- U.S. lodging sector fundamentals have recovered substantially, with demand for hotel rooms near pre-COVID levels; further improvement largely depends on the continued return of business travel.
- Relative valuations may be more appealing in Europe which is earlier in its recovery cycle. We expect the recovery will likely be choppy and result in more distress in the sector than we have seen to date.
- The biggest operational challenges owners face are labor shortages and rising wages.
- We invest in unbranded, under-maintained hotels and aim to reposition them into best-in-class differentiated properties.
Hotels are busy again, but markets have not yet found equilibrium. PIMCO portfolio managers and researchers with Allianz Real Estate discuss the state of the market and where see opportunities.
About PIMCO & Allianz Real Estate:
PIMCO assumed oversight over Allianz Real Estate in 2020 and is now among the largest and most diversified real estate managers in the world, with $200 billion in assets managed across both public and private real estate. The platform invests across core, core-plus, value-add and opportunistic assets to bring a broad set of solutions to investors globally.Footnote1
Q: What is the state of the hotel investment market?
Walters: Hotel investments sharply increased in 2021, albeit unevenly across regions, reflecting the different pace of recovery. The U.S. led the rebound, with dollar volumes more than quadrupling year-on-year and rising 15% over 2019.Footnote2 Volumes in Europe and APAC increased but remained 37% and 24% off 2019 levels.Footnote3 The number of properties transacted has rebounded strongly in the U.S. Average cap rates have remained stable in Europe and Asia but have compressed in the U.S., reflecting the stronger economy.
Although hotel markets are recovering, challenges remain. Total returns are down (relative to other real estate sectors) on the income component.Footnote4 The biggest operational challenges owners face are labor shortages, rising wages, and uncertain scheduling needs amid volatile demand. While we expect operating expenses to rise, newly adopted technologies and pricing strategies may make operations at many hotels more efficient. Hotel investors – having incurred greater losses from price wars during the Global Financial Crisis – have been focused on maintaining a targeted average daily rate (ADR) this cycle. Indeed, despite the sharp decline in demand in 2021 from pre-COVID levels, U.S. ADR was off just 5%.Footnote5
Yet, in our view, the ability of hotels to hedge inflation by repricing room rates daily is compelling in the current economic environment. Although, price per key on average hasn’t risen dramatically outside the U.S., the very high-end of the market (with prices are over $1 million per key) has been active. In the U.S. 14 high-end assets traded since 2019, nine sold in Europe, and five in Asia Pacific.Footnote6
Q: How did the hotel sector perform in 2021?
Chen: After nearly two years of pandemic sequester, workers and vacationers are traveling again. Spending by U.S. and European travelers in December 2021 reached near pre-pandemic levels.Footnote7 Footnote8 And once China eases travel, we can expect its outbound tourism to take flight – after nearly tripling from 57.4 million Chinese tourists in 2010 to 169 million in 2019.Footnote9 For context, about 99 million U.S. travelers left the country in 2019.Footnote10 We expect pent-up household savings to continue to fuel the cyclical recovery in the hotel market, possibly at a faster than expected basis.
The U.S. hotel sector led the global lodging recovery in 2021. Revenue per available room (RevPAR) gained strength during the year. Full-year RevPar sat just 17% off 2019 pre-COVID levels and ended just 3% shy of 2019 in 4Q.Footnote11 While 2022 got off to a slow start as the COVID-19 Omicron variant emerged, the weakness appears temporary with February U.S. RevPAR down just 2% and March expected to be up roughly 4% from 2019.Footnote12
Leisure travel has driven the recovery, reaching and even exceeding pre-pandemic levels. Business transient (weekday) and group demand, however, remain challenged. Demand was 15-25% off 2019 levels,Footnote13 with major gateway markets the most challenged, and although growth has picked-up, longer-term, virtual meeting technology may dampen business travel.
Transaction activity was brisk in 2021. The U.S. deal count ranked third highest in the last decade, far surpassing 2019.Footnote14 Investors are correcting their under-allocation of hotels versus the multi-family and industrial property segments in anticipation of limited new supply. We believe fundamentals look attractive: the current lodging cycle appears in its early stages, cap rates are 6-8%Footnote15 (on 2019 cash flow) on a low all-in financing cost (by historic standards), and relative valuations are appealing.
Overall, as economies continue to reopen, we expect the positive momentum to continue through 2022.
