Borrower's Market-For Now - Investment Outlook - June 2004

Significant debt capital continues to chase quality hotel deals. But, if interest rates move up faster than performance, watch for compression.

By Staff -- HOTELS Magazine, 6/1/2004

(l. to r.) Barry Olson, Archon Capital; Dan Abrams, iStar Financial; and Chuck Rosenzweig, Greenwich Capital Markets, are among the leading lenders who discuss the availability of debt—both today and into the near future.

With billions in debt capital chasing hotel deals, there has never been a better time to be a borrower. “Depending upon who you are, you can get as much debt as you want,” says Michael Robb, head of the real estate division and executive vice president, Pacific Life Insurance Co., Newport Beach, California. But you had better hurry. The fundamentals of a high-yielding industry just off the bottom should keep the competitive debt pipeline flowing freely over the next six months. Beyond that, the crystal ball gets cloudy. There are too many variables. Any signal that RevPAR is not outpacing interest rates or that the economy is stalling is likely to squeeze mezzanine lenders and entrench senior lenders bent on fending off tightening spreads. That can only mean lower leverage, a higher cost of capital and less money in the pool.

Divided Outlook
Interest rate hikes alone will not be enough to shut down the hotel debt market provided they are gradual, which means anything that trails a LIBOR raise of 150 to 180 basis points over the next year and 400 basis points over the next three year. Hotel lenders worldwide are already braced for a when, not if, scenario on rate rises. “We have baked an increasing rate environment for the next several years into our underwriting assumptions,” says Barry Olson, managing director, Archon Capital, L.P., a Goldman Sachs affiliate, Irving, Texas. “So, interest rate hikes do not worry us as long as they track similar to the forward curve. But, if we see a shock to the system like we did in 1998, then all bets are off.”

What does worry Olson and other leading lenders is the economy. “While we have clearly seen signs of recovery in the U.S. lodging sector over the last six months, six months does not constitute a trend and therefore does not warrant more aggressive lending levels from Archon Capital,” he says. Olson’s point is that, while 2004’s risk is not significantly different than 2003’s, this year’s yields to the mezzanine providers are significantly different from last year’s yields, tightening from 100 to 200 basis points. “Our crystal ball does not go out to 2005 and beyond,” adds Olson. “We know we will remain highly involved in the lodging industry, but the form is hard to predict. It is all about appropriate return—whether from debt or equity, domestically or internationally.”

Henrik Bartl, head of international hotel financing, Aareal Bank, Wiesbaden, Germany, also sees debt coverage ratios compressing as interest rates rise. That is making senior lenders more cautious and adding risk to high leverage deals in the mezzanine sector. With the expectation that hotel performance can stay in step with interest rate hikes, Aareal Bank’s hotel lending will remain stable this year, with the emphasis remaining on “high ticket” portfolio and single asset deals. If there is a deal breaker, says Bartl, it is overly optimistic performance projections. “Some sales projections look very high. That is risky. There could easily be a disruption if those high expectations cannot be met. As we learned in 1998 and 2001, liquidity can come and go over night,” he adds.

Not everyone reads the economic map in the same way. “Investors believe the lodging sector has bottomed out and that sustainable recovery is possible,” says Ronald E. Silva, president & CEO, Fillmore Capital Partners, LLC, San Francisco. “By buying at or close to the bottom, they somewhat minimize the inherent risk in the lodging sector—that of an operating business which re-prices daily.”

Jeff Taschler, senior managing director, Bear Stearns, New York, will double 2003’s US$1 billion financing level based on the belief that performance is on the uptick. “The best time to lend is at the bottom. Yes, interest rates have started to creep up. But, the economy is improving. People are traveling and there is more demand for hotels. That should mean performance will cover the interest rate rise,” Taschler says.

“Investors believe the lodging sector has bottomed out and that sustainable recovery is possible. By buying at or close to the bottom, they somewhat minimize the inherent risk in the lodging sector—that of an operating business which re-prices daily.” - Ron Silva

It should, but will it? Some lenders contend that a jobless recovery will not generate the kind of business confidence that will put travel back into corporate budgets and high-spend business travelers back into hotel rooms. How much those worries affect lending levels depends on whether the lenders are concentrating more on asset value or cash flow. Those who use asset value may have an easier time rationalizing deal number since hotels continue to outperform other real estate classes. That is creating demonstrable pent-up demand, especially investors with a lot of capital to deploy and a lot of pressure to find higher yields. “Lenders are increasingly interested in deploying capital into lodging given the higher spreads relative to other asset classes at a lower point in the loan to value (LTV) capital structure,” says Douglas Kessler, chief operating officer, Ashford Hospitality Trust, Dallas. “They, too, see the benefits of a recovering economy. If rate increases get too aggressive then, yes, lenders and borrowers may back off. If the economy stagnates, we will see a slight reversal in the tightening of spreads. But, as this past cycle has shown, higher LTVs are available as long as the pricing spread is high enough.”

