With the figurative punch bowl now removed from the hotel capital markets party, 2008 will most likely turn out to be different than the past few years.
In particular, those of us that have been active in the hotel transaction and financing market for the past few years have noticed that the sector is not quite as crowded out there as it was just 12 to 18 months ago. The question is, where did everybody go?
The fuel that propelled the hotel transaction market over the past few years was cheap debt – and a lot of it. From 2002 to 2006, hotel commercial mortgage-backed securities (CMBS) issuance increased from $2.7 billion to $32.9 billion, an increase of over 1,000%.
Consequently, lenders that compete strictly on proceeds and pricing found it difficult to compete with CMBS lenders. The latter have the benefit of originating loans and bundling them together into pools including several loans – thus creating a diversified loan portfolio.
Bond investors then purchase tranches of that portfolio at blended interest rates, which allows the originator of the CMBS loan to provide a lower rate (most of the time) than a balance-sheet lender could provide at the same proceeds and terms.
Prior to last spring, it seemed as though almost anyone could get attractive debt financing on commercial real estate – including hotels.
But from September through November 2007, CMBS issuance in the U.S. was down over 50% compared to the same period in 2006. This slowdown in debt capital availability has slowed refinancing activity as well as the record transaction activity.
The new hotel transactions
Now, everyone from lenders to bond buyers to equity investors is re-assessing risk and what type of risk premium is being paid to take certain risks. In the recent market frenzy, the main thing that kept being passed around was risk.
Who held the risk? Most balance-sheet lenders significantly cut back their lending as they witnessed more and more aggressive loans being originated by groups that had no intention of holding onto that risk, but planned to sell it off.
The decrease in underwriting standards resulted in more aggressive loans that were being originated at even tighter spreads. So lenders were taking more risk while lowering the spread they were receiving for that risk.
This increased risk, of course, was at first not a problem for the CMBS lenders that had hungry bond buyers ready to snatch up the CMBS bonds that they were originating. But when the music stopped and the CMBS originators were holding onto those risky loans that they could no longer securitize, the problems (or opportunities) began to surface.
In hospitality lending, we are back to a point where groups are making investments, be it equity or debt investments, with the intention of making good investments as opposed to groups that are merely compensated for getting the money out. In other words, risk is back.
As a result, equity investors and lenders are requiring higher risk premiums. Lenders that originated aggressive loans with the intention of throwing them into securitizations are now trying to get them off their books because they never intended to hold these loans in the first place.
With the securitization market slowing down, these lenders are now looking to syndicate loans with commercial banks or sell off junior participations to high-yield debt funds and mezzanine investors. Some are also using brokers to find buyers for loans that they can no longer sell into the securitization market.
For lenders that are underwriting risk, there are several opportunities today, and lenders that were routinely being beaten out on deals to CMBS lenders are now back in business and able to get spreads on loans that are more reflective of the actual risk they are taking.
The idea of getting paid to take risks has returned. In the past few years, that concept had been put on the back burner – as the securitization machines continued to churn out riskier deals at lower and lower spreads.
While securitization brings tremendous benefits, when the market shuts down, it can shut down fast.
Deal volume falls
On the transaction side, the CMBS market also drove the hotel transaction market to new heights with 2006, recording over $35 billion in hotel transactions over $10 million. Furthermore, through the middle of 2007, hotel transaction volume had already hit $32 billion – almost exceeding the entire year amount for 2006, according to Jones Lang LaSalle.
While the transaction market over the past few years was driven by several different groups including real estate investment trusts (REITs), private equity funds, hotel operators and other private buyers, the latest beneficiaries of the cheap and easy debt were mostly the private equity funds.
The floating-rate CMBS market was heavily utilized by private equity funds to finance acquisitions. Those funds prefer floating-rate, shorter-term debt in order to maximize their flexibility on refinancing or selling those assets unencumbered with debt.
These market players could routinely get 80%-90% LTV financing at attractive spreads. This easy money on single-asset deals quickly became easy money on portfolio deals, resulting in several public-to-private deals, as publicly traded REITs were quickly gobbled up by private equity funds, flush with cash, and provided with heavy incentives to quickly get the money to work.
With the cheap and plentiful debt that was available in late 2006 and early 2007, by the middle of 2007, private equity funds accounted for 48% of hotel transactions and REITs only accounted for 12%. Because REITs typically do not use as much debt as private buyers, private buyers had the advantage in winning transactions given the cheap, high-leverage debt they could obtain.
Now, with the sharp slowdown in CMBS issuance, we've seen a sharp decline in hotel transactions.
Uncertain cap rates
The recent credit crunch and the resulting decrease in transaction activity have led to a particular question that continues to be asked in hospitality lending: What is happening to cap rates?
There previously had been much discussion about whether real estate had repriced to a permanently lower cap rate range than that at which it had historically traded.
However, we know that there is still a lot of money out there to be invested. Sovereign wealth funds, high net-worth individuals and private equity funds are still sitting on loads of cash to be invested. Foreign investors are also seeing an attractive opportunity to invest in the U.S. given the declining dollar.
So while the cap rate debate will continue until we see more transaction activity take place, borrowers that took out high-leverage hotel loans with short-term maturities will face a drastically different financing environment when their loans mature.
Today's market is still very volatile. Everyone is wondering whether the residential and subprime problems will spill over into the overall economy and cause the country to go into a recession.
In the hotel sector, even if we go into a recession, we should be more insulated from a downturn than in previous downturns due to the very low supply growth we have seen recently.
Typically, a downturn in the hotel industry is preceded by historically high supply growth, and if anything, the new supply pipeline will be shrinking even more with the current credit crunch. We are also continuing to see strong growth forecasts for revenue per available room for the next several years.
This period will eventually play out like all economic periods have: Capital will eventually flow again, and investors will demand that they are compensated for risks. This concept, while not discussed much in the recent past, remains a pretty fundamental concept in the investment process.
In any case, 2008 will prove to be an interesting year for hotel capital markets financing.
Deric Eubanks is vice president of investments at Ashford Hospitality Trust Inc., a self-administered real estate investment trust. Eubanks can be contacted at (972) 778-9451 or deubanks@ahtreit.com.
