The Federal Reserve’s Febuary 2 raise in the benchmark rate could be just the first in a series of upward bumps aimed at slowing inflation to 2% ASAP.
The drama surrounding interest rates is far from over. Although the Federal Reserve stayed strictly on script with its Febuary 2 announcement of a 25-basis-point increase in benchmark interest rates (which most investors expected), that was just part of the story of 2023.
“We’re spending more time with regional lenders who are good, cheaper sources of capital because we want to make sure debt restrictions are reasonable.”
Ben Rowe
In a press conference on the rate hike, Federal Reserve Chair Jerome Powell said that current economic restraints have not been sufficient to rein in inflation to 2%. “Inflation is moderating but remains high,” Powell said. In response, The Federal Reserve will continue its campaign to lower inflation and, as a result, raised the target benchmark interest rates to a range of 4.5% to 4.75% as of February 2, 2023. “Ongoing rate hikes will be appropriate… We cannot loosen control too much. The focus will not be on short-term moves; it will be on sustained policy,” Powell added.
Wait and see
After seven raises in 2022 that escalated interest rates from 0.15% to 4.4%, opening the door to another series of increases was not the best news for the investment community. The more than 2,600 hospitality owners, operators, developers and investors who attended the Americas Lodging Investment Summit (ALIS) January 23-25, 2023 in Los Angeles did not see this year playing out this way. Generally, they predicted a scenario with two 25-basis-point rate hikes in the first quarter followed by at least a summer of stability.
Powell made it clear that’s unlikely, adding that the next increases could come in May or June. But, overall, even the Fed may have to adopt the same wait-and-see attitude that’s pervasive among investors to get a clearer picture on job growth, prices, savings, purchases and other economic indicators before it acts on rate hikes. “Decisions will be made meeting by meeting,” he said.
The Federal Reserve chair did have some positive takeaways for investors. Chief among them was that 2023 rate hikes would be small—25- to 50-basis points, not the 75-point level reached for some during 2022. Not only would that be more palatable for the investment community, it would allow the Federal Reserve to evaluate the outcome of each increase before determining if and when another is needed to lower inflation.
Keep the powder—and the portfolio—dry
Even before the latest rate hike, well-capitalized hospitality investors who considered strategic sales on the strength of strong performance in 2021 and even better results in 2022, were taking down “for sale” signs. Watch for investors with deeper capital reserves to extend their “hold” period until interest rates cool off and cap rates stop looking so crunched.
“Our typical hold period is five to six years,” said Ben Rowe, managing partner, KHP Capital Partners, San Francisco. “More constrained debt markets are impacting the evaluation of when to buy, sell and hold. With lower leverage and high interest rates, assets are worth less, especially transitional assets where debt is the thinnest and margins widened the most. The question for us as a buyer is, ‘Do we have a market seller with adjusted expectations?’ The question for us as a seller is whether we can sell at premium pricing. We had begun looking at selling some leisure properties as travel trend stabilized. Since the capital markets shifted, we’re not looking at selling now or in the near future.”
While cash buyers have an increasing advantage, Rowe said innovation can give prospective buyers a workable way to play this market. “We’re spending more time with regional lenders who are good, cheaper sources of capital because we want to make sure debt restrictions are reasonable,” he said as part of an ALIS boardroom outlook panel presentation on buying, building, holding and selling hotels.
He’s also working on deals with seller financing. “It can be a meaningful option because it takes risk off the table in certain circumstances,” Rowe said. “It’s a great way to get a deal done.”
Creative deal structures may be more common as investors seek to deploy their dry powder which, according to research by Hodges Ward Elliott, will reach $377 billion by Q2 of this year. Where can it go? The CMBS is one likely destination. “There will be sellers due to the $5 billion of CMBS loan maturities in 2023, according to Trepp, and record levels of dry powder that needs to be placed,” said Alexandra Lalos, managing director, Hodges Ward Elliott.
One ray of hope is coming from SOFR trends. “The one-month SOFR rate is expected to stabilize between May and June. We think stability of SOFR will provide lender and investors some comfort that interest rates will stabilize and potentially cause spreads to tighten,” she added.
Coping strategies
With major resort deals probably off the table and cashed-up owners who can afford it focused on riding out the ebb and flow of 2023’s interest rate tides, how many distressed assets will really come to market? So far, said Mat Crosswy, president, Stonehill Strategic Capital, tailwinds have prevented a flood of distressed hospitality assets coming to market.
“Right now, distress is more of regional phenomenon, such as in specific markets like Portland, Oregon, or Chicago, or San Francisco that were slow to recover after the pandemic and where sponsors and lenders might be having fatigue,” Crosswy said. That picture could change over the next 6-12 months and become more of a universal factor. “Whether it's a leverage issue or, you know, mismanagement, wrong brand, whatever the business plan was going into that investment, you'll probably see more stress there,” he added.
Unlike during COVID, Crosswy cautioned, banks may not be willing to ride it out (and the government isn’t stepping in) – if assets are underperforming. “If you have a good cash flow, banks may extend or reset that loan, but they are heavily regulated to be cashflow-driven rather than looking at the business plan or upside of the asset.”
Expect to see assets facing refinancing or other events forcing changes to debt service to be the ones hitting the market. Interest rates will likely delay cap rate compression, though, despite banks running out of patience on some assets, Crosswy doesn’t see a major reset coming in hotel real estate values.
Beyond that macro picture, is there a “cheat sheet” for investors navigating the probability of further interest rate hikes? Ken Cruse, cofounder and CEO of Soul Community Planet and Alpha Wave Investors, said it’s patience. Not patience to wait until SOFR settles down, but a willingness to think long-term when negotiating deals. “Many of our deals have taken months, almost a year,” Cruse said.
It paid off: on a recent project Cruse scored seller financing at 0% interest. As a smaller company, he deploys an avoidance strategy: aiming for assets that are relevant to his portfolio while staying off the radar of big institutional investors. While his interest in a 22-room resort in a drive-to location in, for example, Oregon might not be equally relevant to every portfolio, smart small and medium-sized firms may want to dodge the capital markets entirely.
That said, the overall outlook might be surprisingly optimistic. “Hotels are a very investable asset class and equity will flow into them,” Crosswy said. “Fundamentals are stronger than in past recessions, and European investors may also want to look to the United States as a relatively stable investment opportunity because of the Ukraine war and other regional challenges.”