As we head into the final election stretch, one thing is abundantly clear—chicken little has packed it in for the time being! As expected, the paranoia that surrounded investors in Q1 has dissipated, and the stock market rebound reflects the renewed investor enthusiasm, despite a solid head punch from the BREXIT referendum. Unfortunately for chicken little and the black swan pundits, the sky is most assuredly there, and the “Dire Prediction” business is a bust!
What does this mean for hotel investment? Although my crystal ball has been smudged a bit by BREXIT, I still firmly believe that we are in a Tremendous (to borrow one of Mr. Trump’s most over-used adjectives) environment for hotel investment. Yes, I know full well that we are in the middle of one of the longest post-WWII economic recoveries, and the farther we go, the closer we get to the inevitable downturn. However, we are also in one of the weakest economic recoveries on record, and absolute growth from the trough is still well below several other recent recovery periods. Also, while the FED is most surely going to raise rates (often the precursor to recession), they have promised to do so quite slowly. Given the current rate environment, a slow progression promises historically low rates for some time to come.
This low yield environment provides a double blessing for hotel investors. First off, we enjoy the benefits of cheap debt—one of if not the biggest costs for hotel investors. Second, hotel yields will continue to offer a significant premium to fixed income investments. As a further benefit, for those who worry about the risk of inflation, hotels’ ability to reprice inventory daily, affords one of the best inflation hedges available.
Given these benefits, one might ask why the hotel REIT’s have not performed better during the last twelve months. There are a number of contributing factors, but I believe the most significant issue was these REIT’s herd-like strategic emphasis on “Core Markets”, which has produced a double whammy for hotel REIT investors. First, the competition for core assets drove hotel yields in gateway cities like Manhattan and Boston down to historic lows, yielding valuations well in excess of replacement cost. As a result, developers ramped up activity in these markets, producing a surge in new supply, which inevitably put pressure on occupancy and rate market wide. As recession fears took hold, hotel REIT investors rushed for the doors to preempt the seemingly investable cyclical downturn.
Fortunately, for those of us who ply our trade in the secondary markets, the above phenomenon has created a huge window of opportunity. The REIT focus on Core Markets not only limited investor demand in secondary markets to begin with, but also the REIT’s are now spending capital to buy back their own shares rather than targeting new investments. The slack investor demand in secondary markets has kept prices from escalating (keeping yields high), yet we also benefit from the low cost of debt—offering unprecedented spreads on hotel investments. At the same time, in many secondary markets (the Southeast for sure), the growth prospects are far better than the core markets, making our forward yields even more appealing.
There is no question that the global economy poses risk (BREXIT just being the latest; however, in a risky environment, capital flies to safety, and BREXIT just made the US a significantly safer hotel investment zone than one of (if not the most) attractive hotel investment markets globally (the UK). It is no wonder then that we are seeing major Asian (particularly the Chinese) investment in the US right now, and we see this trend only growing as the risks in the Chinese economy continue to drive capital flight our way.
As the advantages of the secondary markets become more apparent, we expect the hotel REIT’s to reorient, driving cap rate compression. This scenario has played out in other real estate classes (multifamily, retail and office), but we expect it to take longer for hotels. This means we now have a major window of opportunity to buy right. Furthermore, we welcome the continued global uncertainty that will foster low cost of debt and continued foreign capital flows to the US across all industries.
We look forward to catching back up with you in Q1 2017. We look forward to having chicken (Little) for Thanksgiving this year!! Cheers!