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What California’s transactions dip means for owners

Column: industry Tag: California’s transactions Published: 2017-03-07 11:06 Source: Author:

With high barriers to entry in the California market and, in some cases, seemingly endless demand, hoteliers have scoured the West Coast, looking for any possible way in. However, after riding years of record transaction numbers, the cycle has caught up with California.

The latest California hotel sales survey by Atlas Hospitality Group shows sales volume decreased by 30% from 2015 to 2016 to $6.6 billion, and Atlas President Alan Reay said he expects that trend to continue through 2017.

“In large part I think it’s because we had such a phenomenal year in 2015, there really was nowhere to go but down,” he said. “It’s unusual to have $9 billion a year for California sales.”

Atlas Hospitality Group has been tracking these figures for 20 years, and Reay said in relation to any other year but 2015, 2016 was still a good year for hotel sales.

“It’s only when you compare it to 2015 does it look a little anemic,” he said. “The average year has about $5 billion in transactions. There were still over 300 hotels trading out. It was still a good year.”

Why the decline
A number of factors led to the overall decline, Reay said. One reason is the valuation on hotel competition and hotel real estate investment trust stocks. The hotels had high valuation and there was a lot of money flowing into the stocks, which the REITs then had to use, and they spent a lot of money chasing hotel deals, which pushed down cap rates, he said.

In the first quarter of 2016, REIT stocks were down 50% on average, Reay said, and became net sellers instead of net buyers. REITs are becoming more active buyers again, but they’re more selective now than they were in the past.

“The REITs were really a major, major factor in pushing up volume and prices,” Reay said. “Anyone else was pulled along.”

The Chinese government has implemented a penalty on companies trying to invest more than $5 million outside of the country, Reay said, and the West Coast was a popular destination for Chinese investments. The U.S. industry has seen six years of record revenue increases, but people are now scaling back their projections and leveling out revenue per available room or forecasting declines. Interest rates are likely to increase again, he said, so lenders are being more cautious.

The timing of the cycle in 2016 is partly why pricing is down compared to 2015, said Mary Beth Cutshall, SVP of acquisitions and business development at Hospitality Ventures Management Group. Companies were more wary of the transactional space in 2016, she said.

“People were a little more cautious about what they were paying because we had more indication of what was forecasted for the fundamentals at that level—performance, occupancy and (average daily rate),” she said.

All of that information made its way into analysis for underwriting, she said.

Predictions for 2017
California’s fundamentals are still strong, according to Vamsi Bonthala, CEO of Arbor Lodging Partners, but people are just a bit warier, so that will bring pricing down a bit. Some owners with a high-performing asset might be ready to sell, but when they see pricing come in, they might decide that refinancing is a smarter move, he said.

The current bid-ask gap isn’t anything crazy, he said, nothing like when the industry was in the middle of the downturn and buyers and sellers were on different planets.

Cutshall said hoteliers expect interest rates to increase and are trying to anticipate what might happen if there are more increases in the third and fourth quarters.

“I wonder if that will encourage people to take a serious look at trying to find opportunities in the beginning of the year as soon as possible to lock in the lower rate,” she said. “A lot has been baked in, but it could still have an impact getting to the end of the year.”

The industry as a whole has started to slow, said Robert Hazard III, SVP of acquisitions and development at Hersha Hospitality Trust. There’s not a lot of product on the market right now in California, he said. Los Angeles is seeing robust growth and San Francisco is taking a breather for the next year or so while the Moscone Center undergoes an expansion. When investor-grade assets do arrive on the market, they’ll be fully priced, he said.

“It’s hard in this environment if you’re looking for a 7.5% to 8% unlevered return on investment,” he said. “If you’re buying at a 5% cap rate, it’s hard unless the market is exploding to move that investment up to your target in a short period of time. That’s a challenge and, frankly, that’s the kind of cap rates within pricing we’re seeing.”

Buyers have to be careful when acquiring these types of assets, Hazard said, because it’s hard to get a return up to acceptable levels if they continue operating a hotel the way ithas been operated in the past. There’s no help from the market, he said, and having to find savings in operations makes it a challenge.

Many of the investment-grade assets, both inside and out of California, are mostly in the hands of competent operators, Hazard said.

“The opportunity to find a hotel mismanaged becomes more and more challenging as time marches on,” he said.

Opportunities remain
Arbor Lodging Partners views a number of markets within California as targets, Bonthala said, as they have attractive fundamentals. Those markets are tough at any point in the cycle for short-term investments, he said, but they have good opportunities for medium- to long-term investments.

Bonthala said the company purchased the Hilton Garden Inn Oakland-San Leandro last year after eyeing the San Francisco Bay area for a while. The property was still below replacement cost, he said, but the yield was still attractive. He added that value-add opportunities are less likely there than buying into good yield.

Arbor Lodging Partners doesn’t have a specific number of possible acquisitions planned for 2017, but Bonthala said he would love to do at least a couple of deals in California, possibly in the Southern California region. He added he doesn’t expect the company to sell off any California assets in the near future.

“We’re definitely seeing deals out there,” he said.

There’s a remarkable building boom going on in Hollywood and West Hollywood, Hazard said, and while those markets have been undersupplied for a long time, the new supply will have some impact on operations in the market for a while. Los Angeles is still doing great, even with the new supply coming in.

“If the right opportunity came up, we’d have no compunction about investing more capital in that marketplace,” he said.

Santa Barbara and Silicon Valley are other markets that are doing well, Hazard said. And while San Francisco is a little soft this year because of the Moscone Center renovation, it will come raging back.

“I think that there’s a lot of places one could invest in California without getting into a lot of trouble,” he said.

The issue is the pipeline of product coming out this year, Hazard said, and whether there will there be a batch of sellers realistic in asking expectations. REITs are coming back in the market for acquisition in a big way, he said, so the pool of buyers is going to heat up as well. With all of those factors in mind, he said he expects more people to be chasing a number of deals similar to those made in 2016.

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