Managing risk 2023: Go big or stay home?

After more than two years of upheaval marked by a pandemic, wars, climate-related events and financial uncertainty, risk has become an even higher profile factor in investment strategies. Investors who thought--or hoped--that would change in 2023 were disabused before the end of Q1. The Federal Reserve's announcement of a 25-basis-point interest rate hike on Feb. 2, 2023 and its statement that more are on the way (though not as many as 2022's seven increases and probably no single raise as high as 75 basis points) offered little certainty or encouragement. Though there are shoots of disinflation and jobs growth may be slowing, investing over the next 11 months will continue to be a risky business.

Well-capitalized, cashed up can stand pat as long as necessary. They're still under pressure to put capital to work, but they have the luxury of modulating risk to reward--as they always have. But U.S. private equity, fund managers and institutional investors may have to move off the fence sooner rather than later as some Middle Eastern and Asian investors consider deploying ample stockpiles of capital in European and the U.S. real estate and targeted industries such as hospitality. 

Any owner with maturing debt that will require refinancing or a firm saddled with floating rate debt (which probably looked like a good deal before a year of Federal Reserve rate hikes advanced interest rates from 0.15% to 4.4% in 2022 and may take them to 5% this year), is going to have face down risk aversion to stay afloat. Industry insiders don't see lenders as willing to forebear or forgive as they did during Covid, but they still may prefer to be lenient in the short term rather than hold assets on their books until they regain full value.

Hard-line debt service requirements could allow a long-stalled transaction pipeline to begin flowing in Q3 and Q4. “Rising debt maturities, impending interest rate cap renewals, fund-life expirations and capex requirements are likely to lead to a wave of dispositions in the back-half of 2023,” predicted Gilda Perez-Alvarado, global CEO, JLL Hotels & Hospitality, in the firm’s key takeaways from the Americas Lodging Investment Summit (ALIS) held January 23–25, 2023 in Los Angeles.

Slow and steady win this risk race

Investors looking for panic pricing as a means of mitigating risk are going to be disappointed. “True distress is unlikely to materialize, despite the fact that lenders will not be likely to extend current loans,” Perez-Alvarado added. “Expect sellers to proactively bring assets to market driven by the trigger points I’ve just mentioned.” That should narrow the bid-ask gap, reducing the risk of overpaying for troubled assets. What it won’t do is keep the r-word (risk) from being top of mind.

As Kevin Davis, Americas CEO, JLL Hotels & Hospitality, pointed out in the firm’s ALIS summary, “Despite U.S. RevPAR reaching an all-time high in 2022, all-in debt costs increased meaningfully in the back-half of 2022 as lenders have yet to give hospitality assets credit for their improving operating performance (mispricing risk). Many buyers are currently in a wait-and-see mode as current capital market dislocation has clouded the ability for some investors to transact.”

The number and scope of these “what ifs” were too apparent to raise the general mood among ALIS’s 2,600 attendees beyond “cautiously” optimistic at best to committedly uncertain—if not determinedly circumspect. The reality is that even under pressure to deploy massive amounts of capital, the majority of private equity investors, institutions and investment firms, including giants like Blackstone, are not willing to risk paying peak 2023 interest rates by doing deals now. They’re waiting out the summer in the hope that falling rates could support a disciplined buying spree in Q3 and Q4.

Ways to play uncertainty

Here, industry experts offer new thinking on ways to participate in the markets without over-reaching risk tolerances.

Buy into strength. In this market that means luxury and select-service/extended-stay, said Zach Demuth, global head of hotels research, JLL Hotels & Hospitality. Despite macroeconomic volatility, fundamental performance for luxury and select-service hotels continues to accelerate drive by rising ADRs and growing demand, respectively, he pointed out.

“Both sectors have attracted strong investor interest, reaching all-time highs in portion of single-asset liquidity in Q4 2022. Expect these sectors to lead transaction activity in H1 2023 underpinned by an increased lender pool for smaller cheque sizes and growing interest in luxury assets with in-place cash flow,” he said. “Despite macroeconomic volatility, fundamental performance for luxury and select-service hotels continues to accelerate drive by rising ADRs and growing demand, respectively.

Blackstone added a new twist to this classic risk strategy, opting for deals with layered upside to bolster their exposure to these markets. Recent acquisitions include an expanded presence in select-service/extended-stay (111 WoodSpring Suites properties acquired with Starwood Capital from Brookfield Asset Management for $1.5 billion in 2022) and luxury—specifically resorts (Australia’s Crown Resorts, a $6.2 billion buy that added three casino resorts to the firm’s burgeoning hotel portfolio).

