Lenders have become more conservative in their lending criteria following the busy years of 1997 and 1998. Now that lenders view many markets as overbuilt, borrowers can expect their loan applications to be placed under close scrutiny. Lenders today are looking for specific ingredients in a project: The right location, a choice market, excellent management and an attractive brand name. Market barriers to new competition also are appealing to lenders.
In addition to a top-notch project, lenders are looking for higher equity, a lower loan-to-property value ratio and strong underwriting.
Lenders wary of overbuilt markets Many lenders consider markets such as Dallas, Phoenix and Atlanta overbuilt. They also see a glut of limited service hotels. David Weiss, managing director and senior vice president in the St. Louis office of Minneapolis-based Northland/Marquette Capital Group, believes the limited service segment is saturated.
"We are basically at the trough of the cycle for limited service hotels at this time," he says. Even so, news that the budget sector is overbuilt has not reached everyone.
"[The] hospitality market takes longer to slow down and work through overbuilding than other [real estate] segments because demand is so difficult to judge," says Weiss. Small, limited-service developments are easy and inexpensive to build, so supply is being added even after the criteria for permanent loans have become more restrictive. Weiss agrees, however, that a number of markets remain underserved, including many of the secondary markets.
Michael Huffman, director of the Chicago-based hotel lending group at Heller Financial, says the state of the hotel industry depends on the submarket. "There are lots of overbuilt markets and other markets that could use new supply," he says.
Jerry Earnest, senior vice president in the Hospitality Industry Division, GMAC Commercial Mortgage, Vienna, Va., sees the hospitality industry as a "good place to be. The market is in balance, but there are pockets of overbuilding and excess supply," says Earnest.
However, the hotel industry remains out of favor with Wall Street. Prices for hotel stocks, while recovering, are 50% below their peak in early-1998. Overbuilding and its possible affect on operations and revenue per available room (RevPAR) appear to be a continuing concern for Wall Street.
Wall Street has learned some lessons about hotels. According to Michael Sonnabend, managing director of New York-based AFC Realty Capital, Wall Street now realizes the important role that management plays in hotel investment. He adds that Wall Street seems to be viewing hotels now as "day-to-day operations housed in real estate," says Sonnabend. "People who made investments in the past and didn't focus on management realize now that management drives the market."
Who can borrow on a hotel today? With the perceived glut in limited-service hotels, borrowers with mid-market and luxury-market plans have the best shot at receiving financing, says Weiss. "Speculative projects that do not have very strong operating sponsorship or heavy equity will find it difficult to get financing today," he says.
You have to have a good product, good history and the right kind of operator and location to find a loan," says Weiss, adding that limited-service hotels are "beaten black and blue" by underwriting. Loans are being made for these projects, he says, but in smaller amounts.
Joel Hiser, executive managing director of San Francisco-based Hospitality Asset Services, notes that borrowers have a better chance of obtaining financing if they don't seek high leverage. "If a borrower is at 60% to 65% loan-to-value, a loan can be made," he says.
Getting the right kind of loan Hotel owners frequently discuss the pros and cons of different kinds of loans. Lately, commercial mortgage backed securities (CMBS) loans have been a popular topic. When debt and capital inventory were nearly unavailable in the 1990s, Wall Street came to the rescue with securitized mortgages. Borrowers are now taking another look at their CMBS loans, largely because they are finding that they have limited prepayment privileges if they want to sell or renovate properties.
With CMBS loans, yield maintenance requires guaranteed cash flow for the ultimate purchaser of the share, which can create prepayment difficulties. Typically, CMBS loans do not allow prepayment privileges for the first half of the loan term, and then afterward only with a severe penalty. These loans also do not allow mezzanine loans, also called second mortgages.
"CMBS bring both pros and cons," says Earnest. "The advantage for CMBS is a very efficient market for long-term hotel capital." In addition, there is no limit to CMBS loan size for existing properties. "When we came out of the recession and only CMBS loans were available, borrowers were looking for the lowest price," he says. "Flexibility wasn't an issue until now."
However, CMBS loans carry drawbacks. For instance, a hotel owner with a CMBS loan who wants to fix up property is in a bind, says Kyle Poole, director of Washington, D.C.-based Hotel Finance Specialists. Without the flexibility of a recorded second mortgage, the owner is faced with three unappealing options: Obtain a costly unsecured second mortgage; finance the renovation out of pocket (typically escrows for reserves are insufficient or not available for rehab); or sell the property.
Selling the property can prove to be costly for an owner, says Poole, because the prepayment penalty on a CMBS loan may make it economically unfeasible to pay back. With a loan still in place, several things can happen. If the note rate becomes higher than the market rate, a buyer will pay less for the property because he has to accept the higher-rate loan. If the property appreciates and the owner wants to sell, the purchaser must assume a loan which today may be at 70% loan-to-property value, but in the future might be at 50% loan-to-value. Also, the owner cannot entice a purchaser by offering seller financing, so a potential buyer would have to come up with a large amount of cash, says Poole.
Since owners cannot change the terms of a CMBS loan, Poole says some owners ultimately decide to give the loans back to the lender. He suggests that the industry may see more of this, especially with some overbuilding in the marketplace. "With no flexibility in restructuring, a [CMBS] loan could put the borrower out of business," Poole says.
Mark Finerman, managing director of New York-based Credit Suisse First Boston, points out that borrowers should look into whether a CMBS loan is the right kind of financing for them. "If owners don't like prepayment penalties, then they should get a permanent floating-rate loan," says Finerman.
