Optimistic market keeps cap rates low

Hotel & Motel Management, May 16, 2005 by Jeff Higley

National Report--Low capitalization rates are both among the causes and effects of the ever-increasing buoyancy of the lodging industry, according to several hotel-company executives and consultants who said there is more smooth sailing ahead.

"As long as the debt market holds up and the lodging market stays stable, you'll see cap rates continue to be low," said Pam Greacen, principal of Santa Monica Hotel Group.

John Belden, executive v.p. of business development for Davidson Hotel Co., described cap rates as a benchmark; a harbinger of things to come.

"The decline in cap rates reflects optimism," Belden said. "There's been an increase in demand, which in turn raises [room] rates, which exponentially grows [net operating income].

"The logic holds that the reason cap rates are low is because the sentiment is that the future will be robust," he said.

"There's such a thirst for yield in the institutional markets," said Jim Merkel, managing director of Columbus, Ohio-based RockBridge Capital. "The market has maintained a low cap rate because of that demand."

Lou Plasencia, president of The Plasencia Group, said cap rates are a symptom of property values.

The low cost of capital, the low cost of 10-year treasuries and the much-improved fundamentals of the lodging industry are continuing to keep cap rates low, he said.

"Interest rates are well, well below historical averages and that has created an all-time low in break-even occupancy because the cost to service debt is so low," Plasencia said.

"When treasuries rise above 5 [percent] or 5-and-a-quarter percent, it will be a signal that some of the capital that's playing here now will find other investments," he said. "They'll find safer harbors."

An annual survey released by David Sangree and Rajesh Shah of US Realty Consultants revealed that the average cap rate for full-service hotels in winter 2005 was 8.6 percent-- down 90 basis points from the 9.5-percent rate in winter 2004. For limited-service properties, the average cap rate in winter 2005 was 10.3 percent--about 60 basis points below the 10.9-percent cap rate of winter 2004.

"The magnitude of the drop in the cap rate surprised us," Sangree said. "These are some of the lowest cap rates in at least 10 years."

A cap rate is determined by dividing a property's net-operating income by its estimated value. For the purposes of his survey, Sangree said NOI is determined after reserve for replacement and after taxes, insurance, management and franchisee fees are accounted for.

"The number of potential purchases has skyrocketed," said Sangree, who is based in Cleveland. "Having more lenders helps, and so does having the loan-to-value ratio going up slightly. Buyers are willing to pay more because they're expecting more upside and are willing to take a slightly less level of return."

Sangree said the survey revealed that the LTV ratio is 69.8 percent--up from 67 percent a year ago.

"It's definitely a bullish outlook in the lodging industry, and that indicates there are more buyers willing to pay higher prices," he said. "That means cap rates will stay in line with where they are now."

Jim Francis, president of Highland Hospitality, which closed on 14 deals in 2004, said he is not surprised by the 1-percent drop in cap rates.

"Interest rates have gone up some, one-year treasuries spiked and have come down now, and inflation has ticked up a notch--but long-term rates have not moved significantly," Francis said. "The industry recovery has been stronger than expected. I can't imagine that they can go lower, but I may have said that a year ago. My gut says we're kind of at the bottom."

While cap rates decreased, interest rates remained relatively flat. This year's survey reported a 10-basis-point increase in interest rates to 6.30 percent from 6.20 percent. Sangree said the increase is well below the year-over-year rise in London interbank- offered rates, which climbed to 3.27 percent on Jan. 1, 2005 from 1.46 percent on Jan. 1, 2004.

"This is the best seller's market I've seen in the last five or six [economic] cycles," Plasencia said.

"It would appear that there will be more transactions this year," Belden said. "Sellers are more confident going to market. There will be more product out there, and capital is plentiful."

Davidson added six properties last year--two acquisitions, three management contracts and one development project.

"Our goal is to be as aggressive in 2005 as we were in '04," Belden said. "We hope to meet or exceed what we did last year."

Merkel said there's more flexibility in lending options, which has contributed to the low cap rates.

jhigley@advanstar.com

* Online Visit our Web site, www.HotelMotel.com, to read an article about the future of cap rates.

To order a copy of US Realty Consultants' "Hotel Investor Survey Winter/Spring 2005-- Hotel capitalization rates drop further" for $199, contact Kyle Mossman at kmossman@usrc.com.