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Inflation’s Ripple Effect: High Debt Costs - A Risk for Hotel Investors

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Alex Sogno in Operations

Last updated June 14, 2022

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The hotel sector has grown used to absorbing the blows as the pandemic has thrown punch after punch in their direction. Yet now, as the rather choppy recovery progresses, inflation could well be the blow that lands the knock-out punch to some in the sector.

For those with hotels situated in areas with strong tourism demand, there has been the chance to increase ADR, sometimes with the added benefit of high occupancy, to help soften the impact of wage and cost inflation, but for those dependent upon business travel, the surge in demand is yet to materialise, meaning many remain on the ropes.

Inflation - and the added spectre of stagflation - is greatly feared by both economists and the wider population alike. For those with debt, however, there at least used to be a silver lining as the loss of value in money has a corresponding effect on any debt. This is a particular favourite among some governments, who have been known to use inflation to reduce their borrowings and get out of periods of high spending intact.

But you can go too far. If inflation starts to run away, the borrowing to deal with it can outpace any reduction in value, and then a spiral begins, which is hard to break.

Away from the macro, is the mechanism traditionally used to control inflation in the form of increasing interest rates, leading to significantly higher debt coverage - a negative sting in the tail.

The hotel sector has been through a phase of borrowing just to stay afloat. While we saw Marriott International and Hilton using their loyalty programmes to raise money to build up cash cushions, for the rest of the sector, government support and additional borrowing were the route to staying afloat.

With supply chain issues, inflation, and war in Ukraine grabbing governments’ attention, supporting the hotel sector while it tries to move towards stabilised trading is not a popular issue. Many loans are now being demanded back by governments eager to balance their books.

Of those who looked to the private sector for loans and investment, many are finding money taken to save a business is harder to pay back than they had hoped, hindered as they are by inflationary pressures and increased debt costs. In addition, lenders have continually adjusted their risk appetite, leading to pressure to enforce covenants.

Hotels are finding that what kept them afloat may now sink them as they find ever-decreasing volumes of cash available to meet such demands, let alone service debt, which could drive an acceleration of loan-to-own scenarios as well as an increase in transactions in general.

A critical additional factor is the impact this scenario has in terms of the valuation methodology applied, and the increased potential for the sort of downward pressure on asset values many investors anticipated (and in some cases hoped) would lead to forced sales before now.

Although the focus on the top lines is necessary for a speedy recovery, it’s recommended asset managers and hotel owners re-run their projections: evaluate the inflation impact on their 10-year projection, and clearly estimate the risk of a high debt ratio on the discounted cash flow. It is important not to misjudge the inflation threat until it is too late.

Although tempting, it is important not to play down rising prices and concentrate only the recovery efforts on the operating departments. It is essential to evaluate the potential exposure below GOP and value the risk of rising inflation and cost of debt. Although hotel value is holding up, for now, the current market conditions will soon impact hotel valuations. Combined with the geopolitical instability, the situation may worsen rapidly.

The sector is not yet in desperate straits. The latest study from HotStats, for April, reported: “The higher cost for goods is not yet wrecking traveller appetite. Despite record gas prices, ballooning airfares and crippling inflation roiling the globe, hotel performance remained widely steady, if not getting better, in April, with increases in both the top and bottom line.”

The M&A market is, however, ticking up. 2021 was a year of strong recovery for European hotel transactions. A total of €16.4bn [1] worth of hotels changed hands, representing 322 individual transactions, 498 hotels and 79,000 rooms. Institutional investors and private equity investors were the largest net buyers as they rushed to deploy capital which had been hard to move at the height of the pandemic.

2022 is expected to show increased volumes. Lenders who have been lenient so far are expected to lose their patience, and hotels are forecast to sell rather than refinance. Some owners have been down on the canvas but bounced back due to pent up tourism demand; some cling to the ropes in the hope that improved trading will ensure few fire sales; but investors are still holding out for a bargain, and many are poised, and ready to pick up those who are forced to throw in the towel.

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Alex Sogno
CEO
Mr. Sogno began his career in New York City after graduating with honors at Ecole Hôtelière de Lausanne, Switzerland. He joined HVS International New York, and he established a new venture at the Cushman & Wakefield headquarters in Manhattan. He is the Founder of the Hospitality Asset Managers Association Asia Pacific (HAMA AP) and Middle East Africa (HAMA MEA).