By Steve Kirby, Managing Principal, Mumford Company Originally seen HERE.
In 2019, the United States enjoyed the unprecedented 11th year of economic growth since the “Great Recession.” Economists predicted an economic downturn; the only question was what would be the cause?
Few anticipated that the trigger would be a worldwide pandemic, the likes of which had not been seen since 1918. Around the world, governments used different approaches to stop the spread into and within their countries. Economies were tested by multiple factors—government controls, illness in the workplace, and fear in the marketplace. Then, science developed a vaccine; the population began to develop some resistance. Interestingly, though hardly surprising, while many hotels were forced to shut down due to lack of business, many others—largely in the Sunbelt states—thrived due to the lack of restrictions on population density, warmer climate, and less governmental interference with the free market.
Many still benchmark economic progress by where the economy was five years ago. High water marks have been achieved in RevPAR post-pandemic in many locations but several “corporate markets” still lag due to the devastating vacancy rates in many office buildings and massive changes in retail.
We talk about the changes that have taken place but fail to accept that many of these may be our “new normal.” Among these are:
Labor
Although the pandemic was not the sole factor, the U.S. labor market has undergone a seismic shift. The disruptions during COVID had segments of the economy forced to switch jobs, and many have expressed little interest in returning to their prior employment. As the last cadre of the “Baby Boomers” retire, the younger generations succeeding them actively seek a different life/work balance. Management and employees in some industries have an ongoing conflict over remote, in-office, or hybrid work. Further complicating the labor picture is political turmoil over immigration and the employment of those from outside the United States within the United States. Lodging properties are not immune from these issues and may be the most susceptible due to their historically low pay rates.
Inflation
During the pandemic, people who retained employment had “forced savings” as there were limited venues and goods to purchase. Once the pandemic was under control, this segment pressured markets while they competed for still-limited goods and began to enjoy delayed travel. Geopolitical conflicts also contributed to the scarcity of some goods. Although the inflation rate has not hit the 2 percent goal targeted by the U.S. Federal Reserve, the items in the consumer price index (before seasonal adjustment) are down to 3.1 percent for the trailing 12 months. The cost of property insurance has been a major contributor to inflationary pressures, and it will continue to be a wild card until some stabilization is achieved. A weaker global economy, a return to pre-pandemic supply chain efficiency, and tighter credit conditions should contribute to a steady decline in inflation rates throughout 2024.
Debt Issues
In reaction to rapid increases in inflation, the United States (and other countries) increased interest rates to tamp down inflation. Although these increases have been incremental, their cumulative volume has been a heavy weight to bear for those in the real estate business. An effective doubling of debt service has been a body blow to bottom lines at many hotels. Fortunately, room rate increases have helped to alleviate some of the pain for existing owners but underwriting by buyers and lenders has been revised to reflect the new debt cost.
A significant, but lesser-known factor, for active investors and developers, is the increased equity requirement to place new debt. Those increases will be reflected in new deals but also by those who are refinancing or restructuring debt in the form of a loan paydown. The days of cash-out financing won’t likely be experienced in 2024.
In the final days of 2023, the U.S. Federal Reserve announced that while it will focus on reducing core inflation (which excludes volatile food and energy prices) to 2 percent, it anticipates being able to decrease short-term interest rates over the next 24-36 months. These gently falling interest rates should revive real estate capital markets in the coming year. We likely won’t see CRE debt in sub-5 percent again in our lifetimes, but a lending environment that is less cost-prohibitive seems likely in the near term.
Indirect Effects
Sadly, but not unusually, domestic and geopolitical events may be the speed bumps that dampen the economic outlook. These types of issues are the most difficult to predict and most likely to have longer-term impact.
A promising trend in 2024 is the return of international travel. If international travel returns to pre-2019 rates, it could boost overall occupancy rates by 1.2 percent. Urban and airport hotels would benefit from inbound international travelers the most.
For the hotel investor, the spread between hotel cap rates and borrowing costs is narrower than other real estate classes, making hotel assets relatively attractive. Investors will be looking for trophy assets; newer, select-service assets in markets with modest supply growth; and hotels focused on group travel in markets with a solid mix of business and leisure demand. Tertiary markets should continue to see rate growth in most all product types.
Despite these challenges, the hospitality industry has been resilient. Macro-level performance continues to improve, but all business is local. Mumford Company has been able to assist several sellers in achieving their financial goals while helping to structure future growth for purchasers. We will continue to be in a “sellers’ market” until we reach some equilibrium on the supply and demand sides of property availability. While there is downward pressure on pricing due to all the factors previously mentioned, transactions will continue to occur due to demand for investment opportunity and this demand will prop prices until the pendulum swings or some other geopolitical event, and there are many current possibilities, artificially dampens the market.
Lodging is one of a select few long-term real estate classes that allows management to reprice/reposition/rethink its business model daily. Let us help you make 2024 a financial success.