Rising interest rates are making it more difficult for borrowers to receive favorable loans. Interest on Treasury bonds is up, causing a corresponding jump in fixed-rate and short-term interest rates for real estate development. Interest rates have risen to high 8% or low 9%, says Hiser. "Because of longer treasuries now, basis points (bp) have gone from 150 bp two years ago to 275 to 300 bp at present," he notes.
Poole says the limited availability of capital is another major issue in today's hotel market. "The most important issue is availability of capital," Poole says. "Rates are secondary to availability now, especially for new construction."
Finerman disagrees. He thinks many lenders are chasing the same loans. "Hotel owners are finding it difficult to finance some properties because cap rates have gone up, not because there are unwilling lenders," he says.
What loans are available? All kinds of loan are still available, but borrowers may need to do more homework to obtain them. Those willing lenders include Wall Street conduits, banks and life insurance companies. Wall Street provides price, nonrecourse and unlimited loan amounts. Another option, a construction loan, is the most difficult to obtain.
"Financing just is not as plentiful as it was," Poole says. "Availability depends upon the sector of the marketplace. There can be multiple choices or few choices."
GMAC, for example, offers all kinds of loans: Fixed-rate, seven-year to 20-year permanent loans, floating loans, interim loans for existing or repositioned properties, construction and mini-permanent loans, forward commitments for third-party lenders, and mezzanine loans.
"Fixed-rate loans are now being made to recently stabilized or stabilized properties and mid-market through luxury products," says Earnest. "For interim loans, the operator has to have lots of experience. Interim loans currently are three to five years for stabilized, light-to-moderate renovation and repositioning [properties]." GMAC only makes construction loans to existing clients or clients with whom it wants to develop a relationship. "If a client with an economy- or mid-market product is well-structured and we have real confidence in their ability, we will make the loan," adds Earnest.
Heller Financial provides short-term financing (three years, variable rate) as a bridge for properties that are being repositioned. "A lot of borrowers are waiting to see what's going to happen to the economy, and plan to convert when money is more available or rates go down," says Huffman . Heller focuses on first mortgages of 70% to 80% loan-to-property value (vs. the 65% to 70% typical with other lenders). A borrower has to pay a commitment fee, usually one point, and could find that short-term costs can go up over the loan term.
Heller provides tailored financing that hinges on the strength of the borrower, the strength of the property, the amount of supply coming into the market, strong barriers to entry and the flag. "[Heller Financial] is not interested in limited-service hotels but in better quality, full brands that may be repositions or mid-quality flags that are being upgraded to higher quality branded hotels," says Huffman .
Banks, says Poole, are beginning to play a bigger role in hotel financing. In 1998 (the latest data available), 64% of respondents said banks contributed to a hotel transaction, vs. 42.9% in 1997, according to San Francisco-based PKF Consulting. The advantages of bank financing include an availability of funds in local markets, no prepayment penalties (although this could change) and availability of both construction and secondary financing.
"Local and regional banks understand their own backyard, while conduits, which lend nationwide, tend to cut back when they don't understand a marketplace," says Hiser. The main disadvantage is that banks seldom handle transactions over $25 million.
Weiss has seen a number of life insurance portfolio lenders enter the hotel market over the last six months because they expect yield value to improve through selective hotel investments. Because there is so much competition in core real estate investments, Weiss anticipates the number of lenders for hospitality will increase.
Hotel operation statistics indicate the overall market remains sound. The hospitality industry, as a whole, continues to run up record profits.
However, the January 2000 report Trends in the Hotel Industry USA Edition - 1999 prepared by The Hospitality Research Group, the research affiliate of San Francisco-based PKF Consulting, notes that profitability concerns exist in a few segments, "notably the lowest rate category [an average daily rate (ADR) of less than $50], extended-stay and all-suites hotels."
Due to excess supply, year end 1999 occupancy was 70.4 %, a 1.6% drop from year-end 1998, according to the Hospitality Group. ADR rose 3.3% in 1999, while revenue per available room (RevPAR) rose 1.7%. The Hospitality Group expects similar increases in 2000.
"With companies strategically divesting properties, we continue to be busy to the point where some deals are turned down because we cannot handle any more," says Kimberly Moffit, director of marketing and corporate communications for New York-based Sonnenblick-Goldman.
Hotel property prices have fallen from several years ago when REITs were paying top dollar. Due to this drop in hotel property cost, opportunity funds and pension funds that stayed away from the hotel market are now purchasing hotel properties, Moffit says.
Due to the heated competition in the United States, some lenders consider overseas markets more attractive. The Capital Markets Group of Toledo, Ohio-based Dana Commercial Credit looked at investment transactions and considered the price per room too expensive in the United States. The company is working primarily in Europe, where there is less competition, says Dana vice president Joe Beham.
He says he expects the U.S. investment market to improve as REITs encounter difficulty. If that happens, he says Dana would consider returning to the U.S. market because there would be an adequate return for the risk. Lower prices would also give a better after-tax return on the sale/leaseback arrangements the company handles, adds Beham.
Dana Commercial Credit is not the only lender and investor concentrating on the overseas hotel market. Sonnenblick-Goldman is helping to raise capital for KAMPCO (Korea Asset Management Co.) and recently opened an office in Tokyo to complement offices in Singapore and Hong Kong.