News for the Hospitality Executive
|By Jim Butler, Hotel Lawyer, Author of www.HotelLawBlog.com
Debt and equity financing of hotels and hotel mixed-use projects is critical and can be very challenging. Our clients take hotel financing seriously, and so do we. That’s why we host the annual JMBM Industry Outlook Roundtable every January and our Meet the Money® conference every May.
With the legacy of Meet the Money® propelling us forward, I was delighted to join with leading hotel industry experts for JMBM’s “Outlook 2007, Hospitality Roundtable.” They reflected on a very interesting year just passed and pulled out their crystal balls to see what would happen in 2007.
Outlook 2007 Roundtable: Hotel Finance
I am grateful to the following panel of experts who participated in this dialogue.
Frank Anderson, Senior Vice President, HSH Nordbank AG, New York BranchJim Butler: What is happening with capital pricing and capital providers in general? What’s going on in the marketplace?
Robert Stern: Liquidity, liquidity, liquidity. That’s been the name of the game and it shows no signs of changing anytime soon.
Alex Gilbert: Overall, the opportunity that owners have had to either sell or refinance is unprecedented.
Bruce Baltin: There are a large number of hotels being put onto the market so that sellers can get peak prices. Buyers and owners have also taken advantage of the low supply growth to reposition existing hotels “upmarket.”
Robert Stern: There are more capital providers than ever. Some cycle out, but others backfill. Pricing is rich, and in many cases the buyer is basically paying for some of the projected NOI growth up front. That is not a comfortable position to be in as a buyer, but it will likely continue at least until we see a meaningful increase in new full-service hotel supply in many markets.
Jonathan Roth: Real estate has been one area where yield-hungry hedge funds have found a place to deploy capital over the past few years. Many transactions would not have been accomplished if not for these new providers of capital and their willingness to take on higher levels of risk. That said, we have already started to see some of these funds liquidate their real estate positions as their inexperience in the valuation of real estate assets has already led to losses. For stabilized assets, I believe capital will remain relatively inexpensive and plentiful.
Steve Van: The providers of capital are beginning to resemble the Creosote Man in Monty Python’s The Meaning of Life. They are so immensely full of capital (Blackstone over $25 billion!) that they are in danger of exploding and making a mess of things. Already almost any normal stabilized and healthy hotel for sale gets priced at numbers we feel are bloated.
Jonathan Roth: Yes, prices are being bid up to extraordinary levels. For stabilized assets, the markets are very efficient and, as a result, cap rates should remain at today’s historic low levels. There is also a strong movement for large funds to aggregate assets with an eye towards a public offering as an exit strategy. As long as the appetite for these IPOs remains strong, the aggressive purchasing should continue as well.
Peter Connolly: Real demand growth coupled with limited supply growth has continued to leverage pricing increases for what has certainly been the longest period in my 25 years in this business. That strength in the market is attracting some of the capital, which is fleeing the mid-market residential products that are getting flogged in the press.
Frank Anderson: From a capital standpoint, the influx of residential real estate players that are adding hotels to residential mixed-use projects on the equity side of the equation, has been a very interesting development.
Alex Gilbert: Plus, the securitization market has dramatically changed the real estate landscape. For 2006, the amount of conduit new issuance will exceed $150 billion, which is double what it was just two years ago. There will be over 25 different lenders that will each originate over $2 billion in new loans, in comparison to 14 lenders at that same level two years ago.
Robert Stern: If you can’t access capital now, there must be something seriously wrong with your project. We don’t do plain vanilla deals and we still expect a risk premium for hotels — but let’s not forget how volatile these cash flow streams can be, so it’s tough to find deals we really like on a risk-adjusted basis. Depending on whether it’s a straight full-service domestic hotel deal involving perhaps a re-flagging/ better management story, or an international resort development with a for-sale component, we’re expecting levered equity returns from anywhere in the high-teens to substantially higher, and profit multiples of around 2 times and up. It’s really case-specific, but our domestic expectations are perhaps a couple hundred basis points lower than we underwrote, say, 3 years ago. Our international expectations are unchanged.
