The Current Flood of Capital
Industry articles, analyst reports and convention roundtables all say the hotel recovery is in full swing. All this talk has generated an unusual flood of capital that chasing hotel transactions. Is this overabundance of capital good for the industry?
Several factors contribute to this plethora: (i) new institutional players, such as REITS, and new investors such as Tenancy-in-Common (TIC) groups; (ii) sideline lenders — temporary players who jump in when the market is hot and jump out when it cools; (iii) relatively low yields on such commercial real estate asset classes as office, industrial, retail, and multifamily transactions, compared to yields on hotel transactions; and (iv) favorable reports from Wall Street analysts and industry consultants.
As lenders and investors grow more competitive, borrowers benefit from higher leverage loans, thinner spreads and more flexible terms. Sellers benefit from more aggressive capitalization rates, municipalities and consumers from development of new product. However, this flood of capital leads to deterioration of loan structure due to a decline in underwriting and investment discipline. This decline could affect the entire industry.
Based on recent Fitch reports and other industry articles, there has been a notable decline in structural features such as amortization, reserves and cash management practices across all asset classes. Underwritings have been more aggressive, based on future performance — and on borrowers with less experience and lower levels of equity in their properties. And, many of these statistics are based on CMBS transactions, which are supposed to have controls in place to reject riskier underwriting. While delinquencies are down 42 basis points over the past 12 months, consider the following data about the past 12 months, recently reported by Fitch and others:
Loan-to-value ratios have increased from 82 percent to 87 percent;
Debt service coverage ratios are down from 1.28x to 1.22x;
The number of transactions that require real estate tax escrows is down 16 percentage points to 72 percent;
The number of transactions that require capital reserves are down 15 percentage points to 64 percent in the past 36 months.
The number of transactions with a sub-debt component has doubled from 14.5 percent in 2002 to 29.3 percent in 2004.
The speed with which lenders close transactions has tightened from about 45 days to often less than 30 days, even though deals have become more complex.
While we are arguably emerging from the bottom of a cycle in the hotel industry, we're not out of the woods yet:
Operating costs will continue to rise as labor markets tighten, utility prices rise, consumers again demand better services, insurance costs escalate, and as brands increase their standards. This will ultimately affect flow-through.
The business traveler has yet to return in full force, and savvy travelers on both the business and leisure side are keeping rates competitive through the various Internet venues.
The yield curve is flattening out. In a nutshell, the market does not currently anticipate a material rise in long-term interest rates, due in part to concerns over the economy's ability to grow substantially over the next several years. While rates may remain low, a lack of growth in the economy would prove troubling. Further, event risk is always on the horizon.
A material amount of industry investment is TIC-driven. Just as unexpected tax law changes in 1986 led to significant defaults, history could repeat with changes to current tax treatment of TICs as Congress attempts to overhaul the tax code. Further, these groups often lack hotel experience and their structures may not provide a meaningful means to infuse critical additional capital into a transaction down the road.
History proves that real estate works in cycles. The abnormal levels of capital currently chasing transactions will exacerbate this cycle:
With more lenders and investors chasing deals, marginal projects will be financed. An abundance of new construction will emerge, dampening recovery in many submarkets.
As traditional underwriting criteria return, borrowers may find that their aggressive interest-only loans may not be readily refinanced upon their maturity.
The economy will eventually slow or, at the very least, return to normal. Defaults will increase and inexperienced lenders and operators will unsuccessfully attempt to negotiate with one another, leading to distressed sales and providing attractive acquisition targets for opportunistic operators.
Inevitably, the natural, almost Darwinian, real estate cycle will go on,driving weaker assets, operators, lenders and investors from the market.
At the end of the day, there will be the same small yet consistent handful of lenders, investors and operators that understand opportunities in both up markets and down markets. Consider this when you make a decision with regard to your partners, whether they are operators, investors, or lenders.
James T. Merkel is managing director of RockBridge Capital, LLC and a principal in the firm. An investor in all real estate funds formed since 1995, he is responsible for sourcing, structuring, executing, monitoring and exiting investments, as well as for the firm's marketing and media relations. Reach him at email@example.com or call 614 246 2505.
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