Featuring Michael Simpson and Troy Craig
Thursday 3 December 2020
CC:
Hello and welcome to Talking Property with CBRE. A podcast in which our team of experts share their commercial real estate insights. My name is Chinmay Chitale, Head of Hotels Research here in Australia, and I'm your host for today's episode.
Over the next little bit, we'll be talking about how the hotel sector shaped up in 2020 and what our expectations are for 2021 as the industry navigates its way through its most challenging period in history.
I'm joined by Michael Simpson, Managing Director of Pacific Capital Markets, and Troy Craig, Regional Director of the Valuation and Advisory Business. Thanks for joining me guys.
Michael, the challenges facing the hotels sector have seen many investors adopt a wait and see approach when it comes to purchasing hotels. However, we've started to see some pick up in sales activity over Q3 and at the start of Q4, with a number of major hotel portfolios now on the market for sale. What type of buyers out there purchasing these assets and how they getting these deals of the line?
MS:
Thanks, Chinmay. Look, most people know investors really don't like uncertainty, and obviously, at the peak of the pandemic and at the early stages we used the word ‘unprecedented’ all the time. But it was something that most people if not all people in this generation have never seen. So, we're in times of high uncertainty, and in those times, investors find it very difficult to price those risks so simply they don't and we had no or very little transaction volume because there was limited evidence for recovery in sight.
Now we've got a lot of talk about vaccines and not just vaccines at some nebulous point in the future, but potentially being available within the next few months. There's been a very significant amount of stimulus measures implemented by governments all around the world, and it really feels like a recovery is in sight and were looking towards the future and looking towards some more certainty. So, we think that that will start to free up some transactions.
In terms of who the buyers are, we're seeing three key buckets of buyers, the first are long term owners who have investment views that span 10, 20, 30 or even more years. Those buyers have the ability to look through a short-term earnings volatility and aberrations and to buy in these times and potentially buying assets that they may have been priced out of the during other times or that just simply were not available. We're not on the market in the good times. The second bucket is private equity or opportunistic style investors, so they're looking for quite steep discounts to pre-COVID valuations. They’ve raised a lot of money, they’ve got a lot of money to deploy, but they're very selective about how that money is deployed. The third bucket that we're seeing is patient capital that really have limited conviction about the recovery at this point. So, given that uncertainty they’re neither buying or selling at the moment, they're just waiting to get some more visibility.
Simplistically, though, there are a lot of buyers out there with equity and, we're seeing more and more lenders, both bank and non-bank lenders with capital to lend how they're getting deals over the line? Quite simply, well capitalised sponsors are combining debt with equity or alternatively, acquiring with all equity and taking down those deals that they now have opportunity to buy.
CC:
Great thanks about Michael.
Troy, over to you. Clearly COVID-19 has had a material impact on the current and short-term earnings around Australia's capital cities. How has this played out in values across the sector?
TC:
Look, as you rightly point out is it's a capital city thing. Some of the regional markets within the drive short drive of two or three hours from our major cities are having their best trading conditions ever. Which is great news for the sector from that perspective, as Australians holiday more at home by necessity in terms of the inability to travel overseas or even to other states. But certainly, our city hotels have borne the brunt of COVID-19, and it's been truly challenging year for the owners in those city hotels. Many of them are breaking even at best or making a small profit with the benefit of Job Keeper. With occupancies last 15 or 20% or even lower in the darkest days during the COVID scare during April May of this year, some have been helped along a little bit with quarantine business, so that's been good. But overall, we've seen very significant declines and income levels compared to 2019 levels that are unprecedented in terms of the historic trend of income. So, it really challenging year on every front, especially for a capital city hotels.
So that begs the question what do we think in terms of recovery, what does that look like? How soon and how strong? Most of the forecasts that we do for evaluation work at the moment has a recovery back to 2019 income levels after four or five years with occupancies coming back sooner and average rates lagging in terms of that recovery. Clearly you know that it has an impact on value because you're losing the upfront higher income levels that were using, say, this time last year in doing the valuations.
Despite all that doom and gloom on the income front, I've got to say I'm pleasantly surprised by the resilience of the capital markets. Based on the transactions that we're seeing so far, and we do have the benefit of some real transactions that have all happened, negotiated during the post COVID period. They suggest that city values are down by 5 to 15% and there's a few deals in Sydney we've been looking at like the Rydges Capital Square and then Novotel Brisbane as well as Fantauzzo in Brisbane. They all show that sort of range of declining value in that sort of 5 to 15% reduction on pre-COVID value levels. I've got to say based on some of the more recent deals on hearing about at the moment, that gaps closing back to be at pre-COVID pricing levels, which again highlights the resilience of the capital markets. So against that backdrop to that dark news on income and the recovery, how soon and how strong it is and that's a big unknown, let's face it, in the COVID world, we do have this good news in terms of the transactions, which is giving us some comfort that the values have held out quite strongly. Still down, as I said, but in the context of what's gone on, they've done well. I guess they're in my view there are three key reasons why they have been resilient, and I just think it is a fundamental confidence that the sector will come back. People need to travel for business. They want to travel to get away and go on holiday, the fact that a lot of people have been tied up in their home city or in fact back in their house for the best part of a year now highlights that that demand will come back and people view demand in the sector has been quite elastic once some of the restrictions start to get eased and even more so international travel borders, opening up as well in the medium term.