Monty Bennett: It’s a time of great opportunity—but it is also a time to be cautious and wise because when there is a glut of money, bad deals cannot be far behind.
Frank Anderson: I agree. Construction lenders are increasing in number. Some are trying to “buy” market share through either reduced pricing or eliminating essential structuring protections.
Patrick O’Neal: And we are also seeing a handful of renegade lenders within the CMBS industry who are creating deals that should be recourse bank deals – but they are posturing them into the CMBS industry based on unsubstantiated performance and projections. The mortgage banking community is shaking their heads.
Jonathan Roth: In the pursuit of yield and of putting large sums of capital to work, many capital providers have departed from sound underwriting principals. Many acquisitions and repositioning transactions have been capitalized utilizing short term bridge loans, often times marrying a senior and a mezzanine loan, or creating a highly leveraged senior loan which is later syndicated into tranches carving up the various layers of risk, all in order to increase the overall amount of leverage on the asset.
Patrick O’Neal: While we may not be absolutely at the top of the market, the combination of low cap rates, low interest rates, huge values and loans per room figures — in combination with high LTV and low DSCR — is scary at best. The scariest deals are the ones that actually offer full interest only at huge LTV and maybe have mezz debt stacked on top of that. In a perfect world, it doesn’t matter because in that comic strip, the world always gets better! But history tells us otherwise. The question is: will these properties improve enough in performance to sustain a level of value and DSC that allows them to be high enough above the minimum standards to support future refinancings when the downturn occurs? And it’s not a matter of whether the downturn occurs, but when.
Jim Butler: Thank you, everyone. Those are some valuable insights. I must say that although there are a few wispy clouds on the horizon, and some say that things can't continue this well for much longer, I am very optimistic. I think we have a number of great years ahead of us in the hospitality industry. There may be a few rough spots (we were recently engaged to help on one of the first significant, failed condo hotel projects — a high-profile deal and player), but generally speaking, the environment will be supportive and strong. There will be a lot of deals and a lot of need for matching up capital requirements.
How will you finance your hotel project in 2007?
I am greatly indebted to Patrick O’Neal for his participation in our hotel finance analysis for 2007. Patrick is the National Products Manager/Hotels for PNC Real Estate Finance. With more than 25 years of experience in hotels and commercial real estate, he has been involved in hotel management, commercial brokerage, real estate syndication, mortgage banking, loan & REO asset management, and commercial lending. PNC offers non-recourse fixed rate long-term CMBS financing on mid to upper-tier limited service, select service and extended stay, full service, and upscale boutique hotels in the U.S. PNC closed over $445 million of these hotel loans in 2006 and looks to increase that to as much as $600 million or more in 2007. Contact Patrick O’Neal at firstname.lastname@example.org or (913) 253-9623.
Jim Butler: Patrick, you have been through more than one industry cycle as a lender. Tell us what is going on from a capital provider’s perspective?
Patrick O’Neal: In JMBM’s annual outlook roundtable last year, I predicted that 80% loan to value or “LTV” at 1.30 debt service coverage or “DSC” on 30 year amortizations would become “the norm” for 2006. And that has pretty much happened . . . All of those parameters are fairly readily available on higher end product in better markets, but I would have to admit that it is not the norm across the board. For lenders, margins have become very thin with average pricing hovering around the level of 115 to 120 basis points. Very high quality deals are even priced at less than that.
Jim Butler: Please tell our readers why that causes you concern.
Patrick O’Neal: Well, the market perception on this product type is very positive, but it has now been hyped to the point where people on all sides of the equation have lost sight of the fact that hotels are a very unique real estate product. It has become very popular for debt and equity investors — but it “violates” most of the basic precepts of commercial real estate.
Jim Butler: But loans and investments are still being made at a record pace, so what do you see as the consequence of all this?
