Impact of the Economy on Hotel Investments

Presented by: Jennifer Kane

Investment rates, including the overall and terminal capitalization rates as well as discount rates, fluctuate quarter over quarter reflecting debt and equity pricing as influenced by the state of the economy. The investment data examined in connection with this article was presented in the PriceWaterhouseCoopers’ Korpacz Real Estate Investor Survey over a period beginning in the fourth quarter of 1993 (with the exception of the extended stay segment data which began in 1998), ending in the first quarter of 2009; as supplemented by our experience in working with investors throughout this extended time frame. The PWC Korpacz Survey presents data for four segments within the lodging industry specifically including: fullservice, luxury/upper-upscale, limited-service/economy, and extended stay.

According to the National Bureau of Economic Research (NBER) there have been three recessions in the past twenty years, including the current recession. The first recession began in July of 1990 and ended in March of 1991 and the second recession began in March of 2001, ending in November of 2001, both lasting eight months. The current economic recession, which was determined by NBER to officially begin in December of 2007, is currently the longest running recession of the last two decades at 18 months and counting.

Direct capitalization is a method used to convert an estimate of a single year’s income expectancy into an indication of value. The capitalization rate (cap rate) is divided into a property’s Net Operating Income (NOI) to produce an estimate of value. NOI is defined as income prior to ownership-related expenses including interest, income taxes, depreciation, and amortization (also known as EBITDA). The overall, or going-in, capitalization rate uses the first year’s NOI to produce an estimate of value; while the terminal capitalization rate, or residual/reversionary cap rate, which is used to estimate the resale value at the end of the holding period, typically uses the NOI in the year following the last year of the holding period to produce an estimate of value. The discount rate, which is also known as the internal rate of return (IRR) or pre-tax yield, is the rate of interest that discounts the pre-income tax cash flows received on an unleveraged investment back to a present value that is exactly equal to the amount of the original equity investment.

Although we do not have exact debt and equity figures available for the entire period studied in connection with this article, we are able to extrapolate from our experience that as the economy declines resulting in the increases in investment rates, the debt and equity market also experiences declining measures. The loanto- cost and/or loan-to-value ratios decrease in times of economic recessions while debt and equity become sparse and can be very hard to obtain. It has been noted by industry experts that this economic recession has thus far been the worst for the debt and equity markets as many banks have seriously tightened up their lending and have merged, closed, or had to receive a significant government bailout package. While the debt and equity available from lenders reached a high of approximately 80 percent loan-to-cost/value in some cases in 2006 and 2007 as the economy was in a peak period, loan-to-cost/value ratios have since decreased to as low as 50 percent if the developer or hotel owner can even obtain a loan.

Due to the lag in the presentation of investment data compared to the actual market activity that is a result, in part, due to the time required to gather, synthesize, and publish responses, investment rates have peaked in declining economic markets between two to twelve months after the official end of the recession. Similarly, investment rates have reached low points between two to ten months prior to the official beginning of the recession. Following the recession of the early-1990s, investment rates for the lodging industry generally peaked as late as 1994, followed primarily by periods of declining rates until reaching low points in 1997 and 1998 (different for each of the lodging sectors). The lodging industry investment rates reached another peak in the first quarter of 2002 following the recession in 2001, which was followed by a continuous decline in investments rates until new historic lows were achieved between the third quarter of 2006 and the third quarter of 2007. Since achieving these historic low points, rates have been escalating through the first quarter of 2009 (the most recent data available) in connection with the current economic recession.

The average discount rate for the full-service lodging sector experienced a historical high of roughly 15.75% at the end of 1994, after which it decreased through the end of 1998 to a low of 13.00%, at which it remained relatively steady for nearly two years. The full-service lodging segment’s discount rate peaked in the beginning of 2002 reaching a high of nearly 14.00%, roughly 200 basis points below its historical high in 1994. As the economy began to rebound after the recession in 2001, the discount rate decreased to a historical low of roundly 10.75% in the beginning of 2008 and has since increased approximately 50 basis points through the first quarter of 2009. The average overall capitalization rate for the full-service lodging sector reached a historical high of 11.50% in the beginning of 1994, followed by decreases through the end of 1998 at which point it reached a low of roughly 9.50%. The overall cap rate then increased to 10.75% in the beginning of 2002, followed again by decreases to a historic low of nearly 8.25% at the end of 2007, and has since increased by 30 basis points through the first quarter of 2009. The terminal capitalization rate was the first investment rate to peak following the economic recession of the early-1990s for the full-service lodging sector. It peaked at nearly 12.00% at the end of 1993, after which it steadily decreased by 175 basis points to 10.25% at the end of 1998. The terminal cap rate remained relatively steady at 10.60% percent from 1999 through 2001, and in 2002 increased to roundly 10.90%, followed by decreases to a historical low of 9.00% at the end of 2007. The terminal cap rate for the full-service lodging sector has increased by 60 basis points through the first quarter of 2009.

