Develop, divest, distribute or deal, what’s your best bet for 2009?
“Stagnant” and “frozen” are words commonly used to describe the state of today’s economy in general, but more specifically, the flow of capital therein. While 2006 and 2007 was a veritable bonanza of free-flowing capital (evidently to some sources that had no business accepting it) analysts claim we’re now suffering from an overindulgence hangover. However, if hedge fund managers are any indication, buyers and sellers always have options, regardless of the health of the economy.
In order to figure out a plan of attack, however, it’s important to know exactly where we sit in the current economic cycle. While some economists hope we’re pulling ourselves out, many see the economy languishing on the down-slope, with recovery quarters away. “Performance for 2009 will be difficult, and I’m not sure how many people realize how tough it will be,” says Neil Labatte, principle with Global Dimension Capital Inc. in Toronto. “Canada is lagging behind the U.S., as to where we are in the cycle. And while the situation is more dire in the U.S., in the end we will follow their path pretty closely, with recovery coming in 2010 and into 2011.”
Rick Matheson, managing director of RBC Capital Markets, based in Toronto, also has grim overall predictions for 2009, but he’s cautiously optimistic for the closing quarter. “There will be reduced transaction activity in 2009,” he says. “I expect the market to begin to improve in the fourth quarter of 2009 and in 2010, given the massive amount of economic stimulus expected to be provided by the Canadian and U.S. governments, as well as the dramatic decline in commodity prices, which gives the ‘employed consumer’ greater purchasing power,” he notes. What’s more, Matheson sees the returned-to-earth loonie as a bonus to hotel investors. “The depreciation of the Canadian dollar from a high of $1.08 in November 2007, to a current level of around $0.81, will also help spur Canada’s tourism industry,” he adds.
Of course, the Canadian industry could use all the additional help it can get, given the exacerbating factors that created the current strife. “This is not a normal recession like we’ve seen in the past, where the banking sector is still healthy,” says Vinnie Patel, president and CEO of the Northampton Group. “Even in the 1990s we saw some liquidity, but today lenders are absent from the marketplace. Until they are able to repair themselves we’ll see a great deal of illiquidity, which will force most people into a holding position,” he says. So where does that holding position leave us in the cycle?
“I think we’re headed towards the bottom, but we might not be there yet,” says Patel. “There will be choppier times coming over the next couple of quarters.”
While hardly optimistic in their overall outlook, none of the experts interviewed were absolute in their doom and gloom scenario. In fact, for those in the hotel business with cash on hand, 2009 could set them up for a very successful future, and not just in terms of purchasing distressed properties. “Opportunities to acquire well-located, high-quality Canadian hotel assets well below replacement cost in a major city with high barriers to entry will continue to remain of interest, but the buyer will be required to accept lower returns than available on distressed assets,” says Matheson.
However, he and others are quick to note that deals are tough to make when sellers are unwilling to initially accept their new valuation realities. “Those with limited debt might be in a position to deal, but there will be very few deals getting done in 2009, because prices are downward sticky,” says Labatte. Patel says this difficulty is part of the investment reality for the foreseeable future and agrees with Labatte’s notion. “It’s a difficult environment to operate in, but for those with a good model, it’s a good time to buy. Unfortunately, sellers are not going to sell in this down cycle, unless they are forced to,” he says. “There tends to be a difference between the valuation of the property and the price sellers are willing to accept.”
Matheson also sees a lack of valuation acceptance as a prime reason behind a slow 2009 sales landscape, but also notes reticence on the buy side as well. “The Canadian hotel investment market has experienced a dramatic reduction in sale transactions in 2009,” he says. “Specifically, there is presently a significant bid-ask spread, as the buy side has become more conservative owing to the weakening U.S. and Canadian economies, escalating job losses, wealth erosion and challenging debt markets. This year is likely to be a cyclical low for hotel sales in Canada, as challenging debt markets and opportunities to acquire distressed debt and troubled assets in the U.S. market will serve to divert global interest away from Canada.”
The difficulties in finding a seller willing to take it on the chin, so to speak, doesn’t necessarily mean the end of a property’s capital opportunities. As Labatte notes, those who have access to funds can also develop their existing properties. “It’s a good time to invest in your own properties if you’ve got capital, because others that have insufficient capital will see their properties deteriorate,” he says.
However, even that sort of approach comes with inherent risk, particularly given a precarious outlook. “It’s all about accessing capital, and achieving a return which is higher than the cost of that capital,” says Patel. “It’s the nature of our business structure. In this economic climate, it is difficult to develop assets. You must have a lot of faith in the project, because a valuation could leave you underwater.”
Like Patel, Matheson sees the environment as being unkind to those looking to reap the rewards of any developmental project, at least for now. “Development is best suited when it is possible to sell a hotel for more than it costs to build,” he says. “For the foreseeable future, investors are anticipated to be able to acquire existing properties at a price that’s well below replacement cost. The credit crunch requires developers to contribute more equity, so unless a developer is prepared to hold their investment for a longer period of time after substantial completion, while accepting lower returns than what could be earned on acquiring existing assets, new construction activity will slow until asset values start to escalate,” he says.
While most of those options are on the table, especially for hoteliers with cash on hand, the verdict is far from unanimous as to what course will reap the greatest rewards. In fact, the only consensus seems to be, that the 2010 edition of the Canadian Hotel Investment Conference should be a more optimistic one.