Hotel Investment based on operating performance has turned red. Our Economic Value Added (EVA) indicator shown in Exhibit 1 has turned negative, declining from -.6% (near zero; breakeven) to -1.8% in 2014Q1. What is more alarming is that the hotel cap rate (5.7%) is approximately equal to the cost of debt financing (5.6%) for hotels financed by large life insurance companies, as shown in Exhibit 2. Intuitively, the cap rate represents the return on hotel properties assuming all-equity financing. The use of debt financing is used to magnify the return to hotel properties. For positive leverage (return magnification) to occur, the cap rate should exceed the cost of debt financing, meaning that your return should be greater than your borrowing cost. We will show that the current situation arises because of cap rate compression (a decline in the cap rate) due to a rise in hotel prices. In summary, what these two exhibits suggest is that financial feasibility is becoming more tenuous and investors are having a harder time getting a potential hotel investment to “pencil out.”
Liu, C. H., Nowak, A. D., & White, R. M. (2015). Cornell Hotel Indices: Second quarter 2015: hotel deals are getting harder to pencil out [Electronic article]. Center for Real Estate and Finance Reports Hotel Indices, 4(3), 1-19.