The credit freeze, which the nation's hospitality industry has endured for the past five years, is beginning to thaw.

After getting the cold shoulder from financial institutions, insurance companies and local lenders since the debacle of the 1980s, the lodging industry is now receiving a much warmer reception. Although the past is still fresh, more lenders now are taking a closer look at the hotel sector -- and loosening their purse strings.

"Debt is coming back in a big way with the refinancing of existing assets being more liberal now than anyone had predicted," notes Dr. Bjorn Hanson, National Industry Chairman-Hospitality at Coopers & Lybrand in New York. "There's also more private equity funds to buy hotels that have $200 million or so for acquisition and need to spend it. Not only that, but a new generation of REITs is appearing on the scene."

Timothy Aho, senior vice president of development at Prime Hospitality Corp., calls that recent turnaround in the hotel industry "nothing short of phenomenal." The oversupply and overfinancing of the 1980s hurt the industry, and now there is a return of financial sources back to the industry. "We are seeing a rekindled interest from investors."

The hotel industry is driven by room supply, says Jeffrey Lapin, president and COO of Starwood Lodging Trust, and the demand has caught up with the supply again.

"The industry is seeing a resurgence," says Ken Mason, president of Mason Hospitality Services. "We were dealing with a hotel six months ago that no one would talk to us about. Now, we have more than one group showing interest in it -- and at good rates."

Already, analysts, industry observers and others are seeing a number of trends including:

* Increased flexibility in financing, with lower interest rates and less stringent requirements,

* An expansion of the Wall Street connection by way of securitization,

* Financing for new construction on Main Street, primarily in the budget and mid-priced categories, by local lenders and

* Increased participation of investors through a renewed interest in public and private equity marketing including REITs.

Joel Hiser, senior vice president of corporate finance for Richfield Hospitality Services Inc., also sees improvements in the hotel industry. "The lending criteria is becoming a little more lax, interest rates have come down and the size of loans is growing," Hiser says. His company is using this time of increased activity to buy hotels and try to get its hotel brand, Regal, on the map.

Dana Michael Ciraldo, president and managing director of HVS Financial Services, Mineola, N.Y., which specializes in hotel brokerage and investment advisory services, adds that the full-service hotel acquisition market has become dramatically more competitive. "With a properly managed sales process, it is now common to receive a multitude of credible offers," he says. "Many hotel operators have aligned with capital sources and are seeking investment, with the resulting competition driving capitalization rates downward and prices upward."

"There have been several significant changes in both the hotel investment and financing markets," says Bill Gingrich, executive vice president and CFO at Hostmark Management Group, Chicago. "The investment community has committed a large pool of funds for hotel acquisitions. The most significant change appears to be an alignment between the investment community and large hotel operations." Gingrich notes some examples of this alignment: "Blackstone Capital with Interstate, several pension funds with Bedrock Partners, Morgan Stanley with Red Roof Inns, Carlyle with Sage and Cargill and ourselves (Hostmark Management Group)."

A recent survey by Arthur Andersen found that more financial institutions, large and small, are planning to lend to the hospitality sector -- albeit cautiously. The study polled 21 financial institutions whose hotel portfolios ranged in size from $25 million to more than $2 billion. More than half said they were planning to lend to hotel projects, although they stressed that the amount of debt capital available will depend on potential borrowers' ability to meet still stringent, but loosening, loan criteria.

Roger S. Cline, worldwide director of Arthur Andersen's Hospitality Consulting Services, stresses that financial institutions have not forgotten the past but are sensing an opportunity. "More than half of the banks surveyed said these problems were not fully behind them," Cline says. "And five banks say these problems remain a major concern for their institutions. Banks that do plan to lend to hotel projects ... appear to be taking a wait-and-see attitude to what the market will bring forth and the future performance of the industry."

Financial institutions on the local level are already acting. "You now have lenders who are considering getting back into the market because of the dynamics of the industry," says Gregg Swearingen, director of project finance and investor relations at Promus Hotel Corp. in Memphis. "Financing is more easily accessible in the lower segments, such as limited service properties like Hampton Inns. Local banks are lending for projects to customers they already have a relationship with. They think, 'If John Smith who owns half the town wants to build a hotel, sure we'll give him a loan.'"

Yet lending by local banks, while rising, is limited; neighborhood institutions can't make the $30 million or $40 million loan others in the industry require. Not surprisingly, the industry is turning to the public sector. Already this year there have been three major debt offerings in the public market including Host Marriott, with $600 million of senior notes at 9.5%, $400 million in Host Marriott Travel Plaza notes at 9.5%, and $200 million worth of Marriott International notes at 7.9%.