The WoodSpring Suites acquisition not only fit with Blackstone’s long-standing action plan in the select-service sector, it increased exposure to the affordable extended-stay market with a brand that boasts average occupancy in the mid-70s and has cross-over appeal for commercial travelers who need a home away from home for a week, a month or more.

Well-timed to participate in ample upside based on Blackstone’s expertise in upgrading property and entertainment offers, the Crown deal gave the firm a major presence in Australia’s 5-star resort/casino/entertainment market and delivered its biggest transaction in Asia Pacific to date—perfectly timed ahead of China’s reawakening outbound tourism.

“All eyes on China and the return of international travel and cross-border investments,” said Perez-Alvarado. “The potential impact of China’s reopening cannot be understated. Domestic and regional travel have already seen an uptick, with travel to the U.S. and Europe likely to increase soon.”

Although few investors can rival Blackstone’s deep pockets, they can take a page from this giant’s playbook. “We have sought to mitigate risk by diversifying our portfolio geographically and creating exposure to a broad variety of demand generators,” said Justin Knight, president and CEO, Apple Hospitality REIT. “With that stable base, we are positioned to pursue individual assets in markets that are early in their recovery but where we see strong growth potential over the long term.”

Think small and start early. Investors who don’t want the risk of competing in a last-half deal frenzy can get in early via small deals from sellers who cannot afford the interest rates of refinancing and by using more creative contract terms such as seller refinancing and assumption of existing loans.

“Smart investors plan for risk. They understand the realities of today's market and price that into their deal assumptions,” said Allison Reid, chief global growth officer, Aimbridge Hospitality. “Smart investors also mitigate their risk, first by understanding their internal hurdle return requirements, time horizon, and comparable options. Then they find partners with deep experience in underwriting and managing in all types of market conditions.”

Bigger is better in the game of risk, and newer may be better yet. “Big brands are likely to continue to outperform in the coming years because of the consistency of the product and guest experience they offer as well as the added value guests receive through membership in larger loyalty programs,” Knight said.

While he continues to hedge his bets with traditionally resilient upscale select-service, Knight’s open to emerging flags just launching from the mothership of major players. The risk-controlling double dip is that investors get the infrastructure and marketing power of a household-name brand as well as the advantage of adding a new concept to crowded or under-served markets.

Managing risk in those cases should go beyond due diligence to include proactive measures. “We carefully assess rate potential along with the operating model to ensure the new product will deliver desired margins. We also look to take advantage of brand incentives such as key money and fee ramp where available,” Knight said.

There’s plenty of potential outside the box for bolder investors. “As the lines between work, life, and travel become increasingly blurred, traditional hotel brands and investors have an opportunity to expand their product offerings to new verticals,” JLL's Davis said. “Look for a rise in non-traditional hotel offerings (e.g., branded residential, short-term rentals, and private membership clubs, etc.), particularly in the luxury space, as investors embrace the opportunity to own the entire travel experience.”

Leon Avigad, founder, co-owner and CEO of Tel Aviv-based Brown Hotels International reduced the fear factor of prospective owners regarding curated offers by developing a series of sub-brands to the company’s core lifestyle offers that give investors entrée to aspirational “living” concepts for long stay as well as mini-brand collections under the company’s corporate umbrella.

“Brown Hotels already has a very varied brand structure with a number of sub-brands within the organization aimed at different types of traveler,” Avigad said. “The franchise methods of the three major players in the company also create a lot of diversity. Taken together, these two factors demonstrate an interesting and diverse market offering in Athens. With this in mind, we don’t feel there is an appetite for developing new brands this year. Our focus for 2023 is to establish the brands that we’ve brought to the market over the last couple of years and expand on these sub-brands with our new properties in the pipeline.”

Inaction may be the highest risk. Perez-Alvarado sees cross border openings as a precursor to a freer flow of investment capital. “Look for cash-rich Middle Eastern and Latin American investors to deploy capital across Europe and in select U.S. markets, particularly in the luxury space,” she predicted.  

Reid said she believes new investors show up in markets for basically two reasons. “In some cases, return/risk fundamentals are better than their current investment focus area,” she said. “An example would be office investors looking at hotel opportunities because of negative office fundamentals like COVID impact or oversupply. The other reason is hotel investment inflation friendly pricing opportunities. Disruptors see the opportunities others haven’t seen or are too risk averse to try, whether it be related to segments, markets, or operational efficiencies.”

Reid noted that right now, many investors are sitting on the sidelines, waiting to see how buyers and sellers adjust to the impact of increasing interest rates, spreads, and inflation. “That said, there is still quite a bit of smart money sitting on the sidelines looking for a way to invest. Our industry has very strong long-term fundamentals. I am confident investors understand the reward/risk profile, so this activity won't stay stalled for very long.”