What has the state of the economy done to credit availability for financing hospitality properties? With high gas prices and cash-strapped consumers, are existing hotels running into performance problems? Are there any unusual opportunities to uncover during this challenging time? Steve Hanover, senior managing director for hotel finance at PKF Capital in San Francisco, spoke with MortgageOrb about the unique structure of this industry and how it is faring at the moment.
Q: The industry has thoroughly recognized by now that there's currently an obvious debt shortage. Looking ahead, when might that ease? How might the forecast for hospitality finance differ from the prospects for other commercial property sectors?
Hanover: Credit for commercial real estate is tighter than a year ago, but it is even tighter for hospitality properties. The prospects for more available credit to the commercial real estate industry – and the hospitality industry in particular – depend on the health of the overall economy. They depend also on attracting lenders to help fill the void left by severe reductions of securitized debt.
The reasons that credit is in short supply now to the hospitality also have a lot to do with the way the hotel industry is structured. Hotels do not operate like commercial real estate, with its long-term tenant leases.
Hotel occupancy drives hotel operating revenues, and that can change with the prevailing winds of global economics. Instead of signing 10-year commercial leases, hoteliers often reach one-day agreements with their guests. Lenders know the traveling public is affected by everything from fuel prices to composite economic conditions.
Both science and art – and a lot of industry knowledge – must be creatively applied to make hotel credit deals work.
The credit void will likely be filled by alternative lenders. Those lenders may be existing lenders that were sidelined by the efficiencies of the CMBS marketplace, such as life insurance companies, banks and private lending platforms. Credit will be provided by new lending entities that see an opportunity to fill the credit void.
Over the next six months or so, we will see the emergence of new lending groups and a shift among existing lenders to take advantage of the decline in hospitality lending. Only then will we be able to gauge this effect on the marketplace. It is a very dynamic situation, but one that will produce some opportunities.
Q: What's the structure of a typical hotel financing package these days? How do features like leverage, interest rate, terms, etc., differ from what one might have seen a year ago at this time?
Hanover: Hotel lending is different today than in the recent past in two distinct ways: the economics of the loan (its interest rate and loan sizing) and the borrower's profile.
Creditors are more cautious when assessing the perceived risk of lending to a hotel. This is reflected in higher pricing and smaller loan sizing. Whereas say, 18 months ago, a lender was willing to underwrite a hotel loan on budgeted income and future market performance projections, today's loans are strictly underwritten on proven past income – usually trailing 12 months' income and the past two years of income performance.
Hotel loan sizing is determined by available cashflow to service the loan. This is expressed in the debt service coverage ratio (DSCR) or the multiple of net income needed to pay the monthly mortgage payment.
Eighteen months ago, lenders were underwriting loans with about 120% – or 1.2 times the net income to service the debt. Today, the standards range from 140% – or 1.4 times – to 150% – or 1.5 times the available net income.
With a higher reserved net income to service the loan, the loan will necessarily be smaller. By comparison, a similar loan to an office building or apartment building, for example, would have a DSCR of 1.2 to 1.25 times net income.
Sponsorship and the type of borrowers are critical today. Lenders like borrowers who have long and deep experience in managing hotels throughout competitive economic times. Such durable borrowers give lenders confidence that they really know how to manage their revenue and expenses in challenging economies.
Lenders also like well-capitalized borrowers who have reserves in the event that the economy does not perform as well as projected. Good reserves means hotel owners and operators can provide the capital needed to keep the hotel competitive by being able to spend what it takes on furnishing, physical plant, marketing and operations.
Because so much market information is available today for hotel performance, such as competitive set occupancy (demand), average daily rate (ADR), revenue per available room (RevPAR) and new supply pipeline (supply), it is easier for lenders to develop underwriting standards for loans that will result in their pricing and loan sizing.
Lenders can see trends in markets that may show a downward or upward trend in occupancy. ADR and RevPAR statistics can alert lenders to the possibility of new supply coming into the marketplace. These are all tools that lenders use today that reduce many unknowns in hotel-loan underwriting and provide hotel lenders with more confident underwriting.
