News for the Hospitality Executive
Now Could be the Best Time for Hotel Lending in 20 Years;
What are the Hotel-specific Issues Confronting Lenders?
By Jim Butler and Guy Maisnik
June 22, 2010
Lenders, take note!
"NOW" could be the best time for hotel lending since the early 1990s. We are at the bottom of an economic and a hotel cycle. Hotel values per room are back to where they were in 1996, without inflation adjustment. The current shortage of debt financing for hotels means underwriting can be conservative, and spreads offer attractive profits. And hotel industry fundamentals are now improving from the worst collapse since the Great Depression. Thus, if a hotel can service debt now (or as restructured), on current lending standards, it is hard to imagine a better time to lend.
Having recently assisted three major lenders design their hotel lending programs and loan documentation, we believe that "now" is the best time for hotel lending in 20 years. This article will explain why. The lenders who delay getting back into hotel lending for another year or two that will regret missing the best lending opportunities.
Timing is important. Certainly, good underwriting, solid due diligence, and conservative loan standards are helpful too. But making loans at the bottom of a market is always safer and more profitable than at the top of the bubble. Early in the cycle is better than late.
Lending standards early in the cycle
Early in the lending cycle, with less competition, lenders are able to maintain the discipline to impose tougher lending standards. Today, for instance, loan to value ratios (LTVs) for hotel lending are probably in the 50-60% range, and debt service coverage (DSC) requirements are roughly equivalent to 1.5 times the debt service payments. And of course, these requirements are applied to historically depressed values and cash flows.
Early in the cycle, borrowers often reluctantly agree to recourse, but
recourse becomes harder to get as the cycle progresses.
Property values and cash flows early in the cycle
According to Smith Travel Research, from August 2008 through 2010, the hotel industry lost $17 billion in hotel revenue. That is $41 million lost revenue per day from 215,000 fewer rooms sold per day. Almost 60% of the revenue decline was due to lower room rates, and the other 40% was due to lower demand.
Accompanying these deteriorating hotel industry fundamental metrics was a punishing loss of hotel value. Here is a chart based on data presented by Steve Rushmore, founder and CEO of HVS International, in June 2010 at the NYU hotel conference.
Just look at this chart of hotel valuations and consider whether you would have preferred to make a hotel loan at 60% loan to value (LTV) at the cyclical lows in hotel valuation (such as in 1992-1995, or in 2002-2003 just after 9/11) based conservative cap rates applied to extremely low trailing 12 month actual NOIs.
And compare making 60% LTV loans on low values to making 85% LTV hotel loans at peak values based on low cap rates applied to "projected" or pro forma NOIs as was common at the peak of the bubble years in 2005-2007. Does it strike you as odd that leverage seems to increase as values rise, and debt service coverage (DSC) shrinks from 1.5 to 1.2 even based on revenues approaching bubble peaks?
Maybe it is just the intense competition among lenders that develops later in a cycle, but inevitably the lending standards get lowered as the cycle goes on, particularly as lenders take risks to keep their best customer relationships. LTVs soar on higher values based on increasingly aggressive valuations that climb high toward the inevitable peak.
The following chart from Smith Travel Research gives a 20 year picture of hotel industry fundamentals, again suggesting that the best to lend on hotels (or buy hotels) is now, and that this will probably continue for the next two or three years.
Lending is more profitable early in the cycle
Another phenomenon that we see in every lending cycle is the deterioration of profit margins and spreads. Early in the cycle, loans are priced at margins 450-550 basis points over LIBOR or otherwise have attractive spreads over other indices. Later on, when lending is actually riskier, these spreads shrink dramatically to provide very poor risk-adjusted returns.
Great pent up demand for hotel debt financing and attractive lending opportunities
With virtually no debt financing for hotels since the financial meltdown, there is great pent up demand and lots of attractive borrowers. Initially, there will be little or no construction financings. And existing projects being financed will either be new buyers with a new, realistic valuation on a hotel reflecting the current environment or a "recapitalization" of a distressed situation which greatly reduces or eliminates existing debt. And there will be the occasional property that was not bought or refinanced between 2005-2007 at prevailing leverage and terms.
