How Much Will Hotel Stocks Recover?

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Larry Antonatos, managing director and portfolio manager, Brookfield Asset Management.

Lockdowns designed to slow the spread of Covid-19 dramatically impacted the hotel sector in 2020, driving a collapse in demand in all three components of hotel demand: business demand, leisure demand and meetings. Many hotels closed, particularly hotels in major urban markets and hotels reliant on business and meeting demand. The hotels which remained open generally suffered dramatic declines in both occupancy and rate.

To put this stress into numbers, in the United States, year-over-year revenue per available room — which is a key metric of hotel revenue — declined more than 75% in April 2020 year over year. That slowly improved to a 50% decline by December 2020. Key drivers of this decline were: number one, meeting and convention business was essentially nonexistent; number two, international travel was essentially nonexistent; and number three, domestic travel was down dramatically. The lone bright spot was leisure demand for drive-to destinations and select resorts such as Hawaii.

Accordingly, cash flows across the hotel industry declined dramatically. Public equity markets reflected this stress with severe price declines for the common shares of public hotel companies, making the hotel sector one of the worst performing sectors within public real estate equities and also within public equities broadly for 2020.

This price weakness was concentrated in the March through October 2020 period when lockdowns were most severe and sentiment was most negative. However, in early November 2020 with the positive vaccine news, hotel stocks rallied strongly with the reopening trade. From early November 2020 through today, late February 2021, the hotel sector has been one of the leading sectors within public equity markets. Now, as lockdowns ease and vaccination rates increase, we should look more closely at the hotel sector to understand the potential impacts of long-term behavioural changes resulting from Covid-19.

One way to do this is to look at China, which went into lockdown sooner and more strictly than the rest of the world, then reopened sooner than the rest of the world. In China, year-over-year revenue per available room declined approximately 95% in February 2020. Because of the intensity of the lockdowns in China, leisure demand collapsed along with business and meeting demand.

As lockdowns eased, Chinese revenue per available room steadily improved and was essentially flat by December 2020, led by improvement in leisure and business, driven by pent-up demand in those sectors.

We expect the rest of the world will follow the recovery trajectory of China. Leisure will lead the recovery. We expect leisure to initially show phenomenal improvement, driven by significant pent-up demand, with improvement tapering thereafter. We expect business will recover next, with recovery in meetings being the last.

Beyond the timing of the recovery, we should also explore the magnitude of recovery. We expect leisure travel to recover in full to pre-Covid levels. However, we expect business demand and meeting demand will recover to modestly lower levels, due to the substitution effect of technology rather than face-to-face.

At Brookfield, we believe that contrarian views can drive excess returns. In fall 2020, our optimistic long-term view of the hotel sector was contrarian. Public hotel companies with outstanding portfolios in major global cities were trading at significant discounts to real estate value. This was a compelling investment opportunity but was not without risk. With continued positive vaccine news, some risks have been mitigated, and we have been rewarded with strong performance.

Lockdowns are now easing, and vaccination rates are improving, so we are seeing some short-term positive impact in the office sector. I want to stress that, throughout 2020, despite the fact that office stocks were very weak performers, office cash flow and office values actually held up relatively well, particularly among high-quality office buildings in major markets. The cash flows were essentially 95% plus rent collection throughout 2020, driven principally by the strength of the credit of the tenants and the desirability of having space available for reopening. We have seen a falloff in transaction volume of office buildings — trading — being bought and sold. However, the transactions that we have seen have generally been in line with pre-Covid-19 values.

What that leaves us with is stock prices that have dramatically underperformed. We see tremendous value in the office sector today. And this really is based on our view that, while work from home has been a successful short-term solution, we think that in the long run work from home will ultimately be a supplement to, rather than a substitute for, the office.

While remote work can continue to provide flexibility for employees, office work allows for collaboration, connection and culture — essential ingredients for enterprise growth, risk management and employee development.

We also think Covid-19 will reverse the office densification trend. In the past two decades, office space per employee has decreased from 425 square feet to about 150 square feet. We think this will reverse, driving some increase in office demand.

Industrial has been a terrific performer in the Covid-19 environment. It has been a winner, generally at the expense of brick-and-mortar retail. Industrial real estate is the beneficiary of the rise of internet shopping. During Covid-19, as we were at home rather than at the shopping mall, internet shopping grew dramatically. I think this is simply the acceleration of a long-term trend, not a new trend. Unlike the work-from-home phenomenon, which will be reversed by moving back to the office, we think internet retail is here to stay.

One of the biggest beneficiaries will be industrial property. Industrial stocks were some of the best performers in calendar year 2020, and with the reopening trade, they have actually lagged the market a little bit. The market is more excited about the reopening of hotels, the reopening of office than they are about industrial.

So, industrial is not a contrarian trend. It’s a trend whose resilience has been proven through Covid-19. We think there are long-term good returns to be made in industrial, but the recovery story is not part of the industrial story.