By Brian Flood, AACI, P.App., MRICS
In our role as commercial real estate appraisers, we are tasked with providing value estimates on hospitality assets across Canada. Markets differ widely across the country, with different influencers impacting hotel results and values. In the current hospitality landscape, most of the country has seen substantial increases in property values over the past five years. As values have continued to rise, we are increasingly asked “are current values (in the hospitality sector) too high?” and, “are these values sustainable?”
The answer to the first question might seem obvious since current hospitality values are at a record high in many parts of the country. However, “too high” is a relative term and needs to be given some context. Are values significantly above historic levels? Yes, they are, however, these elevated values should be considered in the context of stronger operating results, increased earnings and strong investor demand driving bullish investment parameters.
Numerous sources indicate a strong growth in top line results over the last five years and this has continued to extend into 2019. According to Smith Travel Research data, Canadian Revenue per Available Room (RevPAR) has grown by a compounded annual rate of 5.0 per cent over the last five years. In key markets, the rates are stronger: 6.2 per cent in Montreal, 7.7 per cent in Toronto, and 12.1 per cent in Vancouver. This growth in top line revenue actually grows net operating income disproportionately, as many operating costs are fixed. As a result, the flow-through to the bottom line increases at a higher rate, impacting on hotel values.
Another factor impacting values is the incredibly strong demand for hotel investments. Capital continues to be attracted to the sector with new lenders and investors looking for opportunities. But hotels are not unique in this regard as demand has strongly increased in all sectors of investment real estate. In fact, the hospitality space is one area where there are still premium returns to be had, as compared to these other sectors. Hotels still provide premium returns, typically in the range of 100 to 200 basis points (bps) above equivalent quality office or retail properties.
In our Valuation & Advisory practice, the primary method of valuation for hotels remains the Income Approach – Direct Capitalization and Discounted Cash Flow. Applying market-based capitalization rates to higher income levels has resulted in record per-room values in markets such as Toronto, Vancouver, Ottawa, and Montreal. Markets outside of these areas such as Winnipeg, Quebec City, and Halifax have also seen strong value growth.
To validate our values, we reference market transactions to benchmark the value estimated through the Income Approach analysis. This approach has been a challenge of late with relatively few transactions of better quality assets trading in key markets. When values rise, the market takes time to adjust to the new pricing and there are often considerable spreads between initial seller and buyer expectations. As well, owners are often reluctant to trade well-performing assets and reinvest their capital unless pricing becomes compelling.
This lack of available hotel investments has motivated some investors to consider development as a way to enter or expand market presence. As a result, when pricing existing assets, investors are keenly aware of the cost to develop hotels. They are also aware that these hotel development costs have escalated in the last three years with land becoming an increasingly rare and expensive commodity. When factoring in the time and risk in developing a new project, investors are far more motivated to acquire existing assets.
In Q2 of 2019, we are beginning to see transactions occur that confirm the rise in income-based values. Markets such as Montreal and Toronto are seeing a surge in sales activity. As these transactions close over the next 3 months, new value benchmarks will be set.
Is the current market sustainable?
Historically, the hotel market has seen cycles in earnings and values. As the economy progresses, so does the hotel sector. Like the economy, despite periodic setbacks, the long-term trend has been upward and we do not expect this to change. Of some concern is additions to room supply, however, the barrier to entry is relatively high given the scarcity and cost of land, and the cost to develop. To date we have seen new hotels absorbed rapidly in stronger markets. That is not to say the market can continuously absorb higher levels of new supply, but over the longer-term, new supply will eventually be absorbed.
As with any investment, a long-term hold strategy underlies successful investment in the sector.
Brian Flood is vice-president and practice leader, Hospitality and Gaming, at Cushman & Wakefield ULC in Canada. He has provided advisory and valuation services to the hospitality industry for 35 years. Cushman & Wakefield's practice includes market and feasibility studies, appraisals, development strategies, litigation support, and other services associated with the tourism and hospitality industries across Canada. Contact him at: firstname.lastname@example.org