When I created the first hotel commercial mortgage-backed securities in 1993, I was told by the rating agencies I had to get appraisals. I did, but as an underwriter, I simply put them in the file and ignored any values they claimed. Sometimes I looked at the area demographics or market section just to get a little more market color, but I made a rule the appraisers’ value was never to be used. The reason? It was never based on sound assumptions, and as we saw in the 1980s, and again now, they’re right by coincidence and not by scientific method.
In the ’80s, lenders used appraisals for loan sizing, and developers got appraisers to MAI—make the numbers as instructed. That’s how the lending crisis of 1989-90 happened. That’s what led to the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIREA). The exact same mistake was made during the past five years. It’ll probably happen again in another 25 years.
Appraisals are based on a set of assumptions that, by definition, can’t be known, nor will they prove to be correct except by random coincidence.
1. 10-year projections. There’s no one who knows anything about the world seven years from now, let alone 10. Any number used is simply a wild guess based on nothing. There has never been a 10-year run of only straight up in the U.S. economy. Somewhere in any 10-year period there’s a downturn—some minor, as in 2001, and some huge as we have now. Typically, you can be sure in any seven- to 10-year period there’ll be a reduction or slowdown in gross domestic product, which will impact your hotel. No appraisal I’ve read makes that assumption.
Not even Federal Reserve Chairman Ben Bernake can forecast interest rates two years out, but the entire appraisal makes 10-year assumptions on rates and financing. Capitalization rates, discount rates, equity returns and other similar assumptions are based on where interest rates will be, and the risk spread the market assigns as a margin over the risk free rate of Treasuries. Nobody has a clue where any of these will be in five years, let alone 10.
2. There’s only up. Almost every appraisal I’ve read throughout the years made the assumption there would be increases in average daily rate every year—usually 3 percent or so, and that stabilized occupancy would be about 71 percent to 74 percent and will remain there. Clearly, this didn’t happen for many properties, and it’s not true for anyone now. I have to assume appraisers will assume by 2013-14 there will be 25-percent to 30-percent increases in net operating income. Maybe there will be, but that assumes a lot that’s unknowable today.
3. Investors’ perception of risk and required returns shifts over time. That’s driven by leverage levels and interest rates, which are driven by perceived risk. Appraisals use a terminal cap rate on a 10-year net operating income to get a sale value. Then that’s discounted back at a supposed discount rate based on investor returns. Assumption, on assumption, on assumption, on wild guess.
4. Within the 10 years, there must be a product improvement plan or a major renovation. I’ve yet to see an appraisal that makes an assumption there may have needed to be an equity or subordinated debt infusion to cover this work because in a number of hotels the furniture, fixtures and equipment reserves aren’t sufficient, especially during the next several years of deeply reduced revenue. Since every major brand requires a PIP at sale, where’s this built into the appraisal assumptions? When we created the CMBS program, we insisted on an engineering study and a holdback from the loan that resulted in more equity being required. Since few are able to do renovations right now, there will be many hotels that need material renovations in four or five years when lending returns. There will be a lot of new owners given all the coming foreclosures, so there will be a lot of PIPs and insufficient funds in the reserves. The lender will have grabbed the FF&E reserves to cover defaulted debt service. Whatever value an investor has for a hotel must be reduced by the inherent requirement for substantial renovation by 2014 or 2015. Where is this in the appraisals?
5. Most lenders are doing their own underwriting of value and determining their own sense of value. They get appraisals because the regulators make them do that in many cases and for CYA reasons, but it’s their own internal work they use.
I don’t know the percentage of properties that turn vs. get held for 10 years. However, many properties are sold in five years or less. Most of the new buyers during the next three years will be vultures who intend to flip the property in five years. The appraisal assumes a 10-year hold, and that period difference makes a big difference when doing a discount to net present value. Internal rates of return tend to decline over time by virtue of the math of discounting.
