Hotel Financing in a Changing Economy

Between the sub-prime meltdown, the roiling stock market and a forecasted good, but slower, growth year for the hotel industry, lenders have become more skittish, which is changing the face of financing.

Despite all this angst, 2008 still holds great promise for experienced hoteliers who have a proven track record, as they will likely see less competition for deals. Another positive side effect is that overbuilding should become less of a threat in many markets, at least for the short term, as a number of new projects on the drawing board are likely to be canceled or delayed.

For those looking for funding in a more restrictive financing environment, there are ways to maneuver around the potholes caused by the current uncertainties.

WHAT HAS CHANGED?

A number of things already have changed in hotel financing since last July when the sub-prime crisis first surfaced. It still remains to be seen how deep the sub-prime fallout and volatile stock market will go, but currently it hasn't had a crushing impact on hotel financing.

However, there are some noticeable changes, compared to just nine months ago. Equity requirements have moved up from the 15-percent level of the past few years to 25 to 30 percent today, well within historic norms.

In our weekly conversations with both balance sheet and capital market lenders, they generally continue to view hotels as a good real estate investment. However, the combination of the sub-prime meltdown and aggressive lending in other real estate classes, where the outlook is no longer as positive, has given some lenders pause about real estate in general.

This is somewhat exacerbated by the fact that many commercial mortgage-backed securities (CMBS) lenders have moved to the sidelines. Their lending policies typically earmark 10 to 15 percent of their funds for hotel real estate. Many currently are maxed out in the hotel sector and with little new money coming into the bond market, these lenders no longer are funding deals.

On the good-news side of the ledger, there has been no noticeable increase in hotel foreclosures and there are no signs that will change for the foreseeable future. From our vantage point today, unless there is a major economic meltdown and RevPAR takes a nosedive, lenders will continue to be interested in the hotel industry.

COST OF FUNDS

So how does the hotel financing market look today? Interest rate spreads are up substantially since last summer. Conversely, LIBOR and Treasury rates have moved downward, leaving the cost of capital virtually unchanged. In addition, underwriters have tightened their requirements. Today, there is more focus on experience, location, branded hotels, the number of hotels the borrower owns and the operator's proven ability to deliver in all phases of the economic cycle.

Debt coverage ratios also have moved up, putting pressure on loan proceeds. Lenders have raised equity requirements and markets are being more scrutinized, with high-barrier markets the preferred choice. Lenders also are more conservative on future performance, fueled by concerns of overbuilding and a slowing economy, which will make room-rate increases more difficult.

The Fed lowered interest rates in early 2008 as concerns mounted over a recession, indicating that they are keeping a close eye on unstable economic conditions. Depending on how the economy responds, rates could go either way. At least for the short term, these actions probably won't have much of an effect on hotel financing. Lower short-term rates will have a positive impact on construction and bridge loans, but the long-term financing cost isn't likely to move downward any time soon.

The days of interest-only loans have largely disappeared. What remains is usually for limited periods. Non-recourse debt remains available, but personal guarantees are beginning to return. Avoiding personal guarantees will require higher equity participation. Those decisions are being made on a case-by-case basis and are likely to become even less available. Lenders are most comfortable underwriting branded hotels, with the leading brands the most favored. Primary markets are the most preferred.

All of these changes will likely cause many developments to be re-analyzed for their feasibility. Overall, this bodes well for the industry and will reduce the potential for a glut of overbuilding.

LOOKING AHEAD

We believe that most of the corrections to the economy have occurred. We don't see fixed rates increasing much above current levels. Short-term rates will likely continue to stay low, and possibly decline for the near term, in step with the Fed's actions. This will be offset by higher equity requirements, greater spreads and tighter underwriting guidelines.

Financing remains very much a relationship business. In these somewhat turbulent times, owners seeking financing will benefit more by using a mortgage broker or banker who specializes in hotel finance. These professionals will have greater understanding of the markets and be able to help borrowers maneuver through the shifting environment.

For example, we closed several loans as the sub-prime crisis hit. Although closings were delayed, and there was some scrambling to get back on track, ultimately we consummated the deals.

Compared to a year ago, lenders for the most part are being more conservative when considering transactions. They prefer to work with mortgage brokers and bankers with whom they have a relationship and who understand the current lending environment. Lenders depend on these specialists to help them identify both the pluses and minuses of a transaction. These relationships can help get a transaction reviewed faster in terms of level of interest so the borrower knows as soon as possible if the project is financeable. In uncertain times, a quick no is better than a long no.

A recession remains the wild card. Because the hotel industry tracks the economy so closely, lenders will become more risk-averse if conditions worsen. However, for those projects or acquisitions that stand on their own merits, financing will still be available. It may require a little more work, but deals will still be done and make money for both the investor/owner and the lender.


Jeff McKee and Greg Morris are managing directors of Seattle-based Premier Capital Associates, LLC and can be reached at www.premiercapitalassoc.com.

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