It’s no secret the aggressive commercial, mortgage-backed securities-fueled lending spree of 2006 and 2007 will have a profound impact on the entire commercial real-estate market, and no sector might feel the impact more than hotels.
There are many reasons for this, but it boils down to a few overarching points. One is hotel loans have (on average) worse credit characteristics than loans backed by other property types, which will make them more difficult to repair. Another is lenders will be reluctant to return to the sector and will be conservative when they do. And hotel fundamentals will take a long time to return to 2007 levels.
The overleveraging of commercial real-estate is well-documented by now. Banks wrote high loan-to-value ratio loans just before commercial real-estate values plunged by approximately 40%. The result is a “funding gap” between the amount of debt on properties and the amount those assets will qualify for at refinancing.
Obviously the problem boils down to individual loans on individual properties, but if we can generalize, the hotel sector is likely facing a bigger funding gap than the market as a whole. For one thing, using CMBS as a proxy for all debt (which we do because more property-level data is available on CMBS than any other segment of the mortgage market), credit characteristics of hotel loans are worse. According to research firm Trepp LLC, as of November 2011, 11% of hotel loans in CMBS pools were 60 days or more delinquent, compared to 6.5% of all loans.
‘Day of reckoning’ approaches
The main reason for high hotel loan defaults is weak credit characteristics. The main predictors of defaults are low debt-service coverage ratios and high LTVs. Hotel loans have less cash flow supporting them than any other property type.
As banks have yet to force foreclosures of underwater loans, with most choosing to extend problems into the future, most loans have yet to face a day of reckoning. So the depth of the problem will depend on many factors.
One is future lending conditions. Lenders are likely to maintain tight loan standards into 2012 and possibly longer, particularly for assets considered riskier. Hotels are deemed riskier than property types with longer leases, making it almost certain lending on hotels will remain cautious as long as financial markets are volatile and economic growth is weak.
Hotel performance impact
Another factor is hotel performance. As hotel net operating income grows, hotels can afford to pay more debt service and can borrow higher amounts of debt. The result is performance will have an impact not only on the total number of defaults but also on the amount of capital needed to repair loans that are delinquent in some way.
If hotel revenues continue to increase at the robust pace enjoyed in 2009 and 2010, they would alleviate the funding gap to some degree. Since the beginning of 2010, consumer demand for hotels has increased dramatically. STR (the parent company of HotelNewsNow.com) estimates total demand in 2011 will approach an all-time high of nearly 1.1 billion rooms. The sector’s performance reflects pent-up demand from consumers, as well as rising corporate travel as companies loosen purse strings at a time when they are earning record profits.
However, hotel performance is largely a function of the economy, as most metrics of performance track closely to gross-domestic-product growth and the number of jobs created. Most economic forecasts have been downgraded in recent months because of concern over the European sovereign debt crisis and weak job growth in the United States. As a result, STR projects demand will grow by 1.1% in 2012, with the forecast being downgraded from 2.5% in April. STR’s revenue-per-available-room forecast is found below.
Creative solutions
Hotel owners also have to deal with the growing amount of capital expenditures postponed during the recession that must be undertaken if they want to compete for customers and increase room rates going forward.
Yet no matter how much property values recover or how much more aggressive lenders are willing to be during the next few years, many hotels are secured by debt that won’t be refinanced at the same level of proceeds. Some of the worst loans already have been restructured, but lenders largely have pushed the problem into the future.
Given the reluctance by banks to pursue foreclosures and the probability they won’t be much more eager to take control of hotels going forward, the market is unlikely to see wholesale liquidations in the sector. Instead, look for banks and special servicers to craft a variety of creative solutions for individual loans that will meet their needs along with the needs of property owners and the investors that will inject necessary capital.
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Paul Fiorilla is VP of Prudential Real Estate Investors.
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