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Potholes around hotels and West Coast multifamily

| December 13, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Lower but positive economic growth and solid commercial real estate fundamentals should keep the CMBS market humming in 2020. But a couple of potholes warrant careful navigation: the hotel sector, where performance has recently turned negative, and any expansion of West Coast affordable housing initiatives that rely on property acquisition through eminent domain.

Hotel sector weakens

Lodging industry performance generally follows economic performance, with hotel occupancy and average daily rates (ADR) rising as the economy expands and turning negative during periods of contraction (Exhibit 1). The hotel industry rebounded from the crisis by 2010, when growth in occupancy and average daily rates turned positive. The US hotel industry, like the overall economy, has enjoyed a nearly 10-year period of expansion although the growth trend has slowly declined over the past few years.

Exhibit 1: Trends in US hotel occupancy and average daily rate

Note: Data shows year-over-year changes in occupancy and average daily rate (ADR) as a 12-month moving average, from January 1990 through October 2019. Changes in occupancy tend to lead changes in ADR on both sides of the cycle. Source: Smith Travel Research (STR), Hotel News Now.

Another primary metric for hotel performance, after occupancy and average daily rate, is revenue per available room (RevPAR), as it is most closely aligned with average revenue of the property as a whole. Revenue per available room follows the strong seasonal pattern evident in occupancy rates (Exhibit 2), while the average daily rate tends to fall more modestly during months of low occupancy – November through February – and rise during the summer months of highest occupancy.

Exhibit 2: Hotel performance metrics (monthly, since 2016)

Source: STR, Hotel News Now, Amherst Pierpont Securities

The weakening growth in hotel performance metrics first turned to outright declines in occupancy rates and RevPAR in mid-2018 (Exhibit 3). In October 2019, All three metrics exhibited monthly declines for the first time since 2010. The driving issue is not a softening of the economy but an increase in supply as more new or renovated construction comes online. The increase in supply is outpacing the increase in demand, which de facto drives down occupancy rates across the industry.

Exhibit 3: Growth (declines) in hotel performance metrics (year-over-year changes, since 2016)

Note: Occupancy and RevPAR exhibit strong seasonality and are extremely sensitive to calendar shifts of holiday weekends. Year-over-year changes in monthly data can be noisy, though longer-run trends are still apparent. Source: STR, Hotel News Now, Amherst Pierpont Securities

The pace of construction has tempered somewhat but remains robust, with 205,000 hotel rooms under construction in the US in October, an increase of 5.5% year-over-year. Construction activity in lodging had been growing at a rate closer to 10% for most of 2019, so the recent drop represents a moderation. The rooms in the pipeline are tilted toward the luxury segment, with 10.9% of existing supply currently under construction.

The consensus outlook for the US lodging sector is for revenue per available room to average 0.8% growth next year. This seems optimistic given the trends in all three performance metrics have recently turned negative, and new supply is forecast to outpace demand at least through the first half of 2020. The hotel sector is perhaps the most vulnerable in commercial real estate to a slowing or disappointment in economic growth, and caution is recommended when evaluating hotel exposure in 2020.

Pockets of agency CMBS exposed to affordable housing initiatives

The monkey wrench of 2019 in agency CMBS was the King County Housing Authority (KCHA) expanding their workforce housing via exercise of eminent domain. Three of the properties taken had mortgages outstanding from Fannie Mae and Freddie Mac in securities with significant price premiums. The impact in the agency CMBS market has been a widening of spreads in any security with exposure to multifamily properties in King County, to discount the potential for principal to be returned unexpectedly at par.

The KCHA is expected to continue acquiring existing workforce housing for another two years to three years as the agency deploys more funding provided by Microsoft. The parameters that KCHA has so far identified as consistent with their priorities for acquisition are somewhat narrow, but unless and until the agency makes it clear to the market that it will not deviate from those parameters, CMBS with exposure to multifamily properties in that jurisdiction will likely continue to trade at a discount.

It is completely unknown if similar purchase or eminent domain actions will be undertaken in metro areas of California. High priced markets including Menlo Park, San Jose and the Bay Area recently received significant investments from Google, Amazon and Facebook, to build and preserve affordable and moderate income housing. Detailed plans for addressing the severe shortage of affordable housing in the areas – and for deploying the funds provided by the tech companies – have not yet been released.

The strategy employed by KCHA of acquiring existing, older properties that were in danger of gentrification to preserve affordable housing was arguably a stroke of genius. The use of eminent domain in some instances was likely the most cost efficient and legally expeditious solution for the local government. It will be interesting to see if other state and local governments adopt the same tactic, as it could have dramatic repercussions in the multifamily market for agency CMBS investors and property owners.

 

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