So that's a big tick for the sector in terms of people taking a view that ultimately people will travel again. I think Australia's done well a destination in terms of managing COVID. It's highlighted or amplified many of our natural advantages in coming to Australia anyway and that's just being magnified significantly by COVID whether it be plenty of space, you know, relatively low population density, big, open, clean cities. All those things that really have been highlighted in terms of Australia's natural advantages have just been amplified significantly over the course of COVID-19 and I think when international borders open up again, that will become obvious in terms of inbound tourist numbers, and I think that's part of the reason many investors are confident, have remained relatively confident in the sector. The other thing I think that is playing out right now as we speak and has got some different perspectives to play moving forward is the fact that many of the world credential capital partners out there in our borrowing at record low interest rates, and that is a factor that is also underpinning the capital investment market.
CC:
Great, thanks for comprehensive take Troy. Michael over to you now, we've seen that major banks have so far not shown any signs that their borrowers are pressured to act on distressed assets. Can you explain why this may be the case and is this likely to change in 2021? Would the risk premium or appetite on lending to the hotel sector change as well as the most recent interest rate cuts on longer term accommodative monetary policy, which may continue to influence how borrowers are expected to react and behave.
MS:
So, you’re right, there has really been limited borrower pressure so far from our banks and that's probably a combination of a number of factors. The Federal Government's Job Keeper stimulus measures has really supported businesses, and certainly in this hospitality industry that's been quite badly affected. Also, there were delays to bank or creditor acceleration rights that we're a slight adjustment to insolvency laws that were enacted at the start of the pandemic. Banks and when I say banks, I'm talking lenders in general. So, both bank and non-bank lenders have offered repayment holidays to a number of tenants and a number of borrowers subject to some conditions, but they've been quite generous with that. And then also, there's been a delay to valuations for some borrowers and technically, some of those new valuations may risk technical breaches of borrower covenants. Now the reality is that these measures they must wear off at some point so Job Keeper will wear off. Banks or creditors will be granted normal acceleration rights and borrowers will be expected to repay their debts.
I think one of the big relaxations, or at least focuses for lenders is going to be there going to be a lot of borrowers, I’m talking of technical breaches, meaning interest cover ratio on loan to value covenants, so they're going to be a number of borrowers who are in breach of those technical covenants. But those borrowers who continue to pay their debts, who continue to service their loans. They're certainly going to be given more latitude from banks and those technical breaches are arguably going to be temporarily overlooked.
In terms of new deals Troy mentioned that there are historically low interest rates on it should also be noted, we've talked about stimulus measures a little bit but even as at June 2020 there was over $10 trillion of stimulus measures that had either been promised or been delivered by countries around the world and on a comparison to GFC fiscal responses, Germany during the GFC was about 3.5% of GDP. Their economic stimulus response is 33% to this pandemic. Similarly, the United States is about five times, six times the size it was during GFC Japan, about 10 times France, about 10 times. So, you can see that there is a significant amount of kind of additional monetary supply washing throughout the system.
For new deals though, our view is that it's going to be very sponsor driven, so lenders are going to focus on the track record and skills experience of the borrowers. If you're talking about the hotel asset class certainly those borrowers that have got experience in owning hotels, both in good times and bad times they're going to focus heavily on the sponsors balance sheet strength and certainly that issue of serviceability. They're going to adopt a conservative loan to value ratio and that's quite common in Australia, anyway we’re a relatively conservative banking environment with limited tranches of debt across the capital stack that you might see in markets like the United States and certainly those lenders are going to have a laser focus on the cash flow projections and build-up of that recovery across the market. But we are seeing limited pressure on existing borrowers, and we are seeing an appetite from banks to borrow to the right sponsors for the right projects and we think that that will continue in 2021.
CC:
Troy, to what extent do you see COVID-19impacting the medium-term supply pipeline across major capital cities?