So there should be a ready supply of new borrowers with staying power, realistic expectations and a revitalized capital stack, looking to add a little debt the property should be able to handle in all but a nuclear winter.
The lending has already started, so you will have to hurry to be "early" in this cycle
From the vantage point of mid-2010, with a sustainable recovery seemingly underway in both the national economy and the hospitality industry, we note that the Wall Street firms have already begun re-entering the hotel lending market, with notable entrants such as Deutsche Bank already launching their programs. And several of the largest banks are also looking to start lending on hotels again.
Interestingly, we are seeing a mix of lender approaches. Some plan to lend for their own portfolios or syndicate the loans the old fashioned way. Some expect a new version of CMBS or securitization ("CMBS-II") to return later this year and expect to be able to off-load the new loans from their portfolios when that market reawakens.
But all lenders should observe a few cautions as they get back in the game.
Avoiding the pitfalls in hotel lending . . .
We believe that NOW is the best time for hotel lending in 20 years. However, anyone wishing to take advantage of this window of opportunity should know a few critical issues and avoid some dangerous pitfalls.
It is a little like taking a flight overseas: Millions of safe passenger miles prove it is safer than driving a car, but your airplane needs to go through a pre-flight check, and your pilot better have the necessary training, experience and licenses. Otherwise things could turn out badly.
Why hotel lending is different. . . and some things you should know . . .
Hotel lending is different from any other kind of real estate lending . . . because hotels are different from every other class of real estate. They are a unique combination of single purpose real estate that is inextricably intertwined with a complex operating business. That operating business (running the hotel) usually accounts for up to 50%, or more, of the value of the hotels that are mid-scale or higher in market segment.
In the past 12 months, we have seen dozens of hotel loans that were badly documented - done like office buildings or other commercial real estate. As a result, they are badly fouled up!
Many of these loans were documented by the biggest international lenders and law firms in the country. The documentation would have been fine for any other class of real estate, but not for hotels. They simply ignored the unique challenges that a hotel presents to a lender, and which can be handled with appropriate documentation for this asset class based experience gained in all the down cycles since the 1980s. Compounding such legal and business learning disorders, these lenders and law firms continued to treat such hotels loans like other classes of real estate in executing upon their remedies.
What are the hotel-specific issues confronting lenders? More than half the value of many hotels is determined by the operating hotel business.
Employees and workforce issues. A hotel usually has a lot of employees to provide numerous services - to market the hotel's rooms, prepare and cook the food, clean the rooms and carry luggage, provide banquet facilities, security, telecommunication services or IT needs, and a host of other such matters. Most branded properties operating at or above a first class hotel standard will have long-term management and franchise agreements with a huge impact on value and use of the property not unlike a long-term lease. Because of the potentially large number of employees (which could easily be up to 1 or 2 employees per room in a luxury hotel), the employment, union and benefit issues can be significant. To make matters more challenging and complex, in these difficult times, many cities or other governmental units are targeting hotels for additional bed taxes to solve government budgetary shortfalls.
Hotel management agreements. The hotel operating business also involves third party hotel operators or hotel management companies, brands. A long-term hotel management contract can easily add - or subtract - 25% or more of the nominal value of a hotel. Many industry experts believe it cost 35% more to run a given hotel property as a union operation, as opposed to non union. What impact does it have if the government suddenly takes another 2% or so off the top, and perhaps drives potential business to neighboring cities that are not so greedy and in fact may be predatory seeking to steal business from its neighbors?