Bidding Wars?
That is attracting more and more debt capital to the hotel market this year. Real estate investment trusts, hedge funds, mezzanine funds and institutions are ensuring that the balance of 2004 will be a borrower’s market. There is a virtual bidding war for the best deals, with lenders laying out “platters” of deal terms. “Liquidity has increased across the board, from structure finance lenders to life companies and conduit lenders,” says Michael Huffman, vice president, Merrill Lynch Capital, Chicago. “Many qualified lenders are vying for business, which makes it good for borrowers. But I would not say that the deal terms are all that creative.”. In his view, it is the efficiency of the market that is allowing for combinations of debt in a single transaction through the use of different tranches, such as establishing several levels of debt stacked at different price points.

Lenders are competing not only with each other but—in the United States and soon in some European countries—with the CMBS markets and mezzanine lenders. With low cap rates and low interest rates, leverage levels for top deals look more like the go-go late 1980s than the disciplined late 1990s. In this business environment, Kessler and others are not averse to taking LTV mezzanine transactions on the right type of deal to 95%. While Robb contends that the sheer amount of debt capital is making some lenders lose discipline, Kessler refutes the idea that lenders are becoming looser in their underwriting standards. “You cannot equate looser standards with a more optimistic view of where the industry is headed,” says Kessler.

But everyone agrees if interest rates accelerate too fast, mezzanine lenders will be the first to feel the pinch. “The mezzanine lenders are the ones who will get squeezed if interest rates move up too rapidly,” says Taschler. “Then they will have to decide whether they will accept lower returns or whether borrowers will pay more for blended debt.”

New Deals
Deal structure is a response to market demand and risk assessment. “If people think we are in a steadily upwardly mobile environment for hotels, they are wrong,” says Daniel Abrams, executive vice president, iStar Financial, New York City. “You cannot underwrite on the basis of overly optimistic cash flows two to three years down the road. That is not creative; it is just very risky.” Abrams predicts that lenders working toward higher proceed numbers will imbed more protection into their loan structures, whether as earn-outs that make more money available as performance improves, as credit support or as recourse debt. “Lenders need to distinguish between more proceeds and lower spreads,” he adds. “More proceeds mean high risk. Unless proceeds are going into a reserve, lenders will have to charge more. Reducing the spread also reduces the likelihood of default, but may not compensate the lender. It is the borrower who ends up with no downside.”

Terms and structures are already adapting, according to Charles Rosenzweig, managing director, Royal Bank of Scotland Greenwich Capital, Greenwich, Connecticut. Although some lenders still provide fixed rate loans, as interest rates move up, there is increasing emphasis on three- to five-year floating rate debt. With so much debt in the market, and so much competition from veterans as well as a new wave of real estate investment trusts (REITs), hedge funds and mezzanine funds, the trend for this year and beyond is to offer multiple tiers of capital.

“Lenders are increasingly interested in deploying capital into lodging given the higher spreads relative to other asset classes at a lower point in the loan to value (LTV) capital structure. They, too, see the benefits of a recovering economy. If rate increases get too aggressive then, yes, lenders and borrowers may back off.” - Douglas Kessler

“In the capital markets, you can buy any level of risk. You can securitize part and structure the rest as junior debt or a mezzanine component,” says Rosenzweig. This flexibility will mean more money for hotel lending. In a fixed rate pool, hotels might account for only 5% to 6%, he says. With this menu of options in a floating rate fund, Rosenzweig sees US$300 million to US$500 million earmarked for hotels.

Securitization in general, and a CMBS structure in particular, may not offer the same advantages when it comes to Europe. The average deal size is smaller. Any added front-end costs would make CMBS options less attractive. “If you are going to put together deals from two or three countries, it becomes a lot more complex and a lot more costly,” says Bartl. “There is no service, no relationship. What happens with CMBS if the borrower wants to renegotiate?” Rosenzweig is more optimistic, especially since many European banks have tested the CMBS markets with their U.S. investments. “Many floating rate investors are European. CMBS is likely to become more prolific in Europe,” he says.

It is equally likely that offshore investors will continue to aggressively compete for U.S. debt deals. “It is extremely hard to out-compete foreign banks. The German banks have been particularly aggressive,” says Robb. The exchange rate has not hurt. Jones Lang LaSalle Hotels reports, even in Europe, currency value is playing a role in keeping debt flowing. UK and Euro interest swap rates continue to decrease from the peaks of September 2003 to the levels of early 2003, which JLL contends should ensure that debt (at least for single assets) “remains relatively attractive in 2004.”

