Crunch Time

20th July 2008 (Last Updated July 20th, 2008 18:30)

Although the hotel industry has recently seen record levels of investment, the credit crisis is making a significant impact. Helen Jones looks at the implications of the crunch and where deals are likely to exist.

Crunch Time

Despite the current economic gloom, a number of landmark luxury hotels will open in New York during the next couple of years. Orient Express Hotels has confirmed it will build a new hotel on the site of the New York Public Library; and the Shangri-La, designed by Norman Foster, is scheduled to open in 2010. But while the most established developers are weathering the storm, finance within the US hotel sector has all but disappeared.


“It’s a challenging time, but there will have to be a significant downturn before we really see distress.”

“The pipeline for new hotel projects in Manhattan is unprecedented and neighbourhoods are opening up where developers never thought of building before,” says Mark Woodworth, president of PFK Hospitality Research. “While the total pipeline of planned hotel projects [across the US] is at an all-time high, only a small number are actually breaking ground. The high costs of construction and land, combined with firmer capital market discipline, have helped to control the volume of new supply additions.”

This is a view shared by Michael Fishbin, Hospitality & Leisure Practice director for Ernst & Young, US. “With the financing tap essentially turned off for a few months and underwriting terms changing dramatically, there will be less new construction in the next two to three years than originally planned,” he says.


While the US has been hit hardest by the credit crunch, the European hotel sector is also starting to feel the pain, despite last year being a record year. “Globally, in 2007, we estimated that there was in excess of $100bn-worth of hotel transactions,” says Nick van Marken, lead partner for Corporate Finance, Tourism, Hospitality and Leisure at Deloitte. “It’s very big business and was worth $75bn in the US, $25bn in Europe and $12bn in Asia. These are record numbers – over the last three to four years we’ve seen a very significant volume of transactions.”


According to van Marken, the reason for the growth in transactions is that perceptions of the hotel sector have changed. “It is now an acceptable asset class for institutional, private equity and property investors,” he explains. “In the past, for example, hotels were regarded as more difficult than offices and warehousing because they were viewed as capital and labour intensive. In the 1990s, the hotel industry cut a lot of the costs and proved it could adjust to changing times. The industry also showed it was relatively resilient.”

“Projects at the moment are proving more difficult to finance, and debt is certainly more expensive.”

Van Marken says that the driver of hotel deals is the separation of ownership and management, particularly in the UK. “We have seen the move from public ownership to private,” he says. “There were a lot of hotel flotations in the UK industry in the mid-1990s and that has been reversed in the last three to four years. Intercontinental, for example, sold a significant amount of its portfolio – several billions worth – and returned that to shareholders. Their shares were positively re-rated on the back of this strategy.”

Van Marken looks to the acquisition of Hilton Hotels by private equity group Blackstone for $26bn, as a landmark event. “It showed that the hotel industry had really arrived,” he says.


In mid-2008, times are tough. Mark Wynne-Smith, CEO of Jones Lang LaSalle Hotels for Europe, Middle East and Africa (EMEA) identifies two distinctive areas that characterised the hotel investment market in 2007. “Investment activity continued strongly in the first half of the year, but was hit by the sub-prime crisis in the summer, impacting the availability of debt,” he explains. “The UK market was the most impacted by the credit problem and reported a decrease in both single asset and portfolio transaction volumes.” Wynne-Smith observes that across the EMEA region, investment activity decreased by almost 33% in the second half of 2007, compared with the same period in 2006.


Stephen Broome, hotel industry specialist at PricewaterhouseCoopers (PwC), says that it is becoming increasingly difficult to raise capital across Europe. “Lenders in particular are more cautious and some have stopped lending to new customers,” he says. “Projects at the moment are proving more difficult to finance, and debt is certainly more expensive. In addition, loan-to-value ratios have been reduced from as high as 80%, prior to the credit crunch, to the long-run average of around 65%, requiring investors to put in larger amounts of equity.” Broome says that this has slowed down development growth and discouraged buyers. The result was fewer transactions in the latter part of 2007, a reality that is unlikely to change in 2008.

Mark Wynne-Smith agrees that financing has become more difficult. “Raising senior debt in EMEA for hotel real estate has become a challenging task,” he says. “Credit committees have adopted a more cautious approach, with a focus on past trading performance, investor track record and the strategic relevance of the potential transaction being carefully considered.”


“Raising senior debt in EMEA for hotel real estate has become a challenging task.”

PwC’s Stephen Broome cannot foresee the economic gloom lifting soon. “Even if debt can be found at the right price, there remains a yawning gap between sellers and buyers in terms of values,” he explains. “There is the possibility of some innovative sale and manage back opportunities, and deals funded through sovereign wealth sources or pure paper deals, but otherwise the outlook is bleak. Various interested parties, mainly property agents, claim that 2009 will see a recovery in values, but frankly it could go either way. And if the US actually lapses into a recession these forecasts will appear wildly optimistic.”

Broome believes that this caution does not just apply in the US and the UK. “The extreme nervousness among lenders is pan European,” he says.

“Only the Middle East is exempt due to the predominance of sovereign funds who remain less or non-impacted.”


However, despite the difficulties in raising capital, deals are still being made. A recent report from Jones Lang LaSalle indicates that continental Europe experienced strong single asset activity in France, Germany and Italy as well as central and Eastern Europe, Turkey and Russia. “The German, French and Italian markets continued to dominate single asset investment volume across Europe [in 2007], achieving total single asset sales volume of €2.8bn, accounting for approximately 62% of total single asset volume in continental Europe,” it said.

While big portfolio deals are likely to become rarer, single assets will continue to attract buyers. “If you look at the Four Seasons Milan, for example, it has sold every time and each time for more than before,” explains van Marken. “It is a one-off: a converted monastery and you can’t recreate it.”


The current economic climate has attracted considerable interest from investors and sovereign wealth funds in Asia and the Middle East. US assets are particularly sought after due to the weakness of the dollar. A recent report from Ernst & Young stated that, “transactions, such as Istithmar Hotels’ acquisition of the Mandarin Oriental in New York and Taj Hotels Resorts and Palaces acquisition of the Ritz-Carlton Boston and the Campton Palace Hotel in San Francisco are indications of this heightened interest from abroad. It is anticipated that foreign investors will continue to drive a significant portion of investment activity through 2008.”

“If you drop in to Mumbai, Shanghai or Dubai no one is talking about the credit crunch,” says Van Marken. “Groups such as Taj, Shangri-La and Jumeirah are still doing deals, although that’s not to say these markets will remain immune if there is a big slow down.”


So, what is the picture for operators and investors for the next few years? “The credit crunch is here to stay for a while,” says van Marken. “It’s a challenging time, but there will have to be a significant downturn before we really see distress.”

Over at Jones Lang LaSalle, Wynne-Smith says the changes in the market will play to the benefits of groups with strong equity positions: “These investors are now expecting to acquire properties below peak and are seeking assets that are being priced realistically. We do anticipate some slight improvement in the availability of debt in the second half of the year but if you blink, you may miss it,” he says. “Opportunities will exist everywhere, but will be more interesting in markets with stronger income growth potential, such as Germany, Scandinavia, central and Eastern Europe.”