While more transactions are expected, individual borrowers are finding that lenders, who used to throw millions at hotels only five years ago, have become more tightfisted. Money is available, the lenders say, but only to qualified borrowers and typically at higher costs.

Roosevelt Jones, president of Megafund Capital, Chicago, says that problems can occur when money is loaned without considering the reputation of the borrower. "As more capital hits the market, this may spur new construction or create cut-rate competition as more traditional lenders clamor back to the market. This may induce lending to marginal borrowers," he says. "The major point here is that some caution should be taken by investors and that particular attention has to be given to the management expertise of the owner/operators."

Thomas D. Papelian, senior vice president of development for The Camberley Hotel Co., based in Atlanta, points out that lenders are being more cautious about the money they give out for development. "Although new construction financing remains scarce, lenders have become more eager to work on acquisitions and refinancing with borrowers who have demonstrated capabilities and a proven track record."

Ken Mason agrees that for people already known in the business, there are loans available. "Mason's track record lends some credibility when people go to get loans."

Sean Hennessey, vice president of Hotel Partners in Chicago, notes that while the availability of debt capital has greatly improved, there is a difference: Pricing is high compared to Treasuries and the spread for hotel loans over Treasuries is twice what it is over other property types.

"Hotel loans are priced at 300 to 350 basis points over Treasuries," he explains. "If a 10-year Treasury is yielding 7% and a hotel loan is at 10.5%, that's a spread of 350 points. That compares to office, retail and industrial lending with a premium of 150 to 200 basis points. In money market terms, that's a huge spread for risk of hotel loans. Thus there are more people getting into it, and the people who are getting into it are those who are doing so because handsome profits are to be made where there aren't that many competitors."

Even so, says Tom R. Engel, executive vice president of Atlanta-based Equitable Real Estate Hospitality Asset Management Group, underwriting criteria is very conservative: a borrower must have a sufficient amount of real equity -- typically 40% -- and a property must generate sufficient cashflow to cover debt by 40%.

"Say you want to buy a 200-room hotel for $8 million," Engel says. "The hotel also needs renovation to the guest rooms and the lobby for another $10,000 a room. That will add $2 million; so the end costs will be $10 million. In this case, a lender would typically want to see 40% in equity -- $4 million -- before even considering providing a loan. Lenders would also require that the hotel have a 1.4 debt coverage ratio -- cashflow of $756,000 or 40% more than interest expense."

Raymond M. Anthony, managing director of Nomura Securities International, New York, which has handled more than $2 billion in hotel financing over the past two years, makes no apologies for the stringent underwriting rules.

"If you compare the standards now to what things were eight years ago, then yes, we are more strict, but then look at all those deals that went into default," says Anthony. "We are very comfortable with hotels today because we are underwriting hotel loans based on values that are realistic -- based on assumptions that are not only conservative but more genuine. You don't want to be conservative just to be conservative. True, if you don't make a loan, you don't make money, but you want to make loans that will perform over the next 10 to 20 years. Right now, I think, lending requirements have reached an equilibrium. I don't see them getting more liberal, or more conservative -- just realistic."

Anthony adds that one of Nomura's requirements when it underwrites hotel loans is the setting aside of a minimum reserve, 4% of revenue, for capital expenditures. This is because one of the problems hotel owners have is plowing sufficient money back into the properties for refurbishment. If this isn't done, the value of the asset will deteriorate.

Nomura, which just completed the $450 million acquisition of Westin Hotels by Starwood Capital Group and Goldman Sachs, takes cashflow and makes a deduction for capital expenditure reserves, typically on a monthly basis. "Oftentimes, borrowers give us NOI figures and won't have a deduction for capital expenditures," Anthony says. "We take the NOI the borrower gives us and in addition to that, deduct 4% of gross revenue for the cost of maintaining the properties. You get a real income number."

Experts expect underwriting parameters will continue to be tough in the future since loans will ultimately be sold in pools to investors as securities. Lenders will want to make sure that every loan meets the minimum underwriting criteria set by the investment bankers who sell the loans to investors, analysts say.

"The shift in capital is expected to have a dramatic effect on the future underwriting for hotel loans and investments," points our Francis J. Nardozza, National Hospitality Industry Director at KPMG's National Real Estate, Hospitality and Construction Practice. "No longer will the game be to convince the lenders' credit committee or the investors' capital committee to do the deal. The game is to convince independent agencies rating the securities that the deal is good since they are the ones that Wall Street investors rely on to rate the underlying securities."

