The Federal Reserve System (the Fed) has relied on multiple interest rate hikes — 11 between March 2022 and July 2023 — since the end of the global pandemic in response to higher-than-average inflation. These rate increases have been the fastest since the 1980 federal funds rate (FFR) peak, which soared to nearly 20%.
Between the collapse of Silicon Valley Bank (SVB) and the struggles of Credit Suisse overseas in March 2023 to a turbulent stock market, short-term treasury yields hovering around 5%, bonds and mortgage-backed securities losing value, commercial real estate activity has slowed.
So what’s next? Will investors continue to purchase real estate like offices and apartments at 4% to 6% capitalization rates, assuming management and risk, especially if other CRE properties like hotels are available and offer more attractive rates? Let’s take a look.
Transaction Activity and Pricing
In Q1 2023, transaction volume for all U.S. CRE dropped over 50% compared to the previous year, and annual price growth was negative at 8%. Hotel-only transactions slipped 55%, aligned with the national average, but still saw a net positive YOY growth of over 4%. Market participants agree that the first three months of this year were very slow compared to Q1 2022, which they attribute to sellers expecting 2021-2022 prices even though debt-market dynamics are less favorable now.
One transaction-based index used to measure CRE price movement via repeat-sales regression methodology reported the decline of all U.S. CRE prices at a rate similar to the 2010 global financial crisis. The primary cause this time? Rising mortgage costs. CRE financial experts predict that capitalization will keep increasing to account for rising capital costs — as has happened in previous cycles — and we’ll see further decreases in value.
Inflation Slows, and CPI Drops
The Fed’s rate hikes are slowing inflation — albeit slowly. According to hospitalitynet.org, the changes in month-over-month CPI since the start of Q3 2022 have been lower. Inflation between March 2022 and March 2023 averaged about 5%, but annualized data at the end of Q1 2023 saw a 2.66% annual CPI change — much closer to the Fed’s target 2% rate. This change is also a vast improvement from CPI’s peak of 9.1% in June 2022.
The data show that the Fed’s interest rate hikes starting in March 2022 are slowly and steadily moderating inflation. Perhaps the Fed won’t need to implement further rate hikes since financial policy often experiences delayed effects.
A slight caveat, however. While it has offered forward guidance, the Fed’s policy stance has fluctuated. Its chairman, Jerome Powell, initially said we’re “not even thinking about raising rates.” Next, he posited that inflation was transitory, and then he led the Fed to hike rates aggressively to slow inflation. On March 7, 2023 — one year after starting those rate hikes — Powell said, “The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.”
Just days after this statement, chief economists and analytics at Goldman Sachs, Moody’s Analytics, Barclays, and other financial entities publicly stated that the Fed should pause future rate hikes. But we’ve seen three more rate hikes (March, May and July 2023). Is the end in sight? Perhaps.
Hotel Investors: Proceed with Caution
If you’re looking for an investment property and considering a hotel or other hospitality venue, do so cautiously. While providing stability in the financial markets is the Fed’s ultimate goal, it’s also becoming a challenge for policymakers. It’s like a dyke with water pressure building behind and causing cracks and holes. Plug one or two holes, and others open elsewhere. We’ve not seen an FFR increase so high so quickly, and the unintended consequences of these hikes remain theoretical (and not fully realized).
Many analysts and economists think the Fed should proceed carefully, pausing further interest hikes — especially since recent data show an improvement in inflationary pressures. And we still don’t know the policy’s full impact (and potential consequences) on the economy.
We’ve seen past Fed rate hike cycles deleverage the economy:
- The Latin America debt crisis of the early 1980s
- The Black Monday Stock Market Crash and Savings & Loans collapse of the early 1990s
- The so-called “Tech Wreck” of 2000
- The sub-prime crisis of 2007-2008
If the economy were to fall into a recession, the Fed would need to employ more robust financial efforts to revive it.
Rising Rates’ Effects on the Lodging Industry
Historically speaking, the Great Recession of 2008-2010 showed a rise in capitalization rates with hotel transactions. It’s too soon to confirm this trend will happen again, but data show hotel capitalization rates did increase to 8.41% in Q1 2023 after dipping to 8.19% in Q2 2022.
Investor surveys saw a similar dynamic, with the average discount rate at 11.5% and limited-service hotels, select-service hotels, limited-service/economy hotels, second-tier hotels, and third-tier hotels hovering just above or below that average.
The average discount rate for full-service, luxury, upper/upscale, full-service, and first-tier hotels was 10.21%, with PWC, HVS, USRC, and Situs RERC data showing hotels falling close to the average, with a low of 9.5% and a high of 10.8%, depending on the firm’s calculations.
Data on hotel properties selling for $2.5 million or more show that the average price per key for hotels sold in Q1 2023 dipped 6.3% compared to Q4 2021’s peak. Hotel CPPI price data grew 4.6% in Q1 2023, even though other CRE properties shrank 8%.
Why have hotels felt less negative impact than other asset classes? Many experts attribute its resilience to renewed interest in the lodging sector post-COVID. We’ve seen:
- Increased travel since 2021.
- Fewer increases in hotel supply, especially in areas where hotels were converted for other uses or emergency housing.
- Renewed interest in the sector, especially compared to the office and multifamily sectors, which are seeing greater declines.
Another benefit to the hotel and lodging industry? Unlike other assets where tenants are locked into leases for multiple years, hotel room rates fluctuate based on demand, with companies able to adjust room rates daily — an excellent inflation hedge!
Hotels also offer the widest cap rate spread to the ten-year U.S. Treasury, providing a deeper cushion against debt’s rising cost. The Fed hasn’t taken future rate hikes off the table, so hotel capitalization rates will likely keep rising, but recent cap growth hasn’t taken anything away from the sector. If anything, hotel cap rate increases have increased the vertical’s attractiveness.
According to the National Bureau of Economic Research (NBER), during the four official recessions the U.S. has experienced in the past 40 years, hotel revenue per available room (RevPAR) levels always decreased. But post-pandemic pent-up demand and rising inflation led to hotels posting record RevPAR levels in 2022. And RevPAR levels continue to increase in 2023, breaking records set last year. Could future rate hikes slow demand and growth and lead to a correction? Possibly. But industry experts doubt the industry will see a decline as severe as 2020’s.
We can’t predict the economy’s future movement or its effect on CRE asset classes. Because they’ll keep benefitting from record RevPAR levels and higher cap rates, hotels remain a solid investment option.
Are you a commercial real estate investor or looking for a specific property to meet your company’s needs? We invite you to talk to the professionals at CREA United: an organization of CRE professionals from 92 firms representing all disciplines within the CRE industry, from brokers to subcontractors, financial services to security systems, interior designers to architects, movers to IT, and more.
