Due to the current market displacement, many of these asset owners are likely to see substantial holding losses, at least over the next year, and possibly much less upside on exit.
Towards the second-half of 2019, the Gulf’s real estate market had begun to show levels of flattening after years of low double-digit rental and valuation declines.
In Saudi Arabia, the retail & F&B sectors were even bucking the trend due to the social changes being implemented, and some recovery was expected in the UAE, as we entered the final lap of the Expo 2020. I was anticipating that we could see more institutional real estate investment activity this year, which would hopefully carry on beyond the Expo.
However, the events of the last 12 weeks have been nothing short of devastating.
So, what do we expect to see in the institutional real estate investment market over the next 12-24 months? I describe the institutional market as investment in large(ish) income-generating real estate by real estate asset managers, institutions, and private family groups. While each country, city, and submarket have their dynamics, I am taking an “airplane view” based on market cycle, demand drivers, investors’ appetite for each asset class, and the premise that Covid-19 vaccine would be developed soon and economies would start their slow journey back to a pre-virus state.
Over the next few weeks, I will present my views on each real estate asset class and what I expect to see based on my conversations with owners and investors across the region. This week’s article looks at the investment appetite in the hospitality sector in the UAE.
The interest or investment in the sector in the UAE has, historically, been driven by private family or quasi-government entities. The limited interest from institutional capital has been due to the requirements of strong sector expertise, the volatility of cashflows, and the lower risk-adjusted returns in this asset class compared to other real estate.
Until 2014, generally considered the peak of the hospitality market from a RevPAR and profitability perspective, inquiries for hospitality investment opportunities were common among seasoned hospitality investors, even though there were only a few transactions due to expectation differential among the parties. However, since then, the asset class has seen a constant decline in income and performance, resulting in the gap widening between the “replacement” and “investment” values.
The investment value is based on a yield and/or IRR (internal rate of return) that the buyer wants to generate, and the replacement value is what it will cost the owner to build the asset, sometimes inflated by higher than supportable land value and cost overruns. This gap and the anticipated market recovery closer to the Expo meant that most owners who were open to selling their assets, choose to hold firm on their values, resulting in bid-ask spreads that couldn’t be breached.
Now, due to the current market displacement, many of these asset owners are likely to see substantial holding losses, at least over the next year, and possibly much less upside on exit, especially if it takes longer for the aviation and travel industry to recover.
At the same time, buyers, who were interested in entering the market in 2019 and earlier, will justifiably expect a cap rate expansion or discount on their expectations, given that the virus has changed risk parameters in the asset class, both for them and the banks. It may well be that some investors might consider the risk in the sector a tad too high to stay interested.
Hence, even though buyers may have moved further down on their pricing, I expect that, for sellers for whom hospitality is not core, will still be open to exiting, to focus their energies and time on their other businesses. The pricing, though, will evolve and will depend on either parties’ view on the time it will take for the market to recover to pre-COVID-19 days.
While there is not much optimism around, the saving grace for the M&A activity is that at least we had an uninterrupted full year in 2019 that can serve as a respectable reference for valuing an asset. My view is that deals at cap rates of circa 7-7.25 per cent on stabilized income, juxtaposed with price per key of circa $225,000-$275,000 per key for standard five-star properties will be the order of the day.
The cap rates would typically fall for higher and increase for lower positioning hotels, resulting in a higher and lower price per key, respectively.
While I can’t predict how may arm’s length deals will be seen in the next 12 months, the one thing I can guarantee is that the sellers will find the above figures excruciatingly low and buyers will find the same insanely high. Therefore, as always, it will take an informed advisor, a commercially minded lawyer, a risk-averse banker, and two sets of reasonable counterparties, to get a deal done.
– Gaurav Shivpuri is founder of CoReal Partners, a real estate and alternative sector-focused M&A firm.