The crux of getting any hotel deal done or new project built is the lending piece. Industry executives share their take on the current state of lending.
PHOENIX—U.S. hoteliers have worked hard to come to terms with the new normal in a post-recession world. Conditions might be tighter, but that has brought with it some stability, sources said.
Every deal, sponsor market is different, said Rushi Shah, principal and CEO of Aries Conlon Capital, during the recent Hotel News Now Deals Roundtable.
“No two things are the same,” he said. “That’s why you have such vagueness or ambiguity in getting a concrete answer on lending.”
Though the markets aren’t frothy yet, he said, when they get there, a great deal of capital goes out of equity, and the first dollar goes into debt, because debt is a safer place to be. Before the “debt guy” is affected, he said, 35% has to dry up, so that’s where the rotation is happening from equity capital to debt capital.
Most institutional players with equity funds going into hotel equity ownership are slowly rotating into debt and diversifying, he said. At this point in the cycle, they would rather be at 65% of the first dollar lost than 100% of the first dollar lost. They’ll make a little less in returns, he said, but then they lever up their position as a fund. They can get 2:1 leverage on capital to go to loans, he said.
The two main deal terms happening are bridge loans and permanent nonrecourse conduit loans, Shah said, adding that conduit markets are as strong as they’ve been since 2007. That year, there were $210 billion in securitizations, he said, and that includes all asset classes. Of that $210 billion, 20% ($45 to $50 billion) comprised hotels, he said. The long-term annual average has been $100 billion, which works out to about $2 billion every week.
“We’re back at that level now,” he said.
Securitization is nothing but a pool of 10-year loans getting pooled up and securitized and sold to bond holders, he explained. For all asset classes the last three years, the average deal size has been $600 million, he said, and hotels have made up 20% of that amount. Now that pool deal size has grown to $900 million, he said, but the amount of capital for hotels remained the same, taking that percentage down to 15%.
“What owners are doing is, they’re basically cashing out their equity using these long-term conduit loans,” he said.
These are 10-year loans, with money available in the mid- to high-4% range, nonrecourse with 30-year amortizations so payments are low, he said. It’s the cheapest way to get access to capital without having to raise a great deal of equity capital, he said, because money is taken from existing assets to build further assets.
The strategy behind that is: If owners are going to refinance out, it works specifically if they are a long-term holder, GF Management SVP of Development Jeffrey Kolessar said. The issue is if they plan to sell that hotel and have a securitized loan in place, it gets re-underwritten again when it’s sold. They have to come up with new capital, he said, so they could be putting 50% of their equity into the deal.
That’s where equity players can make a decision, said Bob Rauch, president and CEO of RAR Hospitality. It can work for owners whose time horizon might only be 10 years of investment (rather than 30), and who want cash flow over those 10 years but also want to pull out their risk money, he said. It’s compelling in terms of being under 5% for a 10-year loan that’s relatively high levered, but the risk is out because they’ve pulled their cash out and are probably at 65% to 70%.
Lending has been at odds with the selling community, Shah said.
“We’re pushing refinance for obvious reasons, because there are tax-free benefits,” he said. “Owners want to double-dip. They want to cash out, but they also want to sell and get more money. That’s where the problems arise.”
In the Midwest markets his company has been in, Steve Martens, president of The Martens Companies, said relationships with community banks to fund deals have worked well. As the deal size grows, he said, those investors will accept some recourse, he said. Once the deals get above $10 million, he said, they’re dealing with a whole different group.
The banks in the Midwest markets have been helpful, as they’ve been aggressive and competitive, he said. Smaller midsize banks could make some money and get more aggressive if the government actually reduces some Dodd-Frank Act regulations. They like the product, he said, and they’re skittish about multi-family and office asset classes.
The situation is a bit different out west, where multifamily housing projects are stealing sites from hotel developers and sucking up lending capacity, said Mark Kallenberger, founding principal at Kallenberger Jones & Co.
“Banks love (multifamily developments) because they have a lower default risk,” he said. “It’s a problem out west.”