Q: You've mentioned that in the midst of the credit crunch, there are some silver linings to be found. What are these specific opportunities, and who is best positioned to take advantage of them?
Hanover: Every cloud does have a silver lining, and this market is no different. The ratio of supply and demand is very important to hotel income. This is expressed through occupancy and ADR. Today, when credit is harder to come by for hotels, lenders are more reticent to lend to new hotel construction.
A reduction in supply means hotel owners can boost their revenues through higher room charges – ADR, and they can maintain their occupancy rates (demand) because there is less competition.
When the number of hotel rooms in the pipeline slows to a trickle, many markets do not dip as severely and recover more easily when economies rebound. This trend provides more healthy market conditions for existing hotel properties during slow economic times.
There are also opportunities on the buy side. Because loan sizing is smaller and interest rates are higher, investor yields are lowered unless asset pricing is reduced. This pattern is reflected in capitalization rates widening, putting downward pressure on property pricing.
Owners may choose to sell, for whatever reason, during these periods – and at cap rates that may be anywhere from 50 basis points to 100 basis points wider than say 18 months ago.
Experienced owner-operators may decide to buy during these periods for a variety of reasons. If property becomes available in a market where owner-operators have existing properties, they may decide to take advantage of current pricing to buy additional properties (or control more rooms) within their marketplace.
Doing so permits them to more effectively manage ADR and operational expenses through centralized revenue and property management.
There are also opportunities for equity investors who are not necessarily hotel operators. When a hotel owner/operator finds that he needs to raise equity in order to refinance his property in today's market, he may consider joining forces with some of the existing – as well as some of the newly emerging opportunity investors.
This arrangement may make for a productive long-term relationship where the owner/operator has longer-term access to reliable equity investment for portfolio expansion and the opportunistic investor may not have the infrastructure to manage and operate a hotel property. This is a win-win situation born out of the necessity created by the current environment.
Q: Where are vacancy rates and related numbers generally trending these days? We've heard a lot lately about families opting to not take that summer vacation or being unable to afford airfare. How much are these trends playing out in existing hotel performance?
Hanover: Hotels reflect the general economy, but more importantly, they reflect their specific geographic marketplace. Many factors are local when it comes to hotel occupancies and ADR.
In some areas of the country, there is an oversupply of rooms and travel become less compelling in a period of high gas prices or reduced lift capacity in the airline industry. They are going to attract less occupancy and ADR.
However, the so-called gateway cities such as New York, San Francisco and Los Angeles will stay popular for several reasons. The value of the dollar with respect to the euro is an offsetting factor in these gateway cities. You can see the evidence in the many European languages one hears on the streets of San Francisco.
The U.S. is downright cheap for Europeans with their high-value euros. Even our $4.50 per gallon gas prices are cheap to Europeans who are paying $8.00 to $10.00 per gallon of gas at home. They can come to the U. S., stay in gateway cities and even drive long distances into the countryside using our ‘inexpensive’ gas.
Hotel development activity along the West Coast – compared with many other parts of the country – has been relatively mild in the last several years. PKF Hospitality Research projects hotel room inventory in the Mountain and Pacific cities to grow just 2.2% in 2008 – the lowest supply growth rate of any region.
With less new competition, hotels in the region are forecast to raise their room rates 4.1% for the year – the strongest regional increase in the nation.
Q: Any advice for a commercial mortgage broker who wants to get a hotel deal done right now?
Hanover: It's important to keep your borrower informed about the state of the credit market and plan with them for the near future. Sometimes long-term plans need to be modified to adjust to current conditions. Offer your clients alternative debt and equity products. Borrowers need to understand realistically what can and cannot be done in this market.
It is also important to stay in continuous touch with your lender. Remember, it is a dynamic credit environment where things are changing on a weekly – and sometimes daily – basis, so today's credit information may not be valid tomorrow.