Nardozza sees this as a double-edge sword. Once the loan is made, a greater amount of periodic business and financial information will be required to allow for secondary sales of the mortgagebacked securities. "Possibly, future loan agreements will require the borrower to provide quarterly and annual financial statements and reports similar to Form 10Q and 10K required by the SEC -- a heavy compliance burden for borrowers," he says.

"Because it is still hard to get money from traditional sources, non-traditional sources have evolved -- such as hotel REITs, hotel conduits and structured financing," says Lapin of Starwood Lodging Trust.

Financial programs continue to be offered through franchiser organizations such as Hospitality Franchise Systems and Choice, which have linked up with firms including Lexington Mortgage Company of Vienna, Va., to provide financing conduits for their franchises.

"At the beginning of the year, conduit programs were not competitive, but that reversed by mid year, and conduits now are very competitive players," adds Hennessey of Hotel Partners. "Conduits still have hurdles to get over, particularly the relatively higher strictness of underwriting standards, which in turn leads to a higher up front charge to borrowers."

Real Estate Investment Mortgage Conduits (REMICs), which originate, underwrite, package and securitize hotel loans, have gained in popularity. Under conduits, Wall Street firms assemble loans that meet certain designated standards and obtain a rating from a credit agency prior to offering the packaged securities to the investing public. The advantage? REMICs link commercial retail borrowers with investors and allow smaller property owners to participate in the securitization market.

"The most significant change in hotel financing to date has been the proliferation of real estate mortgage investment conduits (REMICS) being formed by almost every Wall Street firm," says Megafund Capital's Jones. "This activity is an indication that the lodging segment is again a hot market. The hospitality industry has been virtually ignored by 'Wall Streeters' for nearly seven years, and now, Wall Street recognizes the hotel market has rebounded."

Conduits are not the only Wall Street action. Real estate investment trusts also are becoming increasingly popular financing vehicles, led by the $298 million offering of Patriot American (Hospitality Properties) and the $279 million offering by Starwood Lodging of Los Angeles.

Bjorn Hanson of Coopers & Lybrand labels Starwood and Patriot American the "next generation" of REITs. "These REITs are very different from what we've seen in the past," he says. "Patriot is an independent model, there isn't any overlap between board members and officers of the REIT. In the past, you had one company established as a REIT and another that 'rented' the real estate from the REIT. Patriot is the first modern hotel REIT where there is no overlap between the two boards. That may make some investors feel more comfortable with REITs."

Added to conduits and REITs are the mushrooming hotel investment funds that have raised millions to purchase properties and must spend the capital accumulated. These acquisition fund strategies have been triggered by the potential for realizing both cash-on-cash returns in the first year of acquisition and internal rates of return in the range of 25% to 35% upon exit, analysts say.

"There's an awful lot of capital being raised which is a combination of equity and debt to be utilized by investment funds, similar to the concept of Bedrock Partners," says Paul Novak, president of Dallas-based Bedrock. "People are going out and raising $400 or $500 million in a combination of equity and debt. We initially went out and raised $200 million in equity. We acquired a number of hotels and then were able to go to Nomura Securities and secure a long-term debt line for $200 million. We're now seeing an awful lot of capital raised that way."

Yet those in the industry note that while Wall Street has regained confidence in the hotel business, the sector isn't home free. "If we slip and start aggressively overbuilding in the limited-service and mid-price range, and we start seeing a lack of profit, Wall Street can turn it off as well as they turn it on," says Don Wise, first vice president, lodging hospitality services, CB Commerical in Orange County, Calif.

Prime's Timothy Aho also points out the importance of not falling into the same problems the industry faced in the 1980s. He notes that part of the mid-'80s boom was that everyone was fee-driven. "No one was worrying about the future of the hotel industry."

The Camberley Hotel Co.'s Papelian says that the hotel situation is improving from the perspective of the lender and the borrower and "despite significant increased competition, lenders have remained remarkably diligent in their underwriting procedures and continue to assess their long-term risk and exposure."

CB Commercial's Wise and others note that strong historic cashflow remains the key to the financing puzzle: a property that has good strong operation financials for two to three years is going to find the financial markets interested in placing debt on that property. "For properties with weak cashflow or for those 1960s or '70s roadside properties where the world has changed, financing will continue to be tough," Wise says.