Unique norms, customs, practices and players. On top of all this, the hotel industry has its own norms, customs, practices and players - a very small universe of people who actually know each other. The hotel brokers, hotel lawyers, hotel appraisers, hotel consultants and hotel lenders are a fairly distinct and well-known group who tend to specialize only in hotels. And the unique aspects of the hotel operating business tend to be reflected in some very unique written agreements that profoundly affect the value and marketability of the hotel. Many of these agreements are very long-term, such as management agreements that may run for 50-100 years, or franchise agreements which may "only" run for 20 years. But for lenders, one of the most important documents is the SNDA (subordination non-disturbance and attornment) agreement, which can greatly affect the lender's collateral value and available options with a troubled asset.
Cash collateral. And how does the lender control the "cash collateral" if there is a problem? With an apartment house or an office building, it is fairly easy to figure out how to control the "rents" and how that control should be exercised. But the hotel is an operating business, and there are many sources of cash which are difficult to garner - both because many lenders lack the will to overpower brand operators who resist such attempts, and because negotiating control over these sources can be a difficult process (however worthwhile). In addition to having to wrestle control of hotel revenue from third parties, there can be pure legal challenges because different types of revenue can require different methods of obtaining and perfecting the lender's security interest in them. In a competition among various creditors for such revenue, having proper control can mean all the difference between success and failure of a hotel lending program and a lender's workout or exit strategy.
What does this all mean? Hotels are different from any other
kind of real estate, and therefore hotel lending has to be treated differently
as well. Most of these differences are created by the operating business
inextricably intertwined with a single-purpose piece of real estate. And
that operating business has unique norms, customs, practices and players.
The documentation of a hotel loan should be very different from the documentation
of any other commercial real estate, and the greatest lawyers on the planet
for office building loan should not touch an important hotel loan using
their standard building loan documents. If you don't have a hotel specialist
handling your matter, you are probably in serious trouble.
Guy Maisnik is a partner and senior member of JMBM's Global Hospitality Group®. Guy advises clients on hotel transactions, representing lenders, opportunity funds, banks, special servicers, owners, REITs and developers in hotel transactions, including senior and mezzanine financing, workout and debt restructure, co-lender, participation and securitization arrangements, joint ventures, management agreements, buying, selling and ground leasing of hotels, complex mixed used resort development, fractional and timeshare. For troubled hotels, Guy develops and executes strategies for CMBS and whole loans, and REOs. He also assists investors with recapitalization of distressed borrowers and purchases of troubled assets. Guy has recently assisted 3 major lenders in completely revising and structuring hotel lending programs and documentation, including a hotel construction lending. Guy's practice is both domestic and foreign, where he has advised on hotel matters all throughout the United States, Mexico, Canada, South America, Caribbean, Europe and Asia. He has been recognized in California Real Estate Journal's Best Real Estate Lawyers, Los Angeles magazine's Top Southern California Lawyers, as well as a Top Real Estate Lawyer in Real Estate Southern California magazine. For more information, please contact Guy Maisnik at 310.201.3588 or email@example.com.
Jim Butler is a founding partner of JMBM and Chairman of its Global Hospitality Group®. Jim is one of the top hospitality attorneys in the world. GOOGLE "hotel lawyer" and you will see why. JMBM's troubled asset team has handled more than 1,000 receiverships and many complex insolvency issues. But Jim and his team are more than "just" great hotel lawyers. They are also hospitality consultants and business advisors. For example, they have developed some unique proprietary approaches to unlock value in underwater hotels that can benefit lenders, borrowers and investors. (GOOGLE "JMBM SAVE program".) Whether it is a troubled investment or new transaction, JMBM's Global Hospitality Group® creates legal and business solutions for hotel owners and lenders. They are deal makers. They can help find the right operator or capital provider. They know who to call and how to reach them. For more information, please contact Jim Butler at firstname.lastname@example.org. or 310.201.3526.
|Also See:||What Kinds of Public- Private Hotel Projects Are Underway Now and What Kinds of Public Financing Are Available Now to Build Hotels / Catherine Holmes / May 2009|
|How Will You Finance Your Hotel Project in 2007? / JMBM|