Supposedly, there’s a new methodology that makes an assumption that you’ll refinance in 2012. It assumes 70-percent leverage and a 7-percent rate. The first issue is I don’t believe there will be 70-percent leverage for hotels in three years. Seventy percent of what? Hotel underwriting will go back to what we used in 1993—debt service coverage on proven historic cash flow. That’s the only true measure a lender can use, and it’s what they’ll use whenever lending returns. The appraisals issued in the past several years are totally wrong, so why is any lender going to believe one now? This is how we got into this crisis—investors and lenders believed fantasies. That’s exactly what happened in the ’80s, and that’s why the initial CMBS lending was so tightly underwritten.
These past several years, lenders believed the ridiculous projections on which appraisals were based, and they abandoned the careful underwriting rules we set forth in 1993. In 1993, we absolutely forbade any projections or appraisals from being looked at because we knew they had no validity. That’s what will happen now. Maybe some lending will return by 2012, but remember: Lending essentially stopped for hotels in 1989 and didn’t return in any sort of volume until 1994. That was five years, and this time is vastly worse for the capital markets. This time lending essentially stopped in mid-2008, and it’s unlikely to return in any real way until 2013 at the earliest and more likely 2014 in any volume.
The value devastation for hotels and all real estate is so massive this time that when lending for hotels returns, it will be ultraconservative. In 1993, we initially used 1.5 debt cover. We pretty much eliminated food-and-beverage from consideration and started out with 20-year amortization. Don’t be surprised if this time is similar. We averaged the prior three years NOI, and there was no upside projection permitted.
Most people I speak to who are thinking of buying hotels are assuming an all-cash deal or an assumed loan. You have to assume in your underwriting there will not be a refinance worth doing until 2014, and then it will be conservatively underwritten—60 percent to 65 percent of realistic value and a 1.4 debt cover.
Treasuries will be much higher by then. If you accept that all this deficit spending is going to breed inflation during the next five years, or that the Fed will be forced to raise rates substantially during the next five years to try to control inflation being driven by the fiscal spending coming out of Congress, then you need to underwrite for higher rates.
Lenders agree risk wasn’t properly priced into spreads during the past five years, so it’s almost sure hotel spreads will widen materially again, and it won’t be surprising if they settle at 300 basis points over, or much more, when lending returns. A spread of 325 basis points or 350 won’t be a surprise. The 10-year Treasury is at 3.5 percent. It’s not a bad assumption to believe the 10-year Treasury will be at 5 percent or more in four to five years. A 6-percent index rate in five years is possible if you think inflation is a real possibility, and if the dollar gets weak as a result. The Chinese already are raising real issues about the value of the dollar.
If spreads are 300 or more, then the rate for a hotel mortgage will be 8 percent to 9 percent or maybe more. It used to be 10 percent to 12 percent in my early days of hotel lending in the ’80s. Nobody should assume it can’t go back to that. For years, we assumed, for underwriting purposes and loan sizing, a debt constant of 11.33 percent on the assumption rates will be high but aren’t able to be forecast. So we used a 1.4 debt service cover and an 11.33-percent constant. Nobody is going to use 7 percent and 25 years amortization for underwriting again for many years. You should assume lenders will go back to 11.33 percent or a similar number, regardless of where rates are at any moment. Amortization was 20 years in 1993. Don’t be surprised if that becomes the norm again.
So what’s an investor to do? Make your own assumptions, and do your own underwriting. Assume whatever your hold period is likely to be for you. Assume whatever you wish for interest rates, but you have as good a shot as anyone at being right if you’re looking five years out. Make a cap rate and PIP assumption. Look at replacement cost and the true competitive set. Pay attention to the recent articles by Mark Lomanno about being sure you have the true comp set. Then calculate your expected returns and decide if that’s good enough for you.
(Read Lomanno's "It’s all about who is in your comp set.")
Joel Ross is principal of Citadel Realty Advisors, successor to Ross Properties, the investment banking and real estate financing firm he launched in 1981. A Wharton School graduate, Ross began his career on Wall Street as an investment banker in 1965. A pioneer in commercial mortgage-backed securities, Ross, along with Lexington Mortgage, and in conjunction with Nomura, effectively reopened Wall Street to the hotel industry. Ross also was a founder of Market Street Investors, a brownfield land development company. A member of Urban Land Institute, Ross conceived and co-authored with PricewaterhouseCoopers The Hotel Mortgage Performance Report. Ross served two tours in Vietnam with the U.S. Navy.