Continued momentum is expected in 2012
The Conference Board of Canada predicts Canadian GDP growth will hover around 2.4 per cent in 2012. While this might not be overly bullish, extensive and diverse debt and equity sources, historic low interest rates and a stable financial infrastructure make Canada a highly attractive market for domestic investors. Fortunately, Canada continues to garner broad international interest from investors who recognize the importance and surety of Canada’s strong banking system, wide-ranging resource-based economy and fiscal discipline throughout business sectors. These traits have provided the foundation for a healthy upswing in hotel transaction activity, rather than the unsustainable frenzied activity witnessed in 2006 when mergers and acquisitions activity was at its zenith.
In the first quarter of 2012 hotel transaction volume was 151 per cent ahead of the same quarter last year, representing an increase of 27 per cent over the fourth quarter of 2011. Building on year-end 2011 transaction volume of $1.2 billion, almost three times greater than the recorded volume just two years earlier, the availability of product on the market, improved consumer and business confidence and the general sentiment that debt will remain available and affordable in the foreseeable future, CBRE Hotels projects Canadian hotel transaction volume could reach $2 billion in 2012.
Throughout much of 2011 investors witnessed volatile international markets, tempered consumer confidence and stalled debt markets, particularly in the Eurozone. In the United States, 2011 was characterized by economic setbacks, including slowed residential and commercial construction. Government debt woes and a build-up of distressed properties for sale also contributed to a somewhat tempered outlook for 2012. Canada was not immune to these global forces. However, the country and its commercial real-estate markets continued to represent stability and predictability in a world characterized by uncertainty and risk. The country’s low exposure to European debtors, countered by solid domestic credit markets lead to readily available consumer and business credit, which in turn supported the robust transaction activity experienced in 2011. There was a 10-per-cent increase in the number of hotels sold, which will be the impetus for continued momentum in 2012. The number and diversity of deals being brought to market is escalating and with cap rates and pricing stabilizing, these will drive activity. That said, buyers are willing to pay a premium for value and redevelopment enhancements and these opportunities will continue to attract worldwide, competitive attention.
Transaction activity began to build in the second quarter of 2011 when quarterly activity quadrupled with the sale of the Sutton Place Hotels in Vancouver and Edmonton ($197.5 million) and the Delta Vancouver Airport ($55 million). The year continued with the landmark sale of the InterContinental Toronto as part of the Metro Toronto Convention Centre Complex ($237.4 million for the entire complex, including the hotel, convention centre and office building) and the four-hotel Concord Hospitality portfolio ($71.1 million). In 2012, large-scale transactions have included the sale of the Four Seasons Hotel Toronto for redevelopment (pricing confidential), Radisson Fort McMurray ($25.1 million) and Four Points London ($19 million). The trend to convert hotels to residential condos when there is a convincing development story is apparent, not only from the sale of the Four Seasons, but also from the pending sale of the Sutton Place Hotel Toronto.
Canadian private investors continue to dominate, but there is renewed interest from private equity, hotel investment companies, REITs and sovereign wealth funds. With few exceptions, non-domestic investors have been virtually absent buyers since 2006 when they represented more than half of total volume. We are witnessing a noticeable spike in interest by American investors as well as off-shore groups, largely from Japan, Singapore, Malaysia and China. Although few deals have yet to be finalized with these buyers, we believe foreign interest will strengthen, particularly for highly recognizable cash-flowing assets in high barrier-to-entry markets.
Canadian commercial mortgage transaction volume also continues at a strong pace in 2012 with significantly more debt available to support escalating transaction activity. Deal structures have shifted somewhat in favour of the borrower compared to 2010 when underwriting guidelines remained stringent coming out of the global economic recession. However, lenders continue to favour the institutional type of agreements that judiciously use leverage.
As lenders and investors look for more asset allocation, deal support remains solid and is showing signs of strengthening for hoteliers with strong flags, professional management and business- oriented locations. Large corporate portfolio and individual single-asset financings occurred last year. Pension funds, life insurance companies, private lenders, tier-1 banks, regional banks, credit unions and government-sponsored lenders were active and appear to be gearing up their lending capital for more aggressive deployment for the balance of the year.
Deals are being completed with leverage in the 50 to 65 per cent loan-to-value range. Debt-service coverage ratios are typically 1.50 times or greater. While hotels still command a slight pricing premium, interest rates remain historically low and spreads in the 250 to 350 basis points range translate to extremely attractive finance rates of 4.5 to 7.5 per cent (five-year term) depending on asset quality, location and covenant strength. In some instances, for upscale and luxury hotel properties, spreads may break the 200 basis points level and dip as low as 175 basis points. For hotel properties that sit on corporate balance sheets, covenants are more geared to maximize debt/equity and minimize earnings before interest, taxes, depreciation and amortization (EBITDA) and interest multiples with standard carve outs and cross-default provisions.
In terms of new supply, we’re in the early stages of the development cycle. The increased availability of debt and strong economic activity levels in resource-based markets has spurred new hotel development in several secondary and tertiary markets. New development continues in larger markets as hotels capitalize on robust condominium markets in Toronto, Montreal and Vancouver.
As we approach the mid-year mark there is optimism that activity within the Canadian hotel investment sector will be dynamic throughout 2012. But, in contrast to the past rising markets, the sector has the benefit of strong underlying operating fundamentals, plentiful debt and overall confidence.