A Favored Class
The lodging industry remains a popular place for lenders, and that popularity shows no signs of easing in 2007, even though by some measures the hotel business is facing a slowdown, albeit slightly, in operating fundamentals. A new survey by Hotel Brokers International, in conjunction with Lodging Hospitality magazine, still points to a healthy climate for the financing of nearly all types of hotel deals.
“I've never seen cap rates so low or so much money in the hotel marketplace as today,” Greg O'Stean, executive vice president and managing director of GE Real Estate, said at the Hotel Investment Conference in Atlanta in March. “It's the perfect time to be a borrower on hotel assets.”
2006 was a particularly strong year for hotel transactions, perhaps the strongest in the history of the business. According to Hotel Brokers International's TransActions Data Service, the hospitality market brokered deals for 685 properties last year for a total selling price of $23 billion. The market also generated $17 billion in portfolio sales encompassing 481 hotels. The deals covered all segments, with the greatest activity among the midscale without food and beverage (154 hotels) and upscale (154 hotels) tiers.
Coming on the heels of an extremely active 2005, it's easy to believe that many lenders saw ‘06 as a relatively flat year for deals. Most of those surveyed said the number of loans underwritten by their firms either remained the same as ‘05 or increased slightly. Still, the volumes were significant. One lender surveyed did 33 loans valued at $670 million; another did 17 loans for $800 million; and one lender issued 70 loans valued at a combined $1.3 billion.
Analyzing the data from the lender survey shows that a broad mix of financial sources does a wide range of deals across many segments of the marketplace. About a third of the participants are mortgage bankers. Nearly a quarter are investment bankers, and 15 percent of those surveyed represent national or regional banks. Other participants included SBA providers, credit companies, life insurance company, hotel REITs and lenders.
All of the respondents lend for acquisitions and refinancings, and the majority also finance renovations and new construction. More than 80 percent say they lend money for properties that are underperforming and need a turnaround. Last year, three-fourths of lenders said they financed underperformers.
More than 90 percent of respondents will lend to both full-service and limited-service properties. Seventy-one percent of the group will lend for extended-stay, but only 13 percent provide financing to timeshare projects.
Mid-market properties remain the most popular among lenders, with 82 percent offering financing in the segment. Nearly as many (78 percent) consider upscale hotels, while economy properties can only attract 60 percent of the lenders in the study. Most lenders seem to be location-neutral: about 90 percent will lend in suburban, urban and airport locations, while fewer (78 percent) have interest in highway properties.
Here's a look at the loan terms, pricing and requirements favored by the lenders who participated in the survey:
Loan terms range from two to 30 years, with 10 years being the most common. Amortization periods are typically 25 to 30 years.
Typical debt coverage ratios are 1.3 to 1.4, while loan-to-value ratios average between 75 and 80 percent.
Most lenders offer both fixed- and variable-rate financing packages. More than half of the lenders wrote new-construction loans that later evolved into permanent financing. The majority of lenders will also extend non-recourse financing for stabilized properties and most will allow loans to be assumable.
About two-thirds of lenders prefer to use trailing 12 months of financial data to compute debt coverage ratios. Most lenders include anticipated renovation expenditures, reasonable proformas and projections for future stabilization in their underwriting.
The lenders typically require appraisals and phase 1 environmental and engineering reports. A lesser number also require feasibility studies. According to those surveyed, the approximate cost of these reports to the borrower is $12,000 to $15,000 for economy properties and $20,000 to $40,000 for higher-end hotels.
OUTLOOK FOR ‘07
The consensus among the lenders surveyed is that hotel financing levels will remain high through the rest of the year as a generally strong economy yields robust liquidity for both debt and equity.
“Our hospitality loans expanded in 2006, and with our new higher debt limits we expect to double our output this year,” says John Howell, a hospitality loan specialist with CIT. “My outlook is competitive but cautious as so much new supply begins to enter the market.”
While a lot of capital remains in the hospitality market, the landscape is becoming more competitive, say some lenders. Cameron Larkin, senior vice president of First American Realty Associates, believes that with continued tightening of loan spreads and increasing volume in acquisition and development financing, “some lenders will back away from hotel lending, choosing not to place money in a space with such intense competition.”
Jim Merkel, managing director of RockBridge Capital and a veteran of hotel financing, remains bullish. “Over the past 12 months, we've increased the number of loans underwritten. We predict continued growth in loan volume, with spreads declining as available capital continues to increase.”
Even though Laurie Ivy of PMC Commercial Trust says her firm is “more aggressive than ever in our hotel lending,” a few lenders place caveats on the future financing marketplace. Some see increases in construction loans but a flat environment for refinancings. Others believe underwriting standards will tighten as we enter “the last leg of a prolonged bull market in hospitality.”
“Traditional first-mortgage hotel lenders should start to pull back the reins a little bit this year,” says Jasen Mark, president of Empirical Hotel Investments. “Many lenders are getting a little long on hotel loans and would like to start to pile on ‘quality.’ In other words, they'll continue to be active but will start making safer bets: lower LTVs, higher DSCRs and more conservative outlooks.”
Gary Dunkum of Live Oak Capital is concerned that the “business operations risk has not been priced into the loan spreads and cap rates, as has been historically the case. This should increase attractiveness of the product type and bring more — and more peripheral — players into hotel development.
“The appropriate prudence in funding capital reserve requirements has diminished, as if the historical costs to keep a hotel competitive have somehow been reduced,” he says. “The continued increase in loan amortization periods runs contrary to the potential risk of franchise loss and the historical decline in occupancy over time that are specific to hotels.”
Changes in industry operating fundamentals may also affect the financing paradigm. According to new figures from Smith Travel Research, supply of new hotel units is growing faster than growth in demand, which always results in lower occupancies. And while the past three years (2004-2006) were the best ever in terms of RevPAR growth, demand fell for four consecutive months ending in February.
The signs aren't all ominous, however. STR's predictions for the entire year call for occupancy of 62.9 percent, down slightly from 63.3 percent last year; supply growth of 1.6 percent; and demand growth of 0.8 percent. Average rates will climb 6.5 percent (versus 7.0 percent last year), while RevPAR will increase 5.8 percent, versus a whopping 7.5 percent hike in ‘06.
Still, the lending environment remains strong, mostly driven by strong relationships many owners and developers have nurtured with their financial sources. At a panel of lenders during the recent Hotel Investment Conference in Atlanta, all of the participants spoke of the importance of doing business with familiar people.
“We hedge our bets by building strong relationships with borrowers,” said Chris Allman, vice president of Capmark Finance. “We generally do business with people we know and trust.”
FLY IN OINTMENT?
Some observers are beginning to caution the industry to the possibility of a downturn, likely fueled by expansion in room supply. While bullish overall concerning the short-term prospects for the industry, PKF Hospitality Research recently warned of “unexpected hotel development putting an end to the industry's strong performance measurements.” Even though the hotel construction pipeline is full of planned and proposed projects, PKF believes the high cost of construction has kept many of these projects on the drawing board and not yet in the ground.
“If construction costs continue to grow at rates exceeding inflation and property value increases, it is reasonable to assume that existing hotels will be virtual money-printing machines over the next few years,” says Jack Corgel, Cornell University professor and a senior advisor to PKF Hospitality Research. “Investors should have difficulty matching the dividend return on hotels compared to other property types. On the other hand, should construction costs decline by five to 10 percent, the potential exists for the supply growth to exceed demand during the next two years.”
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