REH Capital Partners’ Francis Nardozza reveals subtle strategies to mitigate risk even for conservative hospitality investors.
After a barrage of adverse events starting with COVID and continuing on through rising interest rates and inflation, the specter of recession, a choked pipeline that saw few assets come to market, war in Ukraine and Chinese travelers' decisions to stay close to home, it's no wonder hospitality investors are slow to overcome their fear factors. But, with pressure to deploy capital, they may not be willing or able to wait for a sure thing.
Strategies aimed at managing the subtler aspects of risk could offer an entree to 2023's upside for even the most conservative investors.
Hotel Investment Today sat down with Francis Nardozza, chairman and CEO, REH Capital Partners, Fort Lauderdale, Florida, to talk about the new rules for risk mitigation, where the rewards will make that worthwhile and why an influx of first-time buyers and some foreign capital may make inaction the riskiest play of all.
Hotel Investment Today (HIT): When it comes to the appetite for risk, we’re hearing a lot of conversations about conservative strategies for the short term and bolder moves for long-term deals. How risk averse are you and how is that impacting your 2023 investment plans?
Francis Nardozza (FN): Generally, I’m somewhat risk adverse. In addition to my own deals, our firm advises clients of all types on hotel investment plans and strategies. For a higher risk deal, the keys would be significant barriers to entry for new competition and the proviso that the deal is well capitalized, with an ample reserve of working capital to ride out a potentially prolonged downturn or sustain operations while a turnaround strategy is implemented.
HIT: Will the uncertainty and other risk factors cap the deal pace this year or, as some are speculating, will maturing debt, interest rates, capex requirements and fund expiration fuel an uptick in the second half of this year?
FN: I don’t see a tremendous amount of M&A coming in 2023 due to economic conditions and high interest rates, but there will always be assets trading for opportunistic deals or quality assets for buyers looking for strategic positioning in particular asset types or markets for the long term
HIT: Some investors at ALIS were talking up opportunities to buy up distressed hotel assets in urban markets. Will the rewards be there?
FN: The big bets for well-capitalized groups who have patient capital and are willing to take on significant shorter-term risk, say over the next 24 to 36 months, might be to buy strategic assets in Manhattan or even San Francisco that might come to market in distress over the next two years with maturing debt. These markets will bounce back eventually like they always have in the past within a five- to 10-year horizon.
What I’m not a big fan of right now is scooping up conversion options in depressed city centers in secondary and tertiary city locations. There are too many hotels in these markets that are already struggling with low hotel asset valuations lingering from the pandemic. That could lead to further depression of these city centers should we enter a recession.
HIT: What are the most innovative structures you’ve seen recently?
FN: I’ve seen some deals structured as turn-key hotel leases to hotel operators--something that previously was more prevalent in Europe--whereby the property owner leases the hotel turnkey to an operator and receives fixed lease payments, with a percentage rent kicker on revenues. This allows the asset owner to shift much of the operating risk to the operator, sometimes with a guarantee of lease payments from the operator’s parent company.
In development deals, almost all new luxury hotel developments are in mixed-use hotel/residential developments, with for-sale residential components necessary to provide more immediate paydowns of debt and for the project investors to realize capital gains earlier in the asset lifecycle as residential units are sold out.
HIT: Which macro-economic factors are you weighing that the market may be missing and which micro factors do you see as important?
FN: Hotel investors must pay close attention to the war in the Ukraine and related impacts on energy and longer term impacts on Europe’s economy. Then there is the opening of China and what that might mean to inbound and outbound travel to and from large metro markets like New York City, Los Angeles, San Francisco, London, Shanghai, Hong Kong, etc. Investors should also look at the office market and what happens when major office leases roll over within the next 24 months (hybrid models and impacts on major law firms, accounting firms and tech firms of reduced space requirements) and what the impacts would be on hotel demand associated with the office market. Another big factor going forward will be climate change and its impact on the insurance market, especially in coastal areas, and, finally, the political stalemate and what that means to economic policy.
One of the big bets might be buying strategic assets in Manhattan or even San Francisco.”
HIT: Are the owners in the driver’s seat on deals? What are brands doing to help owners get more comfortable with risk?
FN: Quite frankly, the mainline families of brands/operators have not yet come around to noticeably more flexibility on contract terms. This continues to be a major stress point in owner-operator dynamics. I’d say the only area I’m seeing brand-operators take on more risk is by moving possibly 100 basis points from base management fees to GOP-driven incentive management fee revenues. Owners/developers might be more in the driver's seat for more favorable contract terms for assets located in strategically important markets for the brands with high barriers to entry – e.g., Miami Beach.
HIT: Where will the safer real estate plays be in 2023 and beyond?
FN: I believe the sunbelt and particularly states like Florida and Texas will benefit greatly from population growth at the expense of major northeastern states and California. Florida will be a magnate for growth in all economic sectors due to population growth.
HIT: Does that apply to all categories, or just resorts and branded residences?
FN: This applies across the board to all categories and price points of hotel in these high-population growth states. Resorts for sure have been and will continue to be big winners in the near term, but already we’re seeing some flattening of demand associated with previous pent-up demand induced by the pandemic. Branded residences are winners, too, but deals have to be structured properly.
The biggest issue for branded residences, especially in mixed-use projects with traditional hotel and resort components, is how operating and maintenance costs of shared facilities are allocated between the hotel operations and residential components. In Florida, this is a common topic for long-term, dragged-out litigation between residential unit owners and hotel owners and operators.
HIT: Is this the time to take a chance on a new brand or are the big players and their core brands going to be the big winners?
FN: Taking a chance on a new brand will make sense only if the new brand is well supported with the right type of backbone infrastructure for reservations and market distribution and strong management. Also, the new brand must have some clear meaning and brand identity to corporate and leisure clientele alike.
To offset risk, owners who sign on with nascent brands can negotiate more stringent performance-based termination clauses in the owner’s favor and identify and lock-in brand standards to avoid costly PIPs associated with quickly shifting brand standards as the brands evolve.
Another way to mitigate risk is to add in “favored nations clauses” on terms to be sure the next owner is not in a much better position on terms and to stage all operator fees (for example, marketing fees, base fees, etc.) at a lower level until the new brand reaches scale in terms of number of properties, rooms or market distribution. This is to avoid the earliest owners absorbing far too much of the brand’s initial corporate marketing, systems infrastructure and management costs.