Bank On It - Investment Outlook - December 2001

With public equity still nervous about the hotel industry, Europe’s banks have emerged as a major financial force—not only for debt but for equity.

By Staff -- HOTELS Magazine, 12/1/2001

Some of the most original hotel deals constructed in the last two years have come not from high-flying venture capitalists or opportunity funds but from four-square banks such as the UK’s Royal Bank of Scotland (RBS) and Bank of Scotland (BOS), Germany’s DePfa and the Netherlands’ NIB Capital Bank. The complex and sophisticated instruments devised for deals such as Nomura’s acquisition of the Le Méridien chain, the joint venture designed to grow Rocco Forte Hotels and Hilton Group Plc’s sale/leaseback of 11 hotels demonstrate how creative thinking can make difficult situations work out. It is exactly this creativity that will keep European banks in the hotel market moving into an uncertain 2002.

Opportunities Ahead

Europe’s banks have little reason to cut and run. In fact, unconfirmed reports in mid-November indicated Guy Hands, head of Nomura’s principal financial group, had opened talks with DePfa regarding a sale and leasback deal for Meridien hotels in Europe.

A study recently released by Andersen, London, showed the hotel industry’s higher risk has it rewards. A sample of regional UK hotels posted unleveraged IRR yields of 17% over the last two decades, easily outpacing the 13.7% return from a holding in the FTSE or the 12% from other types of UK property investments. Add in the residual yield and the figure would have jumped to 21%. Other data reveals UK hotels provided real growth that has averaged 1.5% over inflation for the last two decades—even with the crippling effects of the 1991 Gulf War and recession.

Little wonder, then, that some of the financial industry’s leading voices are not accepting a gloom and doom scenario. Although most acknowledge that a post-September 11, quasi-recessionary scenario may require an increase in spreads and more restrictive terms, there is little talk of shutting down the capital pipeline. In fact, more aggressive teams point to channels of opportunity, especially in the UK. The urge to separate bricks and mortar, and the financial wisdom of doing so, are opening up new avenues for debt and equity deals.

“There may be fewer development opportunities as demand slows. But, there may also be more acquisition opportunities,” says Peter Cummings, BOS’ managing director of corporate banking. As one of the new breed willing to consider both debt and equity deals, BOS’ team can explore the upside of a wider range of deals—from financing to joint venture deals. “We have not changed our deals as much as we have changed our approach to lending. We are not just debt providers, but equity investors. By structuring a total funding package for our partners, we have improved the overall return to the bank,” Cummings adds. The complete debt/equity capabilities play to a market in which “operators are no longer looking to asset ownership.”

Recent joint venture deals have given BOS a broad sweep of niche market potential. BOS is joint venturing with Rocco Forte Hotels to build a portfolio of European luxury hotels at the top end of the market. A joint venture with Hanover International, established as Tweed Investments Ltd., opens opportunities in the 4-star and training center markets. Heritage Hotels, acquired through a joint venture between BOS and Macdonald Hotels Plc, plans to grow its 4-star portfolio via development of existing sites and further acquisitions. Macdonald and BOS contributed equally to the deal and share both the joint-venture profits and capital appreciation on a 50/50 basis. The ability to fund expansion as an equity partner enlarges potential by essentially building a parallel business—one that can continue to drive short-term profit to complement long-term appreciation of real estate.

Given projected ROI of 20%-25% on its hotel investments, BOS remains a committed hotel investor. As a joint venture partner, BOS has invested 20% of its committed equity to date in the hotel sector. The banks’ overall commitments to the industry cover the spectrum, from 5-star to budget and are likely to increase by 21% (assuming no other non-hotel equity investments are made) even in the face of political unrest and economic uncertainty. Cummings readily admits valuation criteria can and will change in a less stable economic environment. “Deals may become more difficult to do, but the right deal will always be done,” he says.

RBS’ Stephen Eighteen, managing director of the structured property finance group, agrees that operators’ need to release capital tied up in bricks and mortar and recycle it into their higher return operating business is opening up opportunities for creative deal-making even in today’s volatile environment. “Yes, volatility is an issue, but it becomes less important if any investment is considered on a longer term view,” Eighteen says. Notwithstanding periods of volatility, RevPAR growth in UK hotels has outstripped inflation by approximately 1.5% per annum over the past 20 years, he adds.

Other fundamentals that point to continued upside in the sector: the investment market in the UK is immature. It is possible to purchase world-class hotels off prices which deliver long-term IRRs Eighteen describes as “in excess of other forms of real estate such as offices and retail.” Next, with turnover provisions, rent reviews are effectively annual, not every five years as they would be for other forms of UK real estate. The investor also participates in the underlying growth of the operator’s business. And, there is a surplus of stock over available capital stemming from the increased preference among operators to separate operating and property owning functions.

Exploring the upside inherent in these fundamentals led to deals such as the trend-setting sale/leaseback instrument created with Hilton Group Plc and the complex acquisition package designed for Nomura’s purchase of Le Méridien—which also took advantage of the sales/leaseback model.