Patrick O’Neal: You are right that loans are being made at a record pace. The CMBS “rollover” or “takeout” of lender debt, combined with a continuing strong equity market and the introduction of a higher level of recently-constructed hotels will continue to fuel both the refinancing and acquisition financing pipelines. I would not expect much further compression of spreads, with notable exceptions for trophy assets. The question is whether or not we have the self-discipline as an industry to avoid the same mistakes we made in 1998 — when “underwriting” became a non sequitur or oxymoron. Greed and fee income became the driving force behind lenders’ decision-making in approving loans.
Jim Butler: I remember the 1998 market very well. At our Meet the Money® conference in May 1998, Larry Shupnick made some opening remarks on how “It doesn’t get any better than this!” And, unfortunately, he was prophetic! It couldn’t have been a more accurate prediction. Please remind us about the loans made in 1998, Patrick.
Patrick O’Neal: If you check the default rates for deals done in 1998 versus any year thereafter, you can only conclude that something “strange” happened that year. Just ask special servicers — they have been scratching their heads trying to figure out what in the world the underwriters and lenders were thinking when they made some of those loans!
I don't know what caused the problem.
Ignorance or stupidity? “Everybody else is on the hotel band wagon, let’s jump aboard — we’ll figure it out as we go?”
Greed? “We need this deal to make our bonus, so make it work.”
Ego? “The production levels are so high and the rating agencies and
B-piece investors are so busy, this loan will likely just slip through?”
The answer probably is: none of the above and all of the above. Just like a defaulted borrower, sometimes good lenders do strange things under unusual circumstances. Some of those loans were probably the result of a pervasive production wave over a very short period of time by an entire industry.
Jim Butler: Do you think we are seeing a repeat of this epic?
Patrick O’Neal: Future trends will depend on the individual situations, egos and common sense — or lack thereof — of the mortgage banking and borrowing community. Consider this scenario: someone underwrites a loan based on next year’s “forecasted ADR” and an optimistic (or some might say “imagined”) increase in occupancy. Such optimistic projections are usually accompanied by a miraculous improvement in expense controls. But with these favorable assumptions, a loan can “underwrite” to an 80% LTV and 1.30 DSC like clockwork.
Oh, I forgot to mention that loan being underwritten is a 5-year deal with 3 years interest only.
So not only is the actual LTV probably closer to 90-95% or higher on an actual or historic basis, but the reality check on DSC showed almost no real DSC even at the “interest-only” level. This is a time bomb. Some of these loans will ignite. With a partial interest-only loan, there are now two “refinance” thresholds and scheduled potential events of defaults (instead of “just” maturity), because this hotel has to meet ALL of the forecasts just to meet the ridiculous minimum DSCR underwritten. What we now have is a deal that is essentially a 3-year deal with a 2-year grace period. The amortization may not be fast enough to keep pace with a market that reverts to higher interest rates, 25 year amortizations and 70-75% LTV.
Jim Butler: Earlier in the 2007 Industry Outlook Roundtable discussion, Mark Lomanno, President of Smith Travel Research, said that we will likely see the first $100 ADR in the history of the U.S. hospitality industry. How do lenders react to that information?
Patrick O’Neal: Lenders depend on good appraisals of properties, and appraisers are struggling considerably in this market. They are simply not used to seeing a market where the ADR is rising so rapidly and is so much larger than the averages shown in the HOST report or PKF Trends. So, some try to apply the same expense ratios that those reports show for a hotel at a $75 ADR to one which is demonstrating a $115 ADR. As a result, they may miss the actual value of the hotel by as 30% or more. Once a hotel has surpassed breakeven and moved into the profit zone, each additional $1 of ADR achieved can produce more than almost 80% of profit that flows through directly to the bottom line (after management and FF&E reserves). The result is that while the some line item expenses will increase, the actual expense ratio will drop as gross revenues rise, sometimes significantly. This requires the appraiser to cross check the expense ratio against the POR and PAR standards, at which point it is much easier to accept the lower expense ratios.
Jim Butler: And how do appraisers deal with the value per room?