“You have to analyze delinquency rates in the CMBS market. You’ll find a much higher delinquency rate and loan loss at the lower end of the scale. The bottom line is that plentiful capital is chasing too few quality deals.”- Michael Huffman

The Dangers
Generally, there will be more debt capital available for hotels in 2004 than in 2003. And, high leverage will continue. The trouble is that, with so much capital available, not every lender is waiting for the right deal. According to Robb, the results could be dramatic. “There is no question that underwriting standards are getting looser. If lenders are wrong about this being the bottom, we could have some major problems,” says Robb.

John Barkidjija, senior vice president, Corus Bank, Chicago, also believes highly leveraged loans could flounder. He points to lingering malaise after the recession, the specter of increased supply as projects on hold since 1999-2001 begin to get built and the advent of low-rate shopping engendered by the Internet as key concerns. Add interest rate hikes, and the mix becomes volatile. “If you bought a hotel today at an eight cap rate and financed it with a 10-year fixed rate loan and performance falters, you will probably be all right,” says Barkidjija. “But, if you finance the purchase with floating rate debt, one misstep in performance on a three- to five-year floating rate deal and you could be upside down very quickly.” Also, rising interest rates will lead to rising cap rates. If you buy at an eight-cap today, you would need net operating income to rise 25% just to break even on your investment if cap rates move to 10. “Some things are just not heading in the right direction. If I owned hotel assets, I would either lock in fixed rate financing, or I would think about selling,” says Barkidjija.

Huffman is more optimistic. “You have to analyze delinquency rates in the CMBS market. You’ll find a much higher delinquency rate and loan loss at the lower end of the quality scale. The bottom line is that plentiful capital is chasing too few quality deals,” he says.

The Outlook On Debt
Unless interest rates take a giant leap, expect the majority of lenders to maintain or expand their lending in the hotel sector. Should spreads compress, the debt flow is bound to slow.

Debt Capital's A List
No lender will say no to the right opportunity. But, there are rules and exceptions beyond the usual minimum requirement of a quality asset and a strong sponsor. They are:

The rule: Luxury hotels. Preferably branded, but even boutique, anything that looks like a one-of-a-kind is going to get a better hearing from veteran hotel industry lenders. “Generally, we like extremely high-end assets such as Pebble Beach. But, the ultimate decision depends on the specific deal, the operator and the owner,” says Michael Robb, Pacific Life. “What we do not want is a brand in the suburbs with six competitors who all look the same.”

The exceptions: Limited-service in areas with high barriers to entry. This would include Corus Bank’s financing for a Residence Inns by Marriott in Manhattan and Baltimore, and portfolio deals such as Bear Stearns’ US$2.6 billion package provided for Blackstone Real Estate Group’s acquisition of Extended Stay America. “We liked the diversification of portfolio deals, both by location and flag,” says Bear Stearns’ Jeff Taschler. Says Corus Bank’s John Barkidjija, “We have done quite a number of high-end limited-service in areas with high barriers to entry. We see strong prospects for a Residence Inn just off Times Square or a Hampton Inn in Washington, D.C.”

The rule: Top-line resorts, with the U.S. West Coast and Hawaii high on the list. The Caribbean and Mexico are still under the radar. Most leading lenders have a mixed portfolio of urban and resort properties. Most resorts have performed better than their city center counterparts during the downturn. The combination of uniqueness and barriers to entry mitigates the complexity of most resort deals.

“Resorts are attractive because the value will not go below a certain level,” says Charles Rosenzweig, RBS/Greenwich Capital. “Even if the income is not there, you still have the land in Hawaii or the golf course. That is why lenders who look more to value than cash flow like resorts. They are more easily financed and have a lower cap rate than limited service. But, resorts need to be irreplaceable.”

The exception: “We are primarily focused on hotels with a business focus rather than those that are resort oriented,” says Merrill Lynch’s Michael Huffman.

The rule: Existing hotels with a track record. Most lenders want to see a history, even if that means a hotel with less than a year’s results on its books. With barely a year of anything close to recognizable trailing numbers, lenders want to see performance trends before they can judge projections.

The exceptions: Too rare to mention. Among top lenders, portfolios and single assets both have their merits. “We prefer portfolios with diversification or very large single assets in areas with high barriers to entry,” says Aareal Bank’s Henrik Bartl. “We look for the large ticket deals.”

More surprising to some may be these lenders’ reluctance to rule out markets industry experts dismiss as over-supplied. “Dallas and Boston may be oversupplied, but that does not mean the right hotel with the right owner and operator would not get financing,” says Robb.