RBS offsets risk factors “by focusing on the most resilient sub-sectors:” business/conference hotels located in city center or airport locations with strong re-letting and alternative use values. Purchasing criteria are tightly defined. To date, RBS has not invested in newly developed hotels or hotels outside the upscale sector. Nor has it invested in hotels not managed by “a major operator.” Properties heavily reliant on tourism are not on the preferred list. Further safeguards come in the form of a base rent floor, an automatic fall-back to a fixed rent obligation if the operator defaults on the lease and use of a fully repairing and insuring lease—whereby maintenance and insurance obligations passed to the operator. Portfolio management techniques such as geographic spread and operator spread, backed by active liability management (from hedging interest costs on funding to swapping RPI rent uplifts) offer further avenues for reducing the risks of equity investing, says Eighteen.

Though Eighteen expects to see fewer transactions near term, he sees the market easing as trends in the economy in general, and hotel trading in particular, become clearer. “Our general investment strategy is driven by macro economics and opportunity,” says Eighteen. RBS invests only in high quality assets—which often become available during downturns.”

Adapting To Volatility

Movement of some of these trends onto the continent is broadening the deal landscape for banks such as NIB Capital and DePfa.

Hans Rijnberg and Bert Volbeda, who head NIB Capital’s European hotel and leisure team, say current proposals focus on larger amounts, tighter time frames, shorter terms and more flexibility. Though ROI of 15% is “challenging” in the present market, Rijnberg argues that the right deal, structured correctly, will tap “the substantial structural upside in hotel real estate.”

NIB Capital cushions its risk with more aggressive asset management requirements for management companies and, in some cases, variable rental income, with or without a guaranteed floor. Fixed lease payments may also form a buffer in a downturn, though Rijnberg says, “they do not result in substantial out-performance against other real estate.” In his view, the deal always goes back to the basics: an understanding of the hotel industry and the specifics of the underlying asset.

That is particularly important at a time when weaker performance may cause a valuation gap between buyers and sellers. “This will lead to fewer transactions in the short run. And, economic uncertainties will increase the margins banks require, which may be compensated by a further decrease of interest rates in the capital markets,” says Rijnberg. “However, the trend toward consolidation and the split between assets and operations will continue. The relatively low stock prices of a number listed hotel companies may also enhance the number of public to private transactions.”

Creativity and opportunity do not cancel out the increasingly conservative mood of bankers in most regions of the world. DePfa’s team— led by Henrik Bartl, head of international hotel financing; Anja Adam, vice president; and Christof Winkelmann, associate—foresees shorter terms and more conservative loan to value (LTV) ratios with stricter covenants. “Cash flow is the key underwriting criteria,” says Adam. “Each deal has to pass a strict covenant ratio test. These tests result in cash traps or early amortization to proactively manage potential downturns.”

Conservative may be a relative term, however. DePfa’s deals, like the creative US$400 million refinancing package designed for New York-based Millennium Partners’ assets (for which DePfa and Dresdner Bank Real Estate served as the lead banks) or its financing of the sale of the RIHGA Royal in New York, show a flexibility not evident in the cautious, fixed rate deals offered by less experienced lenders. The fact that DePfa has expertise not only in banking, but in hotel management agreements, variable cash flows and valuation criteria, enables it to read all aspects of ROI potential and structure deals accordingly. It also helps that Germany’s banks have long been equity providers, unlike their UK counterparts who traditionally focused more on debt financing.

The focus remains on high-quality assets and experienced owners and operators. Targeting markets with high barriers to entry and strong local supply and demand dynamics, Adam sees opportunities available in Europe. Debt financing will be freer flowing for projects in prime locations, she adds. But, there are clear exceptions. “Germany is a special case scenario,” she says. “Despite the poor past performance, construction continues. Development was fueled by tax incentives (especially in the eastern Germany after the reunification of Germany). Nowadays, a lot of developments are undertaken in Berlin as Germany’s capitol has been moved from Bonn to Berlin.”

High Marks

The rational yet flexible approach banks are using for hotel deals is rating high marks, both from bank shareholders and experts. Trevor Ward, joint managing director, TRI Hospitality Consulting, London, says these new instruments offer earnings enhancement at a time of low margins on debt. Strong covenants prevent exposure to commercial risk. Though banks are still exposed to the property risk, the relatively consistent appreciation of hotel real estate—and generous provisions for reserves—makes this risk palatable.

Though continental European banks have yet to enter the sales/leaseback market, the template is being tried out on several UK deals, including some international versions being contemplated by Hilton Group. There is a wait-and-see attitude in at least some sector of the institutional investment community, many of whom want a longer test on the larger deals before passing judgment. One question centers on exposure for corporate backup guarantees. Industry watchers point out at least one major leasing is already being restructured as a conventional debt/equity project.

Most analyses agree that bank ownership lends stability, while the combination of a strong brand and adequate capital provides the freedom needed for strategic growth. The advent of deals that permit capital participation introduces new revenue streams for institutional investing and an added vehicle for delivering real growth.

Increased participation by the banks also means greater liquidity, as the Nomura deal proves. It may also lower the cost of capital, at least for powerful brands with proven performance records. Although all of these banks say they look at the merits of each asset, less experienced operators will have a tough sell in a down market.