How the Changing Landscape of Commercial Real Estate Investment will Impact the Hospitality Industry
The United States Federal Reserve has started raising interest rates in 2017 in response to a strengthening US and global economy. The impact of rising interest rates will surely spell some changes in the commercial real estate investment landscape.
Higher interest rates will impact the financial underwriting of real estate development and acquisitions. According to Sagar Patel, Chief Investment Officer of hotel investment, management, and construction firm The Witness Group, “Debt typically is a large component of any development or acquisition’s capital stack, and a rising interest rate environment will naturally result in margin loss unless average room rates and occupancy growth outpaces the rise in rate increases. Although debt is still relatively cheap, rising rates will likely force developers to be more careful and selective during underwriting to ensure the deal pencils well. Construction lending will see the largest impact as this debt has a higher risk profile and higher interest rates as a result.”
Sagar Patel says, “As a developer, rising rates will directly impact our bottom line as interest expense is one of our largest P&L expense items. More importantly, higher rates will impact the speed at which equity is built up in a development. However, at a macro level rising interest rates likely signal a positive trend in the overall economy and might help curb the plethora of incoming supply coming into several markets because debt has been very cheap over the last decade.”
Rising interest rates will also impact refinancing strategies. Hotel owners will be more careful when taking equity out of their assets since the new leverage is likely at a premium to the old debt, which may impact their ability to sustain a comfortable coverage ratio given the volatility of the hotel market. From an operations perspective, rising interest rates will put more impetus on operators to control costs and preserve margin.
In addition to rising interest rates, other factors are also changing in the commercial real estate investment landscape. For hotels, the introduction of new brands from the main parent companies such as Marriott International and Hilton Worldwide is enabling new developments in markets where many or all of the legacy franchises are represented (i.e. Tru, Home2, Tapestry, etc.). Lenders are also tightening on their exposure to certain asset classes within real estate. Hotels, being a traditionally riskier asset class, have seen a scaling back in debt allocation from banks over the last few years.
DJ Effler, Senior Vice President for Bellweather Enterprise, a mortgage banking firm, is optimistic. He says, “I see a continued long-term flow of capital into all commercial real estate asset classes, including the hospitality industry.” The hospitality industry is still seeing growth, and it is doubtful that the increase in interest rates will curb that trend completely since customer demand for hotel accommodations is still on the rise. Effler says that real estate, in general, has become a more discovered asset class from a long term investment standpoint over the last decade. It’s not as liquid as a stock or bond, but good projects create above average risk-adjusted returns and coupled with tax benefits real estate investments will remain a good long-term option for portfolios—and that’s good news for hotel investors.