2017 Cap Rates, Interest Rates, and New Supply and Thier Impacts
Some may be casting doubt on the hotel transactions market for 2017, but there are many reasons to be optimistic. For now, conditions remain favorable for sellers.
Hotel sales volume may have been down in 2016, but hotel sales were actually strong in 2016 with $23b in transactions. Comparatively, the annual average hotel sales volume since 2005 is $17b, according to Real Capital Analytics. The reason for the negative year over year (YOY) change has more to do with the exceptional sales of 2015 than a poor market.
Cap Rates were relatively level in 2016 at 8.5% overall, stopping a worrying upward creep. A good sign for values of full-service hotels, cap rates fell to 7.9% in the full service sector in Q4 2016. Real Capital Analytics 2016 Trend Report stated:
“Declines in volume while cap rates rise can suggest that buyers and sellers are simply too far apart on pricing expectations. These signs of flattening cap rates might provide a more stable environment for transaction activity to grow in the year ahead.”
This rings very true to my experience in 2016 and YTD 2017. Sellers are still pushing for the maximum price rather than a quicker sale; while buyers have been reluctant in many cases. However, in some cases, sellers that are holding out for a higher sales price may miss the boat on realizing the best possible price for their hotel.
The Federal Reserve raised interest rates 0.25% again in December. The prime lending rate is now 3.75%, from 3.50% a year ago, when the Fed last raised interest rates. Prior to that, the interest rate had held steady for years at 3.25%. Typical SBA 7(a) loan interest rates are floating 2 points, plus or minus, above Prime. What is more, the Fed has hinted that it could raise rates at a faster pace in 2017. [CNN.com] If the cost of capital continues to go up, we will begin to see an impact on hotel pricing.
**UPDATE** Wednesday March 15th, the Federal Reserve raised rates for the second time in three months. The second increase of 0.25% brings the prime lending rate to 4.0%. The Fed expects to raise interest rates two more times in 2017, in June and December. [cnbc.com]
For now, despite the U.S. Prime lending rate increase, interest rates are still historically low. Plus, hotel lenders are hungry. Some aggressive SBA 7(a) lenders are squeezing the floating rate closer to prime, offering a 1% over prime rate for top borrowers and stable hotels. Also, for higher chain scale and strong hotel brands, such as a REIT would prefer, the cost of capital is cheaper and I expect these hotels to remain aggressively priced by sellers and brokers.
Another factor affecting 2017 hotel performance and sales transactions is new hotel development. Bob White of Hospitality Appraisals recently told me that ‘supply will hit the market this year and next year. Smart owners will sell now before new supply opens in their market’.
Lodging Econometrics forecasts that new hotel openings will jump to 1,111 Hotels/ 120,372 rooms in 2017. That should equate to a 2% supply increase in 2017. Unless there is some reversal in declining demand trends, aggregate supply growth in 2017 will exceed demand for the 1st time since 2010.
The best strategy to avoid negative impact from future supply is to sell before that new supply hits the local market. We recommend all sellers plan an exit strategy, whether that means a sale now before the signs of the end of this cycle hit, or planning on holding through the next downturn, and sell in the next up cycle perhaps, or even if you just built a hotel and plan to hold it until the mortgage is paid off, PLAN YOUR EXIT!
Of course, the longer the hold period planned, the greater the risks of market hotel room over supply, economic downturns, or the next impact from AirBNB or whatever.
So, to sum up; here are 3 reasons to take that exit now: (1.) Cap Rates leveled after upward trend, (2.) Interest rates are expected to increase again in 2017, (3.) New supply is coming to a market near you!
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‘Til next time,
– Charlie Fritsch