Rising Interest Rates – Yet Another Blow to Hospitality Industry
10.4.22 | Industry Insights
With the end of so-called “free money” now a reality, the hospitality industry — still dealing with the aftereffects of COVID-19 — must now factor rising interest rates into its recovery equation. On September 21, to tame the four-decade high red-hot inflation, the Federal Reserve raised benchmark interest rates by another 75 basis points bringing them to a range of 3.00% to 3.25% and indicated that it is prepared to raise the interest rates to 4.60% in 2023.1 As a result, the 10-year treasury yield is now hovering near 4.00%.
Rate Hikes Impact Hospitality Industry in Multiple Ways
As rates continue to climb, hospitality industry executives will need to address several new concerns, including:
- Servicing debt is becoming more expensive for all variable-rate borrowers. For hoteliers that are still struggling to come out of the effects of the pandemic, rising interest rates make servicing existing variable rate debts more expensive and add a further financial strain to the bottom line. According to Fitch Ratings’ estimates in February 2022, hotel CMBS loan delinquency, which topped upwards of 18.00% during the pandemic peak and had since retreated to a high single digit, was projected to end 2022 at 5.50%, higher than the pre-pandemic delinquency rate.2 There is concern that rate hikes may lead to a higher delinquency rate.
- Refinancing for existing fixed rate borrowers. Hoteliers with existing fixed-rate debts that are maturing in the short-term, and are looking to refinance, should expect to shed more for interest going forward. Alternatively, the owners may consider putting in more capital to bring the loan-to-value (LTV) ratio down to a more sustainable level. Ideally,
LTV ratio should be no greater than 80%. Anything above that mark is considered a high LTV ratio, and the borrowers may be hit with higher borrowing costs.
- Rising development costs. Along with rising wages, ongoing inflation, and the bottleneck caused by supply chain issues, higher interest rates add to the construction costs of new developments. If construction costs continue to increase, the new development bottleneck will only worsen, likely dampening new hotel developments even further. As a result, developers may be forced to stall current or future developments if it is not feasible to complete the projects within the set budgets.
- Rising cap rates and their effect on hotel valuations. According to a study by Cornell Center for Hospitality Research, a 100-basis-point increase in a 10-year treasury rate results in a 28-basis-point increase in hotel cap rates.3 Therefore, rising interest rates may lead to an increase in hotel cap rates, which could negatively impact hotel valuations and create challenges for debt refinancing discussed above or deal making discussed below.
- Adverse effects on M&A (deal-making) activity. Rising interest rates lead to a higher cost of capital, which is the return on investment that investors seek for investing in a riskier deal. Higher cost of capital and expensive debt puts negative pressure on hotel valuations, resulting in wider bid-ask spreads and fewer deal-making transactions.
There Are Some Bright Spots for Hospitality Industry
Due to the short-term nature of the room rentals, hoteliers can adjust and raise room rates to cope with the rising inflation. Even in this inflationary and higher interest rate environment, the more established investment and private equity firms with access to capital and reasonable debt can still be players. Also, given a strong dollar, there may be a market for more overseas purchases.
Questions: I can be reached at 212.331.7493 | SmShah@berdon.com, or contact your Berdon advisor.
1 The Fed forecasts hiking rates as high as 4.6% before ending inflation fight