Bid/Ask Chasm Created By Both Buyers And Sellers

Posted 11/19/2009 - 1:45:50 PM

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What are these?

 At the recent Lodging Conference in Phoenix, I found it interesting how just about everybody continues to lament the significant difference between “bid and ask” as the major rationale for the lack of transactions taking place in the face of unprecedented distressed asset availability. Most seem to blame the sellers as “unrealistic” regarding the amount of distress currently being experienced and expected in the near future.

While this is true to some extent, my conversations with those who hold much of the reported $15 billion in equity laying in wait to buy hotel assets believe their target acquisitions will require a 10% or higher capitalization rate based on the asset’s trailing 12 months performance. However, if you look at what few transactions have occurred during 2009, virtually all have occurred at cap rates well below 10% based on trailing 12 months performance. 

The majority of these sales not only had cap rates below 10% with most reportedly hovering around the 5% to 7.5% range, but several had negative cap rates on a trailing-12-month basis. Are these transactions just examples of several anxious buyers who have overpaid for their assets? Or are they indicative of the current market value of these assets for which sellers will only consider reasonable before selling even their struggling hotels. To answer this question, one only need look at the trends in cap rates for lodging REITS over the past 30 months. 

As I forecasted over three months ago, cap rates on lodging REITs have fallen to the point where they are currently trading below an average 8% cap rate. Because these cap rates have closely mirrored individual lodging cap rates at virtually every interval examined over the past 30 months, I would suggest that it is the private equity buyers, not the sellers who have increased the chasm between bid and ask in an effort to revive the glory “buyers market” of the Resolution Trust Corp. days. Without the availability of low cost and high loan-to-value leverage, a 7% to 8% cap rate may seem far too low. Nevertheless, as we keep hearing, flat is the new up in the lodging industry so perhaps an 8 cap is the new 10 cap as well. 

Another possibility is that public and private equity are priced very differently right now. This is why we are seeing hotel companies issuing new common stock and even an initial public offering from private lodging icon Hyatt. At this point, public equity markets seem to be in the best position to capitalize on buying opportunities, although very few appear to be buyers right now. 

Following previous downturns, the buying source that enjoyed the lowest cost of capital not surprisingly acquired the most assets early on. In the 1980s the Japanese typically did most of the upscale acquisitions. In the mid 1990s it was public REITS like Starwood and in the early 2000s it was private REITS like CNL and private equity funds like Blackstone. In each of those decades, those respective buyers were criticized for overpaying but were subsequently followed and ultimately dwarfed by the market at large, which continued those trends upward before falling into the next free fall. 

Currently, private money not only has higher return requirements than public sources, but it often requires significant leverage to achieve those higher yields. To date, however, despite their lower cost of capital, the public REITS have not been buying but choosing instead to ensure that they have enough capital to outlast the travel and economic downturn. Perhaps even they are not convinced that the valuation of their (public) equity is at a stable price point. And while no one can be certain that income will not slide for another year, the debt burdens of most REITS, coupled with the fact that much of that debt is non-recourse, probably makes most REIT portfolios fairly secure. 

For the fourth quarter, we should see average cap rates remain in the 7% to 8% range. The question will be whether that is reflected only based on public REIT equities or if we will begin to see a greater number of individual transactions occur. For this to happen, private equity firms will have to either get comfortable with an 8% or lower cap rate in the short term if they want to buy now or we will likely see the public REITS starting to use their lower cost of capital to buy up those distressed assets.

Alternatively, private and/or public investors can wait for the other economic shoe to fall and/or for lenders to be forced by regulators or bondholders to quickly dispose of the estimated tens of billions of dollars in troubled hotel mortgages so they can acquire assets above a 10% cap rate. Not only is that a gamble, but you are gambling on nearly the complete demise of the U.S. economy and/or our industry, which even the most avid short-seller may find as a bittersweet opportunity for profit. Never the less, my advice is to buy now at a 7% to 8% cap rate based on the trailing 12 months that likely still reflect a 50% replacement cost or hunker down for at least another three to six months and wait for Armageddon. 

 

Gregory Hartmann has been advising the hospitality industry for more than 23 years with a specialty in large portfolios. Hartman has appraised or evaluated more than 10,000 hotels, including more than a dozen portfolios ranging in size from 50 to more than 500 hotels.