Patrick O’Neal: For those appraisers stuck on the concept of value per room as a basis for their sales comp conclusions, I would submit that that analysis and concept is not coincidental with the investment analysis which occurs in a rapidly accelerating market. The only hotels being sold — or receiving financing primarily on a cost per room basis — are run down, turnaround opportunities where the total cost of a renovation and reflagging results in a cost that is well below replacement cost. However, strongly performing quality assets are not being sold or bought on a “price per pound” basis. At this stage, the cost of bread is only limited by the amount of pleasure derived from purchasing the bread. These assets are being bought based on YIELD — with cost per room only being viewed as a secondary consideration. It doesn’t matter whether that is a prudent or rational approach. It is the reality of what is going on.
Jim Butler: But don’t appraisers also rely on information from lender interviews?
Patrick O’Neal: Yes, but you have to wonder who are the sources for this! By far, the vast majority of long-term non-recourse hotel loans being done today are being funded by the CMBS industry. So, how is it that the surveys that Korpatz and others provide, continuously indicate maximum amortizations of 20 years (once in a while 25), with maximum LTVs of 65-70% at interest rates clearly 100 to 150 basis points higher than market? Who ARE these people talking to and why are they providing this invalid information to the entire appraisal industry, only to confuse them?
Jim Butler: What will it take to get back to more accurate appraisals and more prudent underwriting?
Patrick O’Neal: At our current levels, it won’t take a “tornado weather forecast” to disrupt the environment. A slight increase in the wind velocity caused by any one of a myriad of outside influences, or an unexpected change in the direction of the wind, could be enough to flip one of these oak trees we call hotels on its side. At 80% LTV and 1.30 DSCR, there is not much room to wiggle and the weather change may create a change in the barometric pressure of these hotels to the point where the meter is in risk of bursting.
Jim Butler: You and I have been around long enough to know that bad loans can seriously derail some highly leveraged borrowers, even when their projects are sound. And of course, these loans come back to haunt the lender that made the bad call in the first place.
Patrick O’Neal: True, but bad loans aren’t just bad for greedy lenders and foolish borrowers. They affect the entire industry. The biggest concern is that somebody will make a loan, probably a large loan, which will be so ridiculous that it will create industry-wide criticism of the hotel underwriting standards across the board. The loan will get kicked out of a Wall Street securitization and the lender will lose its shirt on the deal. But the very concept that it was presented will put both the rating agencies and B-piece investors on heightened alert. It will make it that much harder for everyone else to deal with them on more prudent hotel loans — loans that might otherwise not receive any negative response.
Jim Butler: So what should lenders response be to these market conditions?
Patrick O’Neal: The opportunities in 2007 should be plentiful for both refinancing and acquisitions. The challenges will be to find those submarkets that are not being over-pressured with new construction — a situation we have not faced regularly in recent years. Lenders should look for projects that can actually sustain the income and net cash flow levels that exist not only today, but also are being forecasted for the near future. First it was condo hotels and now it’s water parks…
Jim Butler: Those funding opportunities could be for the next generation of hotel-enhanced mixed-use properties — something way beyond condo hotels and water parks. We are involved this kind of next generation project, with hotels that enhance shopping centers, sports arenas, residential developments and casinos. We see this as a significant trend, with opportunities for both lenders and developers. Thanks for your sharing your perspective, Patrick. See you at Meet the Money® in May!
Can’t wait for the 2007
Meet the Money®? Purchase the 2006 Meet the Money® conference
materials. Another topic of interest to many of our industry friends is
condo hotels, and for that you should look at the 2006 The Hotel Developers
Conference materials, including DVD of the Condo Hotel Boot Camp. Consider
signing up or our 2007 The Hotel Developers Conference with a focus on
hotel mixed use.
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|Also See:||Hotel Financing - Oxymoron or Reality? Robert Shiller, Colliers International / October 2004|
|Industry Outlook: Looking Back on 2006 , Looking Forward to 2007 / Global Hospitality Advisor / December 2006|
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