Sounds like a deal that should sell over the phone at a 10 ½ cap rate, right ? Well, in the marketplace of late 1996, would you believe we’re hearing numerous major REIT buyers saying, "Look, we’re seeking a 13% cap rate after 8 % set aside for management fees and replacement reserve." Of course, those "going in" caps on current cash flow are pretty high, and a seller would have to be quite desperate to sell a good property at that cap rate level, so what’s really going on ? I believe the answer is simple. The hotel equities market is turning bearish, and that means a distinct slowdown in the pace of selling activity, as spreads again widen between the seller and buyer perceptions of value.

Buyers generally value properties based on a combination of current cash flow plus their guesstimate of annualized equity build-up available in the deal. They generally try to "kid themselves" into pre-tax equity returns in the range of 17 to 20 %. So, when someone tells you they’re looking for a 13 % cap rate, you’re dealing with a pessimist as regards the near term upside valuation potential of hotels. After all, a buyer’s belief that the future upside is diminishing naturally causes him to compensate for reduced upside by seeking higher going-in cash on cash yields.

In the early 1990’s, when existing hotel cash flows were almost universally lower than today, we were in the beginning stages of a national economic recovery. New hotel development wasn’t proceeding at the expanded pace that it is today. Then, buyers accepted lower current cash flow returns because they saw significant future upside potential. It’s a piece of cake to have what came to be called "an exit strategy" so long as tomorrow’s value is greater than today’s. However, that’s no longer the case in many people’s minds. The market evidently believes that those times are clearly behind us, even as 1996’s hotel industry profits temporarily rise to new heights.

New hotel development in many markets will, in the near future, obviously cause billions of dollars in lost market value equity for existing hotel property owners. Just as apparent is that the new developments being built will often result in unexpected years of headaches and acid indigestion for those happily optimistic developers who, foolishly, believe the pro formas they’re either creating or being fed. Basically, what’s at work is simply the old maxim that builders will build when lenders will lend—and, boy, are the lenders, builders and franchisers having fun today ! Now, lets remember that all this is occurring in the latter stages of an economic recovery when a likely upward bump in interest rates usually takes place and adds to the damping down of the economy and a reduced pace of business expansion.