Generally speaking, deals are requiring 25% to 30% down, said Danny Givertz, SVP at Hunter Hotel Advisors, and interest rates now are in the high-4% to low-5% range. Though his company hasn’t been involved in debt as much as it used to be, he said his last few deals have been with overseas investors, so they’ve been all-cash deals. The last three acquisitions he’s seen involved South Korean buyers looking primarily in California.
Private equity investors are coming into the hotel space because it’s lucrative from a risk-adjusted return standpoint, Shah said. There’s a lot of South Korean capital coming into the private equity lending space, he said. He pointed to three new funds, including one on the West Coast and one in New York, made up of South Korean limited partnership money. They’re making 10% cash-on-cash return, he said, and the investors want to get their money out of there as fast as they can and generate returns, he said.
His company is looking closely at the South Korean markets, where 80% of the cash is tied to stock or real estate attached to roughly four companies, he said. And that’s a problem.
A lot of the big equity players, such as Blackstone Group and Starwood Capital, have put together debt and are aggressive in the space, said Bill DeForrest, president and CEO of Spire Hospitality.
“And they all have a captive exit,” Shah added.
The private equity investors all have limited partnership money; they just have a different LLC with the money, Shah said. They then go to one of the big banks to lever it up by getting a warehouse line of credit at Libor plus 200 on that money, he said, which allows $100 million to get them $300 million of dry powder.
“They then lend that $300 million—that’s how they juice up their deals,” he said.
For owners, that means 450 to 600 over Libor loans, he said, or for people who want to get out three to five years later without the prepayment headaches that often come with these loans.
“This is the perfect alternative to traditional CMBS lending,” he said.
Bill Blackham, president and CEO of Condor Hospitality Trust, said he comes across private equity lending sometimes as a competitive force on assets his company might be looking to acquire. As a public company, only one of his shareholders is a private equity fund that invested when his company transitioned to Condor.
The size and price tag of transactions that Condor undertakes is typically smaller than those preferred in the private equity space, he said.
Stabilized cash flows
When evaluating a property’s cash flow, Rauch said he likes to go back to 2009 and 2013 when the “crap hit the fan” to see how quickly it rebounded, and then look at 2014 and 2018 to determine where it is now and where he thinks he can take it.
If it’s a stabilized deal, Kolessar said, owners will want to go back far in the history to see peaks and valleys of that particular property. The days of underwriting 7% to 10% revenue per available room growth are just not there, he said.
DeForrest said he still believes the industry is in a growth environment, it’s just not growing at the level it once was.
“We have a slowdown in growth, but it’s not like we don’t know how to grow,” he said.
Even if a property is showing 2% to 3% RevPAR growth, Kolessar said, it’s important to look at the operating expenses associated with those assets, with payroll being the biggest. With wages going up in some states, particularly where minimum wage is increasing, owners have to look at where that eats into RevPAR growth, he said.
On top of wages, it’s property taxes, CBRE Hotels SVP Nate Sahn said.
“Taxes, wages and supply, obviously, are the three things a buyer is paying more attention to and performing more litmus tests on today than they ever have,” he said.
Givertz said his company is not underwriting assets with pro formas that are 2% to 3%. It will never show a downward-trending pro forma or else it would go out of business, he said, but it’s not putting it at the same aggressive levels that it used to. Clients are becoming savvier with property taxes, he said, especially with some deals where the buyer renovated, reflagged and is now selling it.
During the process, he said, his company looks at the last few years of performance and blends it together. A year ago, when it was all rosy, he said, the company would look at one year of performance.
Rating agencies Fitch and Moodys control the lending markets; they rate every bond that happens, Shah said, and everyone anchors to those. Agencies are looking at 2014 cash flows, and when looking to refinance a stabilized property, they don’t like hockey sticks, he said.
“They have to cover at least 1.1 times debt service coverage back in 2014,” he said. “That’s the underwriting we’re looking at.”
There is some danger in evaluating an existing property with the way the market is evolving, Kallenberger said. There was virtually no development during the great recession and a few years after, he said, and now there’s a surge. Owners now expect new properties will kill off the old ones, he said. The older properties had that extra five to six years, and they’re going to be in trouble with the surge of new development, he said.
That requires looking at demand growth in the market, Sahn said, asking whether it’s short-term or long-term sustainable growth.