Although the costs of owning and running hotels are increasing, data shows most hotels are earning enough to pay for their debts even through a downturn.
REPORT FROM THE U.S.—Revenue per available room growth for the U.S. lodging industry will be limited to less than 2.5% through 2020, according to CBRE’s latest “Hotel Horizons” forecast.
Further, CBRE is projecting a 0.6% decline in RevPAR for 2021 as the economy is expected to slow down during the year. The combination of modest increases in revenue and rising operating expenses (especially labor) make hotel owners and operators nervous about their ability to enjoy profit growth over the next few years.
While the profit growth story is concerning, it should be noted that current gross operating profit margins are 500 basis points above the long-run average and at their highest level since the 1960s. Therefore, if underwritten properly, owners should be receiving attractive returns on their investments.
Another way to assess the bottom-line health of the U.S. lodging industry is to examine the ability of hotel owners to meet their debt obligations. If hotel operations are generating enough funds to pay the interest on the loans taken out by the owners for purchasing, building, furnishing or operating their properties, the investment and lending community is at ease.
One metric used to analyze this is the ratio of cash flows to the interest payments made by the hotel. For this article, we analyzed the relationship between the earnings before interest, taxes, depreciation and amortization and interest expenditures of 613 U.S. properties for the years 2015 through 2018. Also, we reviewed the rent payments of the hotels under study to gain insights about total fixed obligations but found that these payments are modest relative to interest costs and not consequential enough to change our results.
In 2018, the study sample of 194 rooms achieved average occupancy of 74.6% and $163.35 ADR. In aggregate, interest payments equaled 10.4% of total operating revenue during the year.
In 2018, the hotels in the study sample achieved an EBITDA to interest payment coverage multiple of 2.6. Because of the recent slowdown in revenue and profit growth, this multiple has declined from a high of 2.9 in 2016. Based on historical analyses performed by CBRE, the interest coverage multiple typically exceeds 2.5 during prosperous periods in the lodging industry business cycle. Therefore, coverage multiples of more than 2.5 can be considered strong.
By chain scale, interest coverage in 2018 was highest for upper-midscale properties (2.8), followed by economy/midscale and upper-upscale (2.7). The lowest ratios were observed at hotels operating in the upscale (2.5) and luxury (2.6) categories. While relatively low, both measures are above the desirable 2.5 coverage ratio benchmark.
Of the 613 properties in our sample, 94% were able to achieve sufficient levels of EBITDA to cover their interest payments in 2018. Like with the interest coverage multiple, the percentage of hotels able to cover their interest payments peaked in 2016 at 96.1%.
Given CBRE’s modest forecasts of revenue for the next five years, how will this impact the ability of hotel owners to continue to pay their interest obligations? To estimate future interest coverage ratios, we utilized forecasts of profit growth generated by our proprietary Investment Performance econometric forecast model to drive future levels of EBITDA.
At the time this article is being written, there are opposing thoughts among economists regarding the future direction of interest rates. While opinions differ, no projections call for extreme movements up or down. Therefore, we have opted to hold interest payments constant at 2018 levels for this analysis.
CBRE’s baseline forecast for future U.S. hotel profits calls for gains of roughly 2% in 2019 and 2020, but a decline of 1.5% in 2021. The falloff in 2021 is attributable to an assumed slowdown in the economy during 2020 that will impact lodging demand the following year. After the blip in 2021, profits are projected to recover at approximately a 3% pace in 2022 and 2023.
Given the preceding pace of changes in EBITDA, and holding interest payments constant, the interest coverage ratios will remain above 2.5 from 2019 through 2023. Even during a 2021 slowdown, the ratio drops to a low of 2.7, which is greater than the 2.6 ratio observed in 2018. The interest coverage ratio peaks at 2.9 in 2023.
During 2021, 94.3% of the study sample should still be able to achieve EDITDA levels greater than their interest expenditures.
Each quarter, CBRE produces alternative lodging forecasts based on a variety of economic assumptions. To test the ability of U.S. hotels to cover their interest payment obligations during potential future stressful economic environments, we used the two most pessimistic economic forecast scenarios and resulting profit projections.
The economic scenarios are labeled as “downside” and “extreme downside.” The “downside” scenario assumes flat or declining levels of employment during the years 2020 through 2022. The “severe downturn” scenario calls for sharp declines in employment, income and CPI during 2019 and 2020.
Using the profit change assumptions of the “downside” scenario, and holding interest payments constant, the interest coverage ratio dips to a low of 2.5 in 2021 and 2022. During this year, an estimated 93% of the properties in the study sample will be able to achieve EDITDA levels greater than their interest expenditures.
Under the “severe downside” scenario, profits are forecast to decline by 11% in 2019 and another 22% in 2020. In light of the lower levels of EBITDA, the interest coverage multiple drops to a low of 1.8. While this is below the current highly desirable 2.5 mark, it does allow for 87%, or more, of the properties in our study sample to generate sufficient levels of cashflow to cover their interest payments.
Even during the most extremely negative circumstances, a surge in outright defaults does not appear to likely in the future. However, a lowering in interest coverage ratios could have some implications. Any downward movements in debt-related ratios could spook a skeptical lending community, which in turn could have a negative impact on the availability of loans and favorable financing terms. Plus, existing loan agreements have performance clauses in them. A decline in coverage ratios could trigger a change in financing terms or require the borrower to reserve more cash.
The relatively strong interest coverage ratios that persist even through the dourest economic forecasts are a significant indication of the positive health of the U.S. lodging industry. As of May 2018, the growth story for U.S. hotels may not be impressive. However, the current and expected levels for lodging profits, returns, and debt coverage are strong.
Robert Mandelbaum is director of research information Services for CBRE Hotels Research. John B. (Jack) Corgel, Ph.D., professor of real estate at the Cornell University School of Hotel Administration and senior advisor to CBRE. To benchmark the profits of your hotels, please https://pip.cbrehotels.com/property-analytics/benchmarker. This article was published in the July 2019 edition of Lodging.
The assertions expressed in this article do not necessarily reflect the opinions of Hotel News Now or its parent company, STR and its affiliated companies. Please feel free to comment or contact an editor with any questions or concerns.