By: Jon Simon, Partner with Evan Bedell, Manager and Troy Furbay, Consultant, Summer 1996

“We’ll never lend on another hotel property!” said the chief executive of a major Midwestern bank in 1991. Despite the prevalence of that sentiment in the recent past, it is clear that debt capital once again exists for hotel properties.

In the environment that has evolved from the 1980s’ overbuilding and early 1990s’ opportunistic buying, we are seeing an increasing number of players making loans on solid properties and aggressive lenders taking calculated risks for potential upside on repositioning projects.

An increasingly crowded field of lenders is providing both public and private capital for quality projects, while at the same time communication harsh realities to owners of properties that do not measure up. This article addresses structural changes in the market and their effect on current and future lending.

Structural Changes

The current hotel lending market is part of the larger hotel sector investment picture. The transfer of investment capital from private entities to publicly traded REITs and C corporations has driven the return to hotel investment and brought with it new investor expectations. Investment decisions of the 1980s were focused on individual properties. Equity return expectations of 15 to 25 percent necessitated high leverage and optimistic appreciation assumptions.

In contrast, investors in both REITs and C-Corps are investing in an entity’s management and strategic advantages, as well as its portfolio of individual properties. Investors in hotel REITs currently require funds from operations yields on equity of 7.5 to 11 percent with further return expectations based on corporate growth and performance improvements. Meanwhile, properties have been available at capitalization rates of 11 to 12.5 percent, based on trailing earnings. Thus, there has been no need to highly leverage transactions. The five largest hotel REITs, according to Realty Stock Review have an overall debt-to-equity ratio averaging a low 13.9 percent, contrasted with ratios of 40 to 50 percent for the office/industrial, regional mall, and factory outlet center REIT segments. Therefore, lenders have been able to re-enter the hotel segment cautiously, finding ample appetites for conservatively structured deals.

First Mortgage Financing

Traditional mortgage lending continues on the upswing as the hotel sector returns to health. The bulk of the financing are spot-rate deals with few future commitments for development, with the exception of limited-service properties. Based on a recent KPMG survey, see Sample of Typical Loan Terms, underwriting standards are fairly conservative, despite the recent entrance or re-entrance of many commercial banks, pension funds, life companies, and competition among Wall Street conduits. For established properties, loan-to-value ratios range from 50 to 70 percent. For most loans, debt service coverage (DSC) ratios are from 1.4 to 1.5. Fixed interest rates for non-recourse loans range from 250 to 350 basis points over like-term treasuries (typically 7 to 10 years), amortized over 20 to 25 years. These spreads are 100 to 150 basis points higher than for similar loans in the office, retail, and industrial sectors.

The flow of equity capital into the market; the relatively low amounts of debt on many balance sheets, both in REITs and C-Corps; and the general health of the industry, indicate increasing lending opportunities. Thus, while lenders see increasing competition for deals, they do not anticipate a substantial lowering of rates in the near future.

Wall Street conduits continue to supply a substantial portion of mortgage financing. Nomur, Lehman Brothers, Donaldson Lufkin Jenrette, and Bear Stearns have been particularly active in the hotel sector. They bring capital to small, limited-service properties that would otherwise have difficulty accessing securitization sources. In order to qualify for securitzation, the properties usually must have a strong operating track record and chain affiliation. If more commercial banks and other lenders become comfortable holding, rather than securitizing, loans of this type, conduits could diminish in importance due to these additional costs, and potentially higher interest rates.

Mezzanine Financing

For the entrepreneurial investor/developer with more highly leveraged properties and/or properties in need of renovation, low-leverage first mortgages fall short of supplying needed capital. The evolution of mezzanine financing has meant survival for some of these owners while providing a source of high yield for aggressive lenders. Mezzanine loan-to-value ratios can reach 90 to 100 percent for properties with perceived upside. In addition to base interest rates of 300 to 600 basis points over treasuries, aggressive mezzanine deals often include a participation position in the property’s cash flow and appreciation. They are typically structured with expected returns of 20 to 30 percent over three to five year terms. Activity in this segment is expected to continue as bullet loans continue to mature and the competitive environment intensifies with more hotels being repositioned and reflagged.

Summary

The markets disguise two significant structural changes. First, hotels are being looked at as operating businesses as well as pure investment properties. The successful use of repositioning, franchising, and joint venturing are critical to hotel owner’s success in raising capital. Second, the growth of the public equity and debt markets has brought a dispersion of risk among the participants in the capital markets. This dispersion has allowed first mortgage lenders to decrease their risk by loaning on more conservative terms.

These changes forecast three trends in the lending markets. First, borrowers with management abilities and well-positioned properties will hold decided advantages. Second, lenders see an increasing appetite for first mortgage financing and can be expected to maintain conservative underwriting standards, at least for the near future. Third, mezzanine lenders will continue to be very active, lending on aggressive terms and on deals which require high leverage or funds for repositioning. Ultimately these higher yield, coupled with lower loan-to-value ratios, may well lure back many of the financial institutions which had previously vowed never again to be in the hotel lending business.

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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