The Lodging Sector: Commercial Real Estate’s Wild Card

It's springtime for the lodging sector, and hotel operators are hoping an economic recovery will get people packing. As both business and pleasure travel increase, more hotels will be able to raise their room rates and obtain revenues needed to qualify for loans. Financing has returned – at least for quality properties with good cashflow in decent markets, experts agree.

‘The prospects are good,’ says Jim Butler, a partner with Jeffer Mangels Butler & Mitchell in Los Angeles. ‘The fundamentals of the industry continue to improve. Springtime is here, but it may be too late for many properties.’
In 2011, hotel operators filled their rooms by holding down rates.

‘Basically, we bought occupancy by not raising rates as much as we could,’ Butler says. ‘This year, occupancy rates are now holding steady while rates are increasing.’

‘Hotels have demonstrated a fair amount of resilience through this downturn,’ says Bruce Lowrey, managing director at RockBridge Capital, a hotel investment firm in Columbus, Ohio. ‘Hotel demand grew in 2011. It grew at a pace that was better than the gross domestic product, and that has helped bring back liquidity. The absolute number of rooms sold grew. I don't think that's appreciated by a lot of capital sources.’

But cutting room rates only increased demand slightly, Lowrey observes. ‘I think it's fascinating that demand was able to grow despite a pretty high unemployment [rate] and a weak economy,’ he says.
Both banks and commercial mortgage-backed securities (CMBS) are back in the hotel lending game, says Butler. Some large banks may finance deals, intending to later funnel them into CMBS. Life insurance companies are also back, but trying to stay below the radar, as they fear being deluged by requests. Regional and local banks prefer deals with customers in their own territories, and hotel experts use private investor funds to pursue the value-added proposition.

‘Everybody sort of has a sweet spot,’ Butler says.

However, underwriting standards are tighter now than during the boom five or six years ago, he notes. Lenders are willing to finance hotels with 50% or 60% loan-to-value (LTV) ratios, not the 80% or 90% LTV ratios of years passed, and they will consider the property's trailing 12-month income, not projected income.

The key for obtaining hotel financing, Butler notes, ‘is existing cashflow in place to cover debt. Without that, you're going to work.’
Lowrey notes that financing terms vary tremendously, depending on the borrower, asset quality, the hotel's brand, loan size, market demand and LTV. ‘Good deals will attract capital. Financing is available for quality transactions,’ he says, adding that borrower experience is probably the most important factor.

Although the economy is recovering, it may not improve fast enough for many hotels.

‘Some are barely hanging on,’ Butler states. ‘Hotels face huge challenges in increasing expenses for labor costs, healthcare and taxes. Many have slashed capital expenses to survive and need capital infusions to meet their brand's property improvement program.’

Many hotels, financed through CMBS with high LTVs and weak underwriting at the peak of the cycle five or six years ago, continue to face problems. When loan balances exceeded property values after loan terms ended, lenders employed the ‘extend and pretend’ strategy, extending the terms while hoping property values and revenues would recover. But now, many loans have run out of extensions, and lenders will have to take over properties.

Variable-rate CMBS loans are not extendable, but they face a similar issue. Although LIBOR remains low, variable rates are substantially higher now because lenders have much higher floors. Hotel borrowers with low variable rates – some as low as 1%, Butler says – may be unable to meet debt service coverage under current variable rates.
Of course, a lot depends on the hotel's location. In typical recoveries, the top 25 markets recover together. In this recovery, only the top five markets – New York, San Francisco, Boston, Los Angeles and Miami – have bounced back well so far, according to Butler. Values for some New York and San Francisco trophy properties are reaching their peak.

‘This is an unusual recovery,’ Butler comments. ‘It's very uneven.’

The good news is that hotels, with their ability to change rates daily, can respond quickly to an economic upturn. Marcus & Millichap, a real estate services firm located in Calabasas, Calif., forecasts an improving environment for the lodging sector, although potential disruptions could create difficulties.

‘Employers are adding jobs at a healthy pace, while advanced bookings for near-term business travel and leisure travel for spring break appear promising,’ says David Luther, national director of Marcus & Millichap's national hospitality group, in the firm's latest hospitality research report. ‘Despite an accumulation of data points indicating the hospitality sector recovery remains on firm footing, potential downside risks loom. High gas prices in early 2012, driven by speculation and rising tensions with Iran, could adversely affect or alter travel plans in the coming spring and peak summer travel seasons. The unemployment rate has declined recently, but it remains high, suppressing income growth.’

CMBS loans are also a potential wild card for hotel investments this year.

‘CMBS loans provide much needed liquidity to borrowers,’ says Bill Grice, senior vice president of Jones Lang LaSalle Hotels. ‘Local and regional lenders are still in the process of repairing their balance sheets, leaving limited-capacity, large-money center banks and life companies to fund the majority of on-balance-sheet loans.’

Jones Lang LaSalle Hotels forecasts that this year's deal volume will continue at last year's pace, with approximately $15 billion in total transactions, as institutional and foreign investors return to the market while real estate investment trusts pull back.

Michael Kling is a former editor of Secondary Marketing Executive and a financial writer based in Stratford, Conn.


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