Hotel Financing in the 1990s
By Kapila K. Anand, Partner and Clay Dickinson, Senior Manager - Summer 1995
Fundamental changes in the hospitality capital markets occurred between 1990 and 1995. Surveys suggest that as many as 70 percent of hotels were unable to meet debt service during the recent downturn in the lodging industry and foreclosures peaked at the level of 1,000 per year. Risk-based capital rules required banks and insurance companies to reassess their real estate portfolios-further restricting the availability of traditional financing for several years. But the lodging industry’s credit freeze is starting to thaw.
After a challenging period of transition we believe that more capital will be available to the industry over the next several years than has been for quite some time. We believe however, that the investing behavior of lenders and investors arriving on the horizon are much more highly disciplined than those of their predecessors from the 1980s. Tempered underwriting attitudes toward financial leverage, financial projections, capital replacement reserves and the importance of proven management expertise are emerging and reshaping the capital markets for hospitality.
Equity Investors
A record number of hotels underwent changes in ownership during 1994. The number of hotel sales in 1994 was up 20 percent over those in 1993 and was the fourth consecutive annual increase in hotel sales volume. During 1994. the most active equity investors in the market included real estate acquisition funds, hotel companies, real estate investment trusts (REITS), and foreign investors.
Acquisition Funds. Special purpose real estate acquisition funds, either acting alone or in conjunction with a hotel management company, have been acquiring hotel assets at bargain prices. Established by a wide range of investors from wealthy individuals to the merchant banking divisions of Wall Street investment banks-- these funds are attracted to the low prices of hotel assets relative to their replacement costs. It appears these funds' acquisition strategies are 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 percent upon exit. This year we expect more specialty funds to team with hotel operators and management companies to continue their search for balanced investments.
Hotel Companies. Major U.S. based hotel companies also figured among the higher profile equity investors in hotel assets during 1994. These hotel companies, many with ready access to Wall Street funding, have been buying for both strategic and investment objectives. The liquidity provided by their access to the capital markets has improved their negotiating position in the market place and allowed them to participate in some of the more publicized transactions of last year. Again, some of these hotel companies have allied themselves with outside acquisition capital sources, a situation appreciated by lenders because it combines commonality of investment purpose with proven hotel management expertise.
REITs. Hotel REITS re-entered the market with a bang in late 1993. The 1990s REITs, unlike their counterparts of the 1970s, are primarily equity REITs and require a complex tax motivated structure that separates the operating facets of the hotel business from the passive ownership aspects of the business. The REITS of the 1970s were primarily mortgage REITS and were grandfathered from the awkward structure enacted by law in I 984. In fact, certain of these pre-l984 REITs are in fact coming back into the marketplace as equity investors. One such trust and an affiliated hotel operating company recently merged with a capital fund to form a hotel REIT which is expected to grow rapidly.
The low interest rates prevailing at the time the REITS were launched combined with the increased liquidity and growth possibilities that they represent, have made them attractive among institutional and individual investors alike. A comparatively low cost of capital also made REITs very active and competitive bidders for discounted hotel assets. However REITs necessarily favored high dividend payouts over capital replacements, which are critical to the long-term success of the hospitality assets they own. Their returns can be highly vulnerable to interest rate fluctuations and the growth of alternative investment opportunities. Seven upticks in interest rates by the Federal Reserve Board have strangled REIT IPO activity since last autumn.
Even last summer we began to see the signs of a possible consolidation of REITS: mergers of REITS as a means of survival have begun. It is unlikely that the hospitality industry will be immune to this kind of shakeout. In spite of the pitfalls several new hospitality REITS are in the pipeline for filing with the Securities and Exhange Commission in 1995. As long as investors continue to search for a balanced investment strategy relative to REITs, the hospitality REIT may be revived on a limited basis as a financing vehicle.
Foreign Capital. Finally, foreign investors continue to represent a significant force in providing capital to the lodging industry. Less aggressive than a decade ago the Japanese are selling many of their hotel assets while pension funds from the NetherIands and the United Kingdom have remained relatively silent. Investors from the Middle East as well as Hong Kong and Singapore, are routinely making headlines as they collect trophy assets in U.S. gateway cities or as they buy into upscale hotel companies. Foreign investment is expected to continue through 1995 albeit at a lower level than this past year.
Debt Investors
A number of other innovative financing vehicles have evolved to fill the void created by the lack of traditional financing sources. Some hotel companies have structured lending programs to finance the renovations and other improvements sorely needed by existing and prospective franchisees. Ever resourceful Wall Street also moved into the marketplace to fill a void.
The creation of Real Estate Investment Mortgage Conduits (RFMICs) to originate, underwrite, package, and securitize hotel loans was the invention of Wall Street. These tax-favored conduits were established in I 986 and bring a trading mentality to the industry. They involve assembling loans that meet certain designated standards and obtaining a rating from a credit rating agency prior to offering the packaged securities to the investing public. The advantage of the conduit is that it was designed to link commercial retail borrowers with investors and allow smaller property owners to participate in the securitization market In fact, the lending arms of many hotel companies have utilized conduits to securitize the loans they originated.
The delay in obtaining the desired mix of mortgages as well as the costs involved with the underwriting and rating process have hampered the full success of the hotel conduit. After seven recent interest rate increases and the return in 1994 of traditional lenders who revamped their underwriting procedures, coupled with the cost of secuntization, the spreads just may not work. Unless interest rates decline in 1995 or the programs are redesigned, conduits are not likely to be major funding source for the hotel industry in 1995. More long-term securitization will be increasingly used by traditional lenders as an additional avenue to help their loan portfolios become more agile in volatile market conditions.
Future Momentum
It must be acknowledged that there are significant differences in the type and terms of capital available today versus that available a decade ago. Capital - through equity and debt sources including Wall Street - is available for acquisition, renovation and for refinancing of well-positioned and well-managed existing product. Construction financing remains scarce but is expected to reemerge as the cost of developing new properties falls below that of rising sales prices.
But the traditional financing coming available is subject to relatively conservative underwriting criteria. Loan-to-value ratios rarely exceed 60-75 percent and debt service coverage ratios are from 1.3 to 2.5 depending on the nature of the property, as well as the vehicle used. Amortization is typically calculated over 10-20 year schedules, and interest rates are from 150 to 500 basis points over five-year treasury bills. Another key factor in the underwriting decision is having proven management expertise in place.
It has been said that the collective institutional memory lasts approximately 8 to 10 years before the decision makers of tomorrow commit the same errors of their predecessors. It is to be hoped that the stricter undertwriting standards of today will prevent the recurrence of the bitter years of the late I 980s. The tighter regulation of financial institutions and a focus on minimum required rates of return will bode well for the future.
The unknown in this equation is the potential new supply of hotel rooms entering the pipeline. It is critical that the capital markets remember that hotels are not like other real estate assets. The operating business and the revenue stream and chain affiliation are critical elements of collateral value, and the impact of proven management expertise on value cannot be ignored. If these factors are not brushed aside by the emerging breed lender, the momentum in the capital markets should continue and so should the hospitality industry's recovervy.
We believe there are several other important financing trends that could characterize and shape the industry. Watch the markets closely in order to take advantage of such events as:
The Real Estate Report is published by KPMG's National Real Estate, Hospitality, and Construction Practice. © 1996 by KPMG Peat Marwick LLP All rights reserved. For additional information email KPMG.
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