Passed the Bottom

In September 2022, as the real estate market showed signs of reaching its peak, the mini-budget delivered a significant blow that had a profound impact on the hotel long-income market. Defined Benefit (DB) pension funds, particularly corporate pension schemes, experienced an acceleration in their maturity by approximately 10 years due to a structural and fundamental shift. These DB funds aimed to limit liability going forward, leading to pricing alterations within the fixed-income market.

The rise in long-term GILT returns and debt Swap rates, influenced by the Bank of England's monetary policy, played a crucial role in pricing changes. The surge in interest rates reached an unprecedented 5.25% in August 2023, impacting financing conditions and investors' internal rate of return (IRR) requirements.

The movement in the Gilt markets made pension transfers more affordable for DB schemes, prompting them to seek liquidity. As a result, assets that lacked the desired characteristics needed to be sold, with many long-income funds finding themselves selling down assets. This influx of quality stock flooded the market.

Fast forward to H1 2024, the market has experienced an improvement in activity and reduced pricing volatility. Key private equity deals, in combination with monetary easing from all leading central banks, have instilled confidence that we are past the peak interest rate cycle. With investors seeing monetary easing over the horizon, market confidence has returned, and we are seeing good growth in transaction volumes and interest in live deals from investors.

While the European market is showing more stability, the UK market traditionally leads the way and presents a favourable investment environment for institutional capital with available funds.

Despite the impact of redemptions and maturing DB funds on the long-income market in general, the demand for hotel assets in the UK remains strong. The sector's resilience and continual tourism growth attract a diverse mix of investors. Additionally, the consolidation of mandated and pooled funds, along with emerging defined contribution (DC) pension funds, ensures liquidity and provides the market with opportunities for strong risk-adjusted returns.

Now that we have fully emerged from the pandemic, there is a compelling case for improved fundamentals across much of the hotel long-income market.

When looking at a case study of Midscale / Economy assets, it’s clear to see there has been consistent outperformance compared to most other forms of real estate, in key UK markets.

This, coupled with low staffing requirements in these hotels, and consolidated functions at head office level, means that profitability for many of these assets has increased significantly since 2019. Additionally, when considering that most long income hotel leases have cap and collar provisions at around 0 – 4%, the vast majority of costs will have been limited below the top line growth achieved.

Our below case study of hypothetical hotels details the changing environment for Rent and consequently Vacant Possession coverage across a range of markets in the UK, and demonstrates the real opportunity that the underlying fundamentals of the sector presents.

Edinburgh has experienced the strongest growth in RevPAR following the pandemic with 64% growth in the Economy and Midscale segments.

This has driven the largest potential increase in Rent Coverage throughout the UK, with an indicative 1.70 coverage, potentially increasing to 2.70 times rent coverage.

The London Economy and Midscale segment has experienced c. 30% RevPAR growth since 2019 which has outpaced average inflation of 23% during the same period and therefore has high potential for improvements in the level of rental coverage vs 2019.

An indicative 1.70 times rent cover in London has likely increased to at least 1.90 – although with prime areas likely to be performing significantly better.

Manchester has reported more muted growth due to significant increases in supply, however the Economy and Midscale segment still managed to outperform.

This has allowed increasing rent coverage from 1.70 to 1.80 times for a notional hotel, even though wider market performance has been at or around inflation.

With green shoots emerging in the capital markets space, the hotel long-income market is positioned to benefit. This market segment boasts several strong fundamentals:

• Stable and Predictable Income Streams: The hotel sector's resilience ensures a continuous cash flow, making it attractive to risk-averse investors seeking secure income.

• Robust Market Fundamentals: Growing tourism and limited supply in key markets strengthen positive demand and supply dynamics, enhancing long-term prospects.

• Diversification Benefits: Investors can diversify their portfolios by selecting different hotel classes and locations, mitigating risk associated with seasonality and market trends.

• Retained Value: Hotels retain their value over the long term, serving as a long-term hedge.

• Strong Collateral Cover and Rent Covers: Improved performance has resulted in substantial rent covers, enhancing the underlying asset covenants and collateral cover (as detailed in our case studies).