Hotel investments: a safe haven when interest rates rise

Hotel investments, which are less well known to the general public than traditional real estate investments, are Europe’s fourth-largest commercial property asset class after retail and office space and logistics. How do hotel investments behave amid economic uncertainty when central banks increase interest rates to limit inflation?

Interview with Jean-Marc Palhon, Chairman of Extendam

Typically, periods of rising interest rates are detrimental to asset values. Is this the case for hotel assets?

Jean-Marc Palhon. Past experience tells us that when interest rates rise, hotel valuations are resilient for assets that include both premises and business assets. This is for several reasons.

Firstly, when investments include both premises and business assets, which is Extendam’s case, the hotel business contributes significantly to the overall value of the property: it represents between a third and 40% of the value. The metrics used for evaluating the hotel’s business performance are independent of the criteria commonly used for evaluating the hotel building. For business performance, the criteria analysed are operating criteria linked to turnover, EBITDA, cash flow, and so on.

All assets are valued according to cash-flow generation and the risk associated with that cash flow. Office and residential building valuations are calculated according to rental income, location, vacancy risk, etc. Meanwhile, hotel assets that include premises and the business are valued according to EBITDA, location, customer mix (leisure, business), etc. According to CBRE data stretching back almost 80 years, hotel cash flows have grown faster than inflation. This means that hotels can offset these periods by adjusting room prices daily and sometimes even several times a day. Hotel assets therefore inspire more confidence in times of market stress and their yield rates are less exposed because the risk is lower.

Furthermore, the capitalisation rates used to value hotel assets have always been higher than their equivalents in other prime real estate asset class categories such as office space, residential and logistics, because they include a higher risk premium. While other asset classes have seen their risk premia fall sharply in recent years, this is not the case for the hotel industry. As a result, interest rate rises, to which rates of return are directly exposed, have a far greater impact on the other asset classes because margins are too small to absorb them. In the hotel industry, higher risk premia dilute the rate increase. Consequently, the difference between the risk premium on traditional assets and that of hotel assets has lessened.

Are hotel assets structurally better able to withstand periods of inflation and rising interest rates?

J.M.P. Even before the onset of rising interest rates and Covid-19, relatively limited hotel supply fell short of high demand.

In addition, the hotel market is very different to other real estate markets because office and retail space is mainly owned by institutional investors, asset managers, and French or foreign property developers. In France and Europe, hotels are mostly owned by families whose property has been the tool of their trade for several decades. When these families decide to sell an asset, they only do so under price conditions they find acceptable. Otherwise, they prefer to wait a year or two rather than sell at a significant discount. Hotel transactions are a supplier’s market, which helps to maintain prices.

What about the impact of the rising cost of financing?

J.M.P. When Extendam invests in a hotel project, bank leverage accounts for up to 50% of the overall investment including the acquisition and building work (or VEFA – sale in the future state of completion). 50% is a conservative level. Currently, all Extendam’s acquisitions are financed over approximately 15 years by fixed-rate loans. New projects will be exposed to rising interest rates and stiffer lending standards. However, these periods are favourable for professional and specialised investors, as the banks already know them and their track record of expertise in terms of asset choice and financial structuring. For value-add projects combining hotel premises and business assets, the expected gross IRR stands at around 12%. If we break down this figure, bank leverage contributes one third and the other two thirds come from the value-add strategy (hotel business operations and asset repositioning). Currently, interest rates are close to 3.5%. Based on a scenario where interest rates increase by 200 basis points to take variable rates to 5.5%, the impact on IRR would be just 1.1%.

In terms of inflation, investments comprised of hotel premises and business assets outperform rental property. In terms of rising interest rates relative to capitalisation rates, hotels outperform other prime property asset classes. Finally, in terms of financing costs, investment performance is the ultimate measure of the impact of rising interest rates.