Zavodov: Europe’s recovery has been significantly slower as differing local regulations across the continent prevented any meaningful increase in cross-border travel throughout 2021. European RevPAR saw a marked recovery in the second half of the year, but remained 44% below 2019 levels for the full year.Footnote16 Average daily rates recovered to 93% of pre-pandemic levels, although occupancy lagged at about 60% of 2019 levels.Footnote17 Countries with larger domestic markets performed better.Footnote18
Hotel managers have adeptly identified operating efficiencies to support margins, but the earnings recovery has lagged, weighed down by the drag from operating leverage during the occupancy ramp-up and associated tightening of brand standards, rising labor costs, worker shortages precluding many hotel owners from fully reopening, and the gradual phasing out of grants and other government support.
Overall, while we have seen encouraging signs of a hotel sector recovery in Europe over the last 12 months, the full operational ramp-up is likely to be choppy and may result in more distress in the sector than we have seen to date, particularly as inflation pressures capital-intensive refurbishment projects and impacts the availability of financing for complex business plans.
Q: Which hospitality segments are winners and which are losers?
Zavodov: While the long-term fundamentals remain robust, near-term winners and losers emerged during the pandemic. A clear winner has been drive-to, leisure-oriented assets that outperformed during the pandemic, as customers sought rural locations and smaller hotels. Assets reliant on international tourism have seen intermittent recovery, significantly outperforming during the months with limited COVID restrictions.
Domestic business-oriented hotels fared well in part by capturing some of the drive-to leisure demand. International business and group-focused hotels have been the hardest hit and we believe they will take longer to recover, and may incur structural impairment to occupancy and higher cash burn rates.
Overwhelmingly, across hospitality segments, owners who used the downtime afforded by the pandemic to reposition their properties and create a differentiated product see their assets recovering faster and achieving greater profitability, even those exposed to international travel and groups. In fact, corporate bookings in memorable locations are now seeing order books that in some cases exceed 2019 levels.
Walters: We think the luxury end of the market will grow faster than the whole by differentiating product in terms of amenities and quality. Luxury brands are capturing the trend in global demand for ‘wellness.’ In the U.S., many opportunistic investors are repositioning properties to appeal to the health and well-being trend.
In Europe, heritage luxury brands are opening hotels, including a recent hotel in Paris.
Q: Will the growing trend of hybrid working help or hinder the hotel industry?
Walters: We believe hybrid working will impact hotel usage over the long term. Business usage will not likely fully recover because business-as-usual communication with established customers and internal management of regional offices can be done mostly virtually with few downsides.Footnote19
Still, changes in where people live and work may create new sources of hotel demand. We believe offices will shift toward city centers.Footnote20 Conversely, employees have moved further out as long commutes are less of an issue. This is giving rise to hotel-office concepts targeting business travelers needing temporary accommodations.Footnote21
Q: Where are you finding opportunities in the hotel space?
Chen: Since the onset of COVID-19, we have been capitalizing on the market’s constrained liquidity, deploying over $6 billion into hotel assets and securities spanning public and private debt and equity markets. We believe the recovery to pre-pandemic levels will be a multi-year process in certain geographic areas, with some market segments – including leisure and extended stay properties – recovering faster than others.
In the U.S., lodging asset prices are approaching pre-pandemic levels and our focus has shifted to market segments where we believe can generate strong and resilient cash-on-cash returns, in many cases by adding value through extensive capex. Assets in dense gateway cities may also present opportunities. While demand in these markets is likely to require a more prolonged recovery period due to dependence on business and international travel, pricing remains depressed and could present attractive entry points for investment.
We work with strong, highly experienced hotel operators and focus on high quality assets in markets that we feel benefit from diverse demand generators, and where we expect limited new supply over the secular horizon.
Zavodov: In Europe, our focus is on extending hotel brand penetration. In the U.S. about 70% of hotels are branded, whereas in Europe it ranges from roughly 50% in the UK down to just 16% in Italy.Footnote22
We target unbranded hotels (or hotels with brands lacking sufficient recognition) that often have gone through a period of underinvestment either because they lacked professional management or suffered from capital constraints, often brought about by financial distress. We invest into comprehensive modernization plans, aim to reposition the properties into best-in-class differentiated product, and use the brands’ marketing channels in seeking to grow the top line at an above-market rate and generate alpha.
Chen: To summarize, the pandemic has resulted in unprecedented disruption to the hotel market globally. To capitalize on this dislocation, we have cast a wide net, investing in hotels across the capital structure in both public securities and private assets. Our investment process focuses on (i) developing an informed view of the recovery trajectory of particular hospitality segments, (ii) performing granular asset level analysis of local demand generators, competition, and potential supply, and (iii) identifying potential opportunities to generate attractive return on investment by making targeted capital expenditures. We believe our large team of portfolio managers with specialized expertise in macro lodging dynamics and on the ground capabilities are key to delivering alpha in the hotel sector.
The authors would like to thank Luke Latham for his contributions to this article.
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