Through these recent tumultuous economic times, financing hotels has undergone a considerable sea change. In the past years, financing for a hotel property priced below $6 million was 90% through Small Business Association loans with much of it channeled through the SBA 504 program. While lenders were guaranteed approximately 75% of the loan value on an SBA 7(a) loan, a conventional loan on the 504 program gave lenders a loan at 50% of the sale value. The common belief at the time was that it would be impossible for the value to decrease to less than 50% of an arms-length purchase price.
However, as lenders and the rest of us in the business have seen over the past four years, it is not only possible for the value to decrease to less than 50% of the actual sale price, but also in many cases the value decreased to 25% or less of the previous sale price. A majority of lenders have experienced major losses from the 504 program, and they are only offering hotel or motel financing under the SBA 7(a) program.
While under the 7(a) program, they know they might lose 20% to 25% of their loan value; they will not lose 50% to 75% of their loan value as they have experienced during the past few years under the 504 program.
In fact, the financial institutions lending in the hotel property markets are paying referral fees of 1.5% of the loan amount for a 7(a) loan and only 0.5% referral fee under the 504 program. In addition, they pay the referral fee under the 7(a) program when the loan funds, but on the 504 program, they will not pay the referral fee until the SBA portion is funded. In cases where there is upgrading of the property involved in the total loan project, the lenders do not pay the referral fee until the 504 portion is funded, which could take up to a year.
In past years, when it came to hotel financing in the less than $6 million sales price range (the SBA maximum loan is $5 million and that generally relates to a sale price of approximately $6 million to $6.5 million), SBA and lenders would fund turnaround projects where the loan value was based on the future value of the hotel property after the upgrading work was done, and the business had recovered to industry standards for that particular market area.
For example, a savvy purchaser might have found a hotel property that was showing below-market area income. The buyer could see if they added or changed the franchise and installed tighter expense controls, they could turn this below-market purchase of a hotel property with below-market income into a top-flight hotel property with incomes comparable to other hotel properties in the area. The buyer would only invest about half of the projected value into this turnaround property.
However, we are now seeing that the majority of banks are not accepting these turnaround projects. They only want to finance hotel properties where they can see the projects have actual existing incomes that are producing debt service coverage at ratios of between 1.3 and 1.5 to 1. Previously brokers could sell turnaround projects all day long to experienced investors. Nowadays they can still sell them but usually only to all cash buyers. The number of buyers available to make offers and have the available cash for those turnaround projects has diminished considerably.
The lenders also are looking for more experienced buyers. While the limited-service hotel property operations are not as sophisticated as full-service hotels, lenders once believed that common sense was an adequate qualification for operating one successfully. We have seen many inexperienced investors make a hotel property successful. However there are also many operators that do not have the common sense for business and have failed at the hotel business.
In this respect, where lenders previously thought that anyone can operate a hotel property, now they are looking for operators with more hands-on hotel operation experience, and they are more hesitant to make loans to the novice operator. If the lenders make loans to the novice operator, then they are looking for stronger cash reserves from those buyers or co-signers, or they make sure the novice operators have other sources of income and are not relying on the cash flow of the subject property to fund their day-to-day living expenses.
While lenders are coming back into the market of financing hotel properties, they are now much more cautious. Some are looking at only the strong cash-flowing projects with existing revenues sufficient to produce a strong cash flow and are shying away from the higher risk turnaround projects. While some turnaround projects are still being financed, it will take a more experienced operator with strong reserves to obtain the loans they previously acquired with ease.
Howard has owned operated or managed over 40 motels and hotels ranging in size from a 22 unit motel in North Lake Tahoe to a 310 unit full-service Ramada Inn in Salt Lake City. With his knowledge of what to do with a property and probably more importantly what not to do, Howard can show buyers the upside potential of a property. His operational expertise can guide a client in turning a distressed or marginal property into a profitable one. Howard can be reached at email@example.com or 925.634.2299.
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