bank of New England/RECOLL Management Corp.  

O’Connell has represented public companies, private equity funds and high net worth individuals across the country and is known for having completed more hotel transaction in the region than any other broker.  

O’Connell is a graduate of Massachusetts Maritime Academy.

 

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