All investment rates for the luxury/upper-upscale lodging sector experienced historical highs at the end of 1993 with the discount rate at 15.50%, the overall cap rate at 11.75%, and the terminal cap rate at 10.75%. The discount rate then experienced significant fluctuations through the end of 1998 at which point the rate remained relatively unchanged at 12.75% through the beginning of 2001 before peaking again at nearly 13.75% in the beginning of 2002. This peak was followed by continuous declines until reaching a low of roughly 10.50% in the beginning of 2008. The discount rate has since increased by nearly 30 basis points through the first quarter of 2009. The overall capitalization rate for this segment decreased nearly 275 basis points through the end of 1994 before it increased again by approximately 175 basis points to 10.75% in the beginning of 1995. The overall cap rate declined to a new low of roundly 8.75% at the end of 1997 and increased steadily through the beginning of 2002 where it peaked at 10.50%. The luxury/upper-upscale lodging segment’s overall cap rate has decreased to a new low 7.50% where it remained from the beginning of 2007 through mid-2008 and has since increased to 8.00% as of the first quarter 2009. The terminal capitalization rate for the luxury/upper-upscale lodging segment did not experience as significant fluctuations throughout the 1990s as the segment’s other investment rates did. The terminal cap rate decreased to 9.50% in mid-1997, followed by increases to 10.50% in the beginning of 2002, and has since decreased to a historical low of roughly 8.70% in mid-2006, where it has remained relatively unchanged through mid-2008. The terminal cap rate has since increased 10 basis points through the first quarter of 2009.

Throughout the extended period studied, the economy/limited-service lodging sector has experienced the most variation between the recession of the early-1990s and the recession in 2001. The discount rate peaked at the end of 1994 at approximately 16.50%, an increase of roughly 200 basis points from the end of 1993. The discount rate continued to fluctuate significantly between roughly 13.25% and 16.50% through the beginning of 2000 where it reached 15.00%, after which it experienced steady declines until reaching 12.35% in mid-2007 where it remained unchanged through the end of 2008. The discount rate for the economy/limited-service sector has increased to nearly 13.00% in the first quarter of 2009. The overall and terminal capitalization rates have experienced similar variations throughout the period studied, peaking at roughly 12.75% in the beginning of 1994, followed by a significant decline at the end of 1994 and a significant increase in the beginning of 1995. Following the recession of 2001, the overall cap rate peaked at 12.25% in mid-2003, followed by continuous declines to roundly 9.60% in mid-2007. The overall cap rate has since increased nearly 125 basis points through the first quarter of 2009. The terminal capitalization rate reached a low of roundly 10.75% in the beginning of 1997, followed by steady increases through mid-2000 at which point it remained relatively steady at roundly 12.25% through the beginning of 2002, peaking at roughly 12.40% in the beginning of 1994. The terminal cap rate reached a historic low of 10.00% in mid- 2007 and has since increased approximately 125 basis points through the first quarter of 2009.

The extended stay lodging segment has realized the most steady investment rates over the period studied (third quarter of 1998 through the first quarter of 2009) with variances between 100 and 135 basis points throughout this period. The discount rate reached a high of 14.50% in mid-1999 and experienced steady declines between mid-2002 and mid-2006 at which point the discount reached the a historic low of 13.30%, where it remains unchanged through the first quarter of 2009. The capitalization rates increased approximately 100 basis points from end of 1998 to roughly 11.75% in mid-2002. The overall cap rate reached a low of 10.75% in mid-2006, where it remained unchanged through the beginning of 2008 and has increased less than 15 basis points through the first quarter of 2009. The terminal cap rate reached a low of roundly 10.50% in mid-2007 and remained relatively unchanged through mid-2008; however, the terminal cap rate has increased nearly 100 basis points in the first quarter of 2009 within the extended stay lodging segment.

As previously mentioned the NBER determined the current economic recession to have officially begun in December of 2007. This recession has been determined to be the most severe recession in recent history lasting 18 months thus far. While the economy has not officially reached a trough determining the end of the recession, as of the writing of this report, economic experts have said there are several signs that the economic indices are bottoming out which could mean the end of the recession is nearing, possibly even within the next six to twelve months. However, due to the severity of this recession, the rebound is expected to occur at a much slower pace than that following the previous recessions. As such, based on the data studied within this article, we can expect that the investment rates for the lodging industry will continue increasing for the next two to three years.