Economic Activity and Hotel Demand in D.C.
According to George Mason University’s Center for Regional Analysis, the Leading Index for the Washington MSA, which provides a projection of future economic conditions based on an amalgam of indicators, has seen month-over-month increases since the fourth quarter of 2009. While the market lost almost 8,800 jobs between March 2009 and March 2010, D.C. fared better than any of the other top 15 job markets in the country and still has the lowest unemployment rate among this group. During the 2009-2010 period, the federal government added approximately 16,000 jobs, with another 11,000 brought about by the expansion of the education and health services industries. These increases were not enough to offset the loss of jobs in construction, state and local government, and information services. But being the type to spark office demand, the new jobs should in turn drive hotel demand in the near future.
The Center for Strategic Research predicts employment growth in the Washington MSA of 24,900 jobs in 2010 and 34,900 jobs in 2011. By 2012, the Center predicts an additional 42,400 jobs, meaning the market will again exceed its 28-year average of 37,000 new jobs per year. Much of the recent and projected near-term expansion is in response to the stimulus packages passed in 2009, along with new or expanded federal agencies, bureaus, and departments. Furthermore, corporate presence in the D.C. market is expanding. With the recent announcement that Northrop Grumman will relocate its headquarters from California to Northern Virginia, the region will soon be home to 18 Fortune 500 company headquarters.
So what does the expansion of federal government and the growth of the private sector mean to hotel values in the D.C. area? In short, they’re heading up.
Transient demand is already on the upswing. Our interviews with general managers of many of the smallest and largest hotels in the market revealed a clear consensus that demand for both business and leisure travel grew through the first quarter of 2010. It’s no secret that between last year’s TARP legislation and this year’s health care and financial reform bills, the catalyst of economic activity for the country rests somewhere between 1600 Pennsylvania Avenue and North Capitol Street.
Moreover, the expected groundbreaking of the convention center headquarters hotel has brightened the outlook for group demand. This 1,175-key Marriott Marquis is expected to induce demand to the convention center and much of the D.C. hotel market by providing for more citywide conventions.
Hotel Transactions Activity, Values, and Cap Rates
Demand growth has not yet led to an increase in hotel transactions. The only major sale in the past six months was the purchase of the Sofitel Lafayette Square by LaSalle Hotel Properties. This luxury property sold for just over $400,000 per key, far below the peak of the Four Seasons sale ($800,474 per key) in 2006, but perhaps a sign of things to come. The Sofitel sold at a 5.5% overall capitalization rate (cap rate) based on 2010 numbers. In a press release about the purchase, Michael Barnello, President and CEO of LaSalle Hotel Properties noted that “Washington, D.C. continues to be one of the strongest markets in the U.S.”
HVS interviews with managers, brokers, owners, and management companies revealed that there is no shortage of interest on behalf of buyers of D.C. hotels—there’s just nothing for sale. To help project where investment return rates are heading for D.C., we considered the trends of overall cap rates for alternative real estate investments in D.C. relative to the rest of the country, then extrapolated the trajectory of hotel cap rates in the D.C. market. The following table and chart quantifies the spreads between the National Urban Office markets and the D.C. Office market as tracked by PricewaterhouseCoopers/Korpacz (aka the Korpacz Survey). We have presented the trend leading into and through the current recession. The following chart illustrates cap rate trends for hotels and office buildings over the past seven years.
The following table presents first-quarter cap rates for national office markets vs. D.C. markets since 2003.
The data show that spreads between the D.C. CBD office market and the National CBD office market are growing. This suggests that investors view D.C. more favorably than the typical CBD. This sentiment holds true for the two close-in submarkets of D.C.: Northern Virginia and Suburban Maryland. The average overall rates in both these locales are lower than those of the National Suburban Office market. Furthermore, cap rates have either held steady or decreased in the most recent quarter when compared with the fourth quarter of 2009.
So what does this mean for hotel cap rates in D.C.? Traditionally, overall rates for hotels have been at least 100 basis points above other investment types. This increased return was always considered reasonable given the greater risk in needing to “lease” the property on a nightly basis versus the long-term leases on office, retail, industrial, or even apartment buildings. The following table shows the spreads for hotel cap rates over their respective office markets.
As one might expect, the spreads for limited-service hotels were much higher than in the luxury category because the low barriers of entry for these assets allow for more potential buyers, thus more competition on price. These spreads are illustrated in the following table.
Still, toward the second half of the past decade, spreads between hotels and other real estate assets came in as more capital became available to chase deals. Specifically, between 2007 and 2008, the impact of CMBS money drove cap rates to all-time lows across the board and narrowed the gap between overall cap rates for hotels and other commercial asset classes. With the financial meltdown that followed, overall cap rates shot up, with hotel cap rates outpacing the rest of the herd.
Did hotel cap rates rise too much? Well, this depends on whom you ask. Most recent hotel acquisitions, including the Sofitel, were not made based on cap rates, but rather long-term holds or turn-around opportunities. Still, with sidelined money itching to get back in the game, there has to be downward pressure on rates as bidding competition heats up for quality assets in good markets. Furthermore, several institutional lenders we surveyed implied that since they are facing greater competition placing multi-family and office loans, they are considering doing more hotel loans, and more hotel underwriting would put additional downward pressure on overall rates. This will likely be borne out in the luxury and full-service segments first, again due to the higher barriers to entry for these product types.
Conclusion
The evidence of lower cap rates for D.C. assets is clear. If cap rates are heading down for D.C. real estate investments—and we expect that cap rates are stabilizing if not falling for some hotel asset classes nationally, as well—then it follows that D.C. hotels, especially luxury and full-service hotels in downtown D.C. and its immediate suburbs, should also fall. The table shows that the average cap rate for downtown D.C. office buildings is currently 7.11 percent. Furthermore, the cap rate spread premium for luxury hotels and national CBD office buildings is just under 100 basis points, and the premium for full-service hotels is about 175 basis points. It follows that the cap rate spread between D.C. luxury hotels and D.C. CBD office buildings is less than 100 basis points, while the full-service premium is less than 150 basis points. Thus, if top-end office buildings are selling for sub-7% cap rates, then luxury hotels should be in the low- to mid-7% range, with full-service hotels just above the 8% mark.
Beyond the cacophony from Capitol Hill, we can hear a more pleasing strain with respect to property values and cap rates. It will take some time, but the evidence shows that these will come back into concert for area hotels, leading to a livelier transactions market and healthier times for the industry overall. The HVS consulting and valuation office in Washington is keeping tabs on hotel trends in markets throughout the Mid-Atlantic. Please call or write David Fuller, MAI (202) 828-9666 or dfuller@hvs.com) to learn more.
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