By Jack Corgel, Ph.D., Senior Advisor, CBRE Hotels Research
A small piece of cardboard with NBA super star Luka Doncic’s picture and autograph recently sold for $4.6 million. Foolish? Au contraire. This is his rookie card from a rare set. Now, if it were a signed Tom Brady rookie card - even though more widely distributed - who would not fork over $1.32 million, as did FitBit CEO, James Park? From another part of the professional sports world, I was struck by recent comments by Dallas Cowboy owner Jerry Jones at the signing of talented quarterback Dak Prescott to a lucrative multi-year contract. When asked about the size of the contract, Jones responded:
"The truth is, most anything that I've ever been involved in that ended up being special, I overpaid for, every time, to the end. Anytime I've tried to get a bargain, I got just that, it was a bargain in a lot of ways and not up to standard."
Institutional investing in securities and alternatives, such as commercial real estate, operates quite differently from collector and human talent acquisitions. Decision makers are professional managers of others’ money, often with considerable discretion. They must ‘hit’ return targets or be fired. Managers may not readily admit to overpaying but sometimes it is the best path to generating oversize returns that ‘beat the bogie’ (i.e., a return index, such as NCREIF, or a target return in management contracts). The concept of overpaying sometimes goes by the code words ‘paying up.’
Hotel occupancies, room rates, and values dipped in 2020 more than financial performance measures in any other sector, save other hospitality businesses (e.g., restaurants and cruise lines). The CBRE Hotel Horizons® forecasts call for a general recovery of hotel markets in the U.S. by 2025. But this recovery may look substantially different from the latest two recoveries - the post Global Financial Crisis and post 9/11 periods. Potential structural changes in the geographic distribution and occupancy mix of demand will influence the recovery timeframe. The cities that provided solid investment returns in 2019 may lag other cities in 2023 and beyond. The business hotels that provided solid investment returns in 2019 may underperform leisure hotels in the future. The types of hotels that investors will ‘pay up’ for in the coming years may differ from those selected prior to the COVID-19 pandemic.
When and How Overpayment Occurs
Public transactions involving hotel properties either occur in a listing market (including private placements) or at auctions. The potential for overpaying in auction environments is well known. Only a small percentage of hotels transact through auctions, thus the interest here is with listing markets. Buying at more than the list price does not necessarily define overpayment because list prices may be set below fundamental values. Purchasing at prices more than investment model valuations is a reasonable, albeit imperfect, way to identify overpayment. Some investment models are better than others.
The theory of Positive Economics promoted by Nobel laurate Milton Friedman says that models should be judged by how well they predict, not on their assumptions. Every experienced market participant I have known has a hotel investment model that is constantly refined to enhance accuracy. Hence, we can feel comfortable that:
Overpayment = Transaction Price – Modeled Fundamental Value Estimate.
But not with:
Overpayment = Transaction Price – List Price.
Overpayment benchmarks sometimes exist. For example, in a corporate acquisition the premium above an approximate 15-day historical average share price generally runs in the 20 to 30% range. A price per share paid above this range signals overpayment. In property transactions, bargains may be identified by acquisition prices consummated at below replacement cost, but no universal benchmarks are known for premiums or overpayment.
Hotel Investment Moving from Value to Growth
The next few years will bring notable changes in the hotel property markets. Investors have already begun to seek growth opportunities as the number of value opportunities fades. Those value investments occurred because of owner distress and rotation out of hospitality assets. In 2020, value investors capitalized on time arbitrage and snapped up distressed assets at a +/- 30 percent discount to pre-pandemic levels as valuations reflected a steeper discount than projected cash flow and asset appreciation over a typical investment horizon would suggest. Now, investors are attempting to predict how the altered state of hotel demand will generate revenue growth up to stabilization and perhaps new highs. A representation of recent past and expected hotel real estate investment strategies appears in Exhibit 1.
Blackstone Real Estate Partners’ and Starwood Capital Group’s offer to privatize Extended Stay America (STAY) exemplifies this transition. A recent Wall Street Journal article (3/21/21) explained that Blackstone
“…became an investing powerhouse by making successful bets on undervalued companies. For the next leg of its expansion, the firm is focused on companies with big growth prospects, even if it has to pay up for them.”
News reports about the impending STAY transaction mentioned the acquirers feel that while STAY survived the pandemic better than other types of hotels, the guests were lower rate non-corporate customers. Post pandemic they believe strong growth will occur as the result of increased occupancy from higher rate corporate customers as companies return to more normal levels of business travel and short-term relocations. Incidentally, the $19.50 per share offer for STAY is hardly a large premium or overpayment at approximately 15% over the recent closing price.
Question to Experts: What hotels would you overpay for today?
With the preceding thoughts on overpaying as a background, four hotel investment experts share their thoughts on which hotels investors can overpay for and still receive excess returns during the upcoming seven-year holding period.
Here are their responses:
I would likely pay up in markets with heavy reliance on leisure with minimal corporate contribution (other than life sciences and pharma). Some examples include Waikiki, coastal California and Napa/Sonoma resorts, Florida resorts, New Orleans, select ski resorts with a summer season such as Aspen, Jackson Hole, maybe Tahoe, Nashville CBD, and hotels adjacent to large research hospitals, such as a medical center in Houston, the Cleveland clinic, and Philadelphia Children’s Hospital.
I would overpay for hotels in markets with barriers to new supply and high relative ADRs. Some examples include Beverly Hills, Santa Monica, Key West, Charleston, California Wine Country, Aspen and niche markets like Newport, RI, and certain resort locations in Florida.
This response emphasizes two important tests for overpaying:
· Market and location characteristics - The market infrastructure needs to be able to accommodate meaningful future growth. Specifically, modern transportation systems, attractive quality of life attributes which encourages migration, and a diverse labor force.
· Property attributes - Hotels with many moving parts warrant a premium (e.g., multiple restaurants, spa). These types of hotels are also difficult to replace. Future growth of hotel profits will come from substituting capital for labor.
This expert would overpay for existing beachfront (or within two short blocks thereof) hotels in Sunbelt locations built during the 21st century regardless of market segment.