And, as with everything, timing is important. "Now is a good time to structure equity and debt transactions particularly with full-service properties," Ciraldo says. "Within the next two to four years, more full-service properties will be built, thereby negatively affecting full-service values."

Given the large amount of unspent equity targeting the hotel sector, the early 1990s strategy of buying low and selling high may not by itself maximize returns in today's hotel market, particularly for passive investors. The full-service hotel acquisition market has become dramatically more competitive; it is now common to receive a multitude of credible offers during the typical sales process. Many hotel operators have aligned with capital sources and are seeking investments, with the resulting competition driving capitalization rates downward and prices upward. In many cases the operator/owner becomes the prevailing bidder because they receive the additional benefit of management and/or affiliation fees and are able to economically offer a higher price than the non-operator. This "operator arbitrage" can now be applied to the debt markets in the form of mezzanine financing.

Mezzanine financing is usually either, (a) wrapped around an existing first mortgage, like a second mortgage or (b) a single debt instrument tranched (split) into a first mortgage component and a mezzanine or "B-rated" component. Generally mezzanine financing provides for a high loan-to-value ratio (LTV ratios in excess of 90% are not uncommon) or a below market interest rate. In return, the provider of mezzanine financing receives interest payments and a significant portion of a property's future appreciation. Additionally, the mezzanine financing provider may receive other "equity-like" rights, which may include management contracts and affiliation agreements. Mezzanine financing, which by definition generally includes a sharing of future appreciation, can be structured so that appreciation sharing is a percentage split, pre-determined fees paid upon maturity or as a negative amortization loan.

For example: a hotel owner purchasing a property in the late 1980s paid a purchase price equivalent to, or perhaps even above, replacement cost (say $100) and financed 75% or $75 with a bullet loan that is now due. Today that property's value is $75 and the owner can refinance at 75% of its current market value or $56 (75% x $75). Unfortunately the owner does not have the $19 necessary to pay off the original mortgage ($75 - $56), and the original note holder is not willing to accept a 25% write down from $75 to $56.

This owner finds a mezzanine lender (in a joint venture with a hotel operator) that provides $70 of financing (a 93% loan-to-value ratio), the original lender accepts $65 as payment-in-full on the existing mortgage, and the owner receives $5 in cash. The mezzanine lender and hotel operator's joint venture effectively control the asset and hold it two to three years until the hotel's market value rises to equal replacement cost or $100, thereby realizing $30 in appreciation (43%), the majority of which is a return to the mezzanine lender/hotel operator joint venture, besides the interest paid during the holding period, and management and affiliation fees of say 7% of the hotel's room revenue.

If a hotel operator creates a joint venture mezzanine fund, the "operator arbitrage" that is now present in the equity acquisition markets can be applied to the debt markets. In the previous example, the operator mezzanine joint venture fund could either (a) fund more than $70 in debt, (b) pay a higher interest rate because they would receive the additional benefit of management fees and/or franchise fees or (c) discount their management or affiliation fees.

Lehman Brothers has provided nearly $500 million of financing in the last nine months for borrowers seeking acquisition or refinancing capital for transactions requiring in excess of 70% loan-to-value. Lehman funds the loans with its own capital but then finances or sells an interest in the loans through a securitization and/or private placement. For example, Lehman recently provided approximately $66 million for affiliates of Boykin Management in a floating rate loan with a 36-month maturity and a 12-month extension. The loan is secured by cross-collateralized, cross-defaulted mortgages on four full-service hotels, with the interest rate augmented by additional renumeration (fees) paid to Lehman at maturity. Aldrich, Eastman and Waltch has completed 13 mezzanine financings in the last 12 months, totaling roughly $80 million.

Other active mezzanine lenders include Starwood Capital Group, Apollo Real Estate Investments, Lennar Corporation, LaSalle Partners, Ocwen Financial and CRI, Inc.

Per-room average price: (mid-market hotels) 1994: $19,068 1993: $17,411

Lender-owned sales: 1994: 25% of all hotels sold Previous three years: 45% of all hotels sold

Average daily rate: 1994: $63.44 projected 1995: $66.00 +

Occupancy: 1994: 65.3% projected 1995: 67.2%

Money provided by Wall Street: (in 1994) through hotel REITs: $1.2 billion +

First-class/luxury hotels/destination resorts: Individual transactions 1994: 100 +

Value per transaction: $10 million +

Source: 1995 edition of TransActions by HMBA[R]