Transaction volumes in the UK hotel sector have dropped off significantly as asset owners and investors come to terms with heightened debt costs. Data from broker Knight Frank shows investment totaled approximately £860 million ($1.1 billion; €994 million) for the first half of 2023, down around 60 percent from H1 the previous year.

The mismatch in pricing expectations between buyers and sellers continues to impact the volume and timing of deals across private real estate markets, but in the hotel sector, strong trading performance is contributing to a particularly wide bid-ask spread. According to hotel benchmarking provider HotStats, revenue per available room in London was 50 percent higher for the first five months of 2023 than in the same period in 2022.

“Owner-operators are a little bit incredulous that pricing was better when their hotel was shut during 2020 than it is today, when they’ve got their doors open and are trading incredibly well,” says Shaun Roy, partner and head of hotels and specialist property investment at Knight Frank. “It’s quite easy to look at a hotel and extrapolate your pricing because your trading is going up, but the pricing of investment assets must be set within a capital markets universe.”

Against this backdrop, private equity real estate firms have pulled back dramatically on purchasing activity. After representing 58 percent of total volume transacted for UK hotels last year, this buyer group has fallen to just 13 percent in H1 2023, equating to around £103 million in value.

The largest UK hotel deal so far this year, however, closed just after the mid-point of the year. Manager Henderson Park and operator and asset manager Klarent Hospitality acquired the Waldorf Astoria Edinburgh – The Caledonian for £85 million from Abu Dhabi-based investment company Twenty14 Holdings. The 120-year-old building is the third Edinburgh hotel acquired for Henderson Park’s Klarent Hilton portfolio.

Institutional investors have also retreated as they rebalance their exposures, representing just 10 percent of transaction volume this year, down from 19 percent the prior year. More capital is exiting the sector from this cohort than entering it, according to Roy.

Debt costs are prohibitive

Roy says the current cost of debt means private equity funds, which rely on leverage to achieve appropriately high returns for their investors – typically through capital-intensive refurbishment, repositioning or rebrands – cannot afford to make deals stack up at the prices sellers are asking for. “The sector has not lost its attractiveness, but the buy-sell mismatch in pricing needs to work itself out,” he adds.

Stuart Blacklock, a real estate finance partner at London-based global law firm Ashurst, agrees valuations in the sector have been “materially out of step with underwriting” since debt costs began their rapid increase. He adds that general market uncertainty has also made it harder and slower to execute deals, leaving transactions vulnerable to external factors such as financing costs, inflation and valuation uncertainty “changing the game before the ink is dry.”

One of the largest known UK hotel transactions currently under offer involving a private equity buyer is the sale of a portfolio of 21 assets from real estate investment trust Landsec to Los Angeles-based Ares Management. The deal, which is yet to be completed, is reported to be worth more than £400 million.

Blacklock says that, in his practice, he has seen more refinancings than sales of hotel assets in recent months. “This is driven by the expiry of pre-covid financing packages that sponsors have had no choice but to refinance – often accompanied by the injection of new money, given many assets are no longer able to sustain borrowing at the same levels.”

Hotels remain a popular asset class for lenders due to their resilient performance in an inflationary environment, he adds, but “the recent turmoil has forced a laser focus on appropriately stress-tested underwriting, particularly for transactions involving refurbishment or redevelopment where lenders look to ensure that business plans contain healthy contingencies and coverage for rising costs.”

Family affair

While private equity capital sits on the sidelines, some buyers that are not heavily reliant on debt have continued to transact. Family offices and high-net-worth individuals, which are typically focused more on wealth preservation than generating value, are the biggest growth area in the UK hotel market, according to Roy. Knight Frank data shows this proportion of total investment volume increased to 9 percent in H1 this year from 2 percent in 2022, and 1 percent in 2021.

“Where institutional capital may have to sell the best bit of a portfolio because they are overweight, family offices can ignore those kinds of allocation metrics and act with a bit more conviction,” says William Laxton, the UK chief executive officer of Mactaggart Family & Partners, the co-investment management platform of family office Western Heritable. The platform owns and operates a UK hotel platform, The Resident, and typically buys buildings that need change of use through planning and heavy repositioning.

Laxton sees an “interesting buying opportunity” in the market while borrowers grapple with the cost of debt and refinancing risk. “If you’ve got the capital, you can be extremely aggressive on all of the key metrics, like price per square foot.”

That said, economic uncertainty is keeping stock off the market even at the smaller end of the spectrum. “If you don’t need to sell something, why would you? All you’re doing is exposing yourself to the risk of significant loss of capital and write-downs. Unless there’s some major strategic reason for exiting a geographical market altogether, it would be a very odd decision to bring a UK hotel asset to market right now.”

Until more forced selling emerges and the economic environment stabilizes, private equity and institutional capital will remain, in large part, on the sidelines. But when these buyers do return to the hotel sector, asset selection will be more discerning. As Roy observes, “institutions are so rigorous about ESG that if they can’t get energy performance certificates, energy reporting from tenants and clarity on fire safety and cladding, they’re not going to be in the sector full stop.”