TC:
Look, Australia has had a supply increase in most markets. After years of no new hotels, we saw a surge of new hotels in Perth and in Brisbane as those markets benefited from the mining boom at the time and the fact that hadn't had new hotels for the best part of a decade. Obviously, those markets we’re hit both with the decline in mining demand, but also with an increase in supply so even before COVID we weren’t going to see new projects in those markets for those reasons. Our two main markets are Sydney and Melbourne. Sydney really hadn't had a new hotel since the Olympics and the years running up to COVID had a number of years of good RevPAR growth which underpinned the feasibility for new projects. A number of key transactions that struck really strong prices for rooms highlighted the feasibility of building new hotels in Sydney.
So, for that reason we do you have a new pipeline of new hotels gathering pace, or did gather pace in Sydney for a time there, we saw a number of new projects actually commence construction and a number of projects that were approved DA level so those that are under construction now will obviously proceed to open. It may be that that opening date is delayed because the developer decides to slow the project up for whatever reason, or decides to withhold or delay the opening of the project, given the current impaired trading conditions, but nonetheless as I say, if it's under construction today, we take a view that those projects will continue to proceed into the pipeline or into the hotel inventory in the market. But those projects that are approved and there's quite a few of those in Sydney and Melbourne and were getting very close to studied construction before COVID in terms of developers appointing builders and sorting their finance out and getting their structure right. Many projects in that category in the run up to COVID I just don't think those projects will actually proceed to construction in the current phase. That's because the feasibility or the viability of those projects has been called into doubt. You've got downward pressure on values we were talking about before.
Although the market has been resilient undoubtedly, people taking a much more cautious view in terms of what these things are worth when they're built and at the same time, the building costs have been fairly in elastic, the cost of construction, that cost of buying sites, all those things in terms of the ingredients for the feasibility of a new hotel, no real change is there in the current environment. So, all of that weight up means that the feasibility viability gap emerges is a problem for those developers, on top of the fact that finding debt and equity that's prepared to commit to it in this environment is also diminished. So all of those factors, I think, point to the fact that whereas in Sydney we had just under 4000 new hotel rooms in our pipeline, all we have at the moment is 2200 rooms, which are those that are under construction in Melbourne it was about 5000 in the pipeline. We've pulled that back to reflect the fact that we do have projects that are under construction which we know will come. I think there's 2500 rooms opening in 2021 for instance.
Those projects will come, but again those projects that were approved and likely to proceed even only six or nine months ago will be taken out. So clearly, we've got demand challenges in terms of COVID and we've had a reduction in average rates after taking into account the dilutionary impact of quarantine business but, you know, in the medium-term horizon, there's no doubt in my mind that we'll have less supply to deal with in terms of our medium-term forecasts. So that recovery probably comes a bit sooner because those projects have been taken out of that pipeline that were, they're sort of only a few months ago.
CC:
Great. Thanks for that, Troy. Michael, last question here. We know that locals have been effectively locked in with no international travel likely for the remainder of this year for certain, and we expect for the majority of 2021. How do you see this displacement of travel impact hotel demand over the medium to longer run?
MS:
I have to say I don't expect for there to be much international inbound travel for all of 2021 so it looks like we'll be a domestic market, certainly for the next year. We've already seen what happens in China that has a significant domestic travel business there, and they're largely back to pre-pandemic levels and certainly, in fact, some of the markets like Sanya, are above pre-pandemic levels on. I think there's a similar story for Australia, so there is a pent-up demand to travel. You can see it in the so called ‘revenge spending’ when people get the opportunity to.
If you look at past numbers, the overnight visitor expenditure in Australia for domestic travellers was circa 80 billion last year and international travellers were sub 50 billion. So about two thirds of that expenditure was coming from Australian travellers travelling within Australia and then what also has to be remembered is that they were over 11 million outbound trips from Australians travelling overseas who spent about 65 billion overseas. So, all those people are going to be unable to travel overseas. In fact, what we're also finding is that there's a significant number of Australian expats that are returning to Australia and who will want to travel. So, a reasonably substantial amount of disposable income, quite a lot of demand and certainly no ability to travel out of Australia. So, we think that the recovery for the market here is definitely going to be domestic led.
We’re very excited about the fact that the Sydney-Melbourne and then Sydney-Melbourne-Brisbane travel routes are being opened up. Certainly, they generate a very large amount of demand and expenditure for Australia and that Sydney Melbourne air route, its well-publicised. It's in the top three busiest by passenger movement and by flight movements in the world and so it effectively creates a kind of co-dependency between Sydney and Melbourne, with business and leisure travellers travelling each way. So, I think that domestic recovery will start well, it's already started but it's going to gather momentum immediately with those border openings. We hope that Western Australia follows suit soon as well. We'd love to see that full connectivity all around Australia and I think we'll see next year both those visitor numbers and the kind of key performance indicator and economic recovery for the hotel industry start and really gather some pace as Australians travel around Australia.
CC:
Thanks for listening to Talking Property with CBRE.
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Until next time.
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