Hotel financing pipeline is open, but don't expect a gusher

Psssst. Don't tell anyone, but lenders are ever-so-quietly turning on the financing spigot for the hospitality industry. In dribs and drabs, money is trickling out for the construction of hotels - including full-service properties - in contrast to only a few years Ago when the financing pipeline was not only shut off but padlocked as well.

"We haven't seen financing available at this level since 1988 and that wasn't a phenomenal year," says Dr. Bjorn Hanson, National Industry Chairman-Hospitality at Coopers & Lybrand in New York. "It's quite a turn around. Financial institutions now are liquid and need to get the money to work and the length of some memories not as long as everyone said it should be."

Hanson adds that while the underwriting criteria now is stricter than 1988, financial institutions have stepped up hotel lending while publicly professing that they will only do "occasional" lending. "That's not what their behavior is," he adds. "There is not only refinancing, but money for new construction. Maybe the reason the financial institutions aren't talking about financing is they're concerned about being barraged by inquiries and requests and they would rather control the flow."

Whatever the rationale, the word is out: Once again, financing is available for hotels, not only from investor pools and financial institutions but also insurance companies and pension funds.

"There seems to be substantial cash available to hotels for refinancing, for financing acquisitions, for expansion of existing hotels, for renovations of existing hotels and for the responsible development of new hotels," says David Elmore, vice president/finance of Choice Hotels International. "There is a euphoria on Wall Street, which had four times the debt and equity offerings for hotels as it had in 1994."

Lodging industry health improving

Investors, financial institutions, Wall Street and even some insurance companies and pension funds are hot for hotels. Occupancy will climb six-tenths of 1% this year to 66.3%, then 66.7% in 1997 and 66.9% in 1998, according to Coopers & Lybrand's Lodging Industry Forecast. But what's catching the eye of potential investors is that during the same period, the average daily rate will increase 4.5% this year 4.4% next and 4. 1 % in 1998. At the same time, the room supply will increase 1.9% this year, 2% next and 2.1% in 1998.

"With corporate profits up, business travel has been been booming," reports the market research division of Newport Beach, Calif.-based Marcus & Millichap Real Estate Investment Brokerage Co. in its first quarter 1996 Hospitality Report. "Strong companies also mean individuals will have the confidence and ability to travel more. And if the dollar does not get too strong, more foreign tourists will be encouraged to visit the United States. This is especially true this summer during the Olympics, when many foreign tourists will take time out to visit other major U.S. cities on their way to and from the Games."

"We're no longer talking about a recovering industry," says Frank Nardozza, KPMG Peat Marwick National Hospitality Practice Leader. "We're talking about a strong industry where profits are at an all time high due to increasing occupancy and room rates and strong overall values."

According to KPMG Peat Marwick, industry profits are expected to be up by as much as 10% over 1995. In addition to increasing occupancies and room rates, KPMG reports that operating costs are expected to be further trimmed as a result of operations re-engineering efforts going on within most major hotel companies.

"A healthy average daily room rate and occupancy picture translates into an increase in value for hotel properties, and what is perhaps rosier for the hotel business is that increased REVPAR (Revenue Per Available Room) last year was driven more by a rise in rates than a rise in occupancy," adds W. Martin Winfree Jr., vice president in the San Francisco office of PKF Consulting. "While the hotel investment skies are not cloudless, there is relatively smooth sailing through the end of the decade. The only cloud on the horizon could be the aggressive development in the limited-service sector could darken the skies in some areas."

"New construction poses the most immediate threat," agrees the Marcus & Millichap report. "Oversupply is often the death knell to hospitality growth cycles.

"If interest rates reverse their past downward trend or the economy dips into recession, then financing sources could dry up and the current growth would be smothered," the report continues. "However, if interest rates stay down and the economy stay healthy, even at a lower growth rate, the hospitality market is positioned to continue its strong performance."

Debt, equity sources available

As the positive trend in lodging market fundamentals continues, a number of sources of debt and equity financing have become available to hotel developers and investors, reports Chase Burritt, national director of hospitality services, E&Y Kenneth Leventhal. "The hotel industry, with a discernible upward momentum in average value per room, has begun to regain its ability to raise both public and private debt and equity financing," he continues.

"There's a lot of money becoming available and interested in finding its way to hotels," agrees Randy Heller of FINOVA Capital Corp., Scottsdale, Ariz. "I guess there will be a lot of money around for at least a few years."

While this situation is good news for those seeking financing, Heller notes L, it does mean a high level of competition for the lenders.

According to a survey by E&Y Kenneth Leventhal, sources of capital today include:

* Commercial Mortgage Backed Securities (CMBS), which totaled some $1 billion last year and serve as an important source of debt financing for hotel acquisition or refinancing through the conduit structure;

* Real Estate Mortgage Investment Conduits (REMICs), which bridge the gap between commercial retail borrowers and investors, allowing smaller property owners to participate in the securitization market;

* Life insurance companies and pension funds, Which have returned to hotel lending after an absence of more than half a dozen years; and

* Foreign investors from around the world - those from the Middle East and Pacific Rim are among the most active off shore investors.

"Financing is going to be very active on both fronts, since owners are tending not to sit still and are taking advantage of refinancing opportunities because there is lot of money to lend and rates are favorable," says Paul Jones, president of Hotel Partners of Chicago. "We're talking to various funds who want to putmoney out, and discussing how to do that. Buyers are very active and have a lot of money to spend, owners are testing waters. We're finding buyers who are ready, willing and able, but won't do crazy deals."

Hotel financing is coming from a combination of sources, particularly Wall Street. "Nomura is one of the most active lenders, they believe in it and are doing prudent underwriting," Jones continues. "Wall Street has become comfortable with hotels. As far as getting creative, it's only in terms of mezzaninefinancing, which, at a riskier level, also carry higher costs."


Yet the watchword in the hotel financing world that is 1996 is prudence. "This is not the 1980s when lenders were lending 100% or 80%," Jones says. "Lenders are doing safer underwriting, in the 60% or 70% range. We just closed a loan yesterday, with a 70% LTV in a strong market with strong barriers to entry. The property was performing at almost 80% occupancy, and the lender felt comfortable making the loan, because of extreme difficulty of new construction. Five years ago, a lender would probably make a loan at 110%."

Raymond M. Anthony, managing director of Nomura Securities international - which has handled more than $2.5 billion in hotel financing over the past three years and will probably do $1 billion + in 1996 - adds that business is strong, stressing that Nomura's underwriting remains conservative and its outlook more cautious.

"We are underwriting hotel loans based on values that are realistic, based on assumptions that are not only conservative but genuine," Anthony explains. "We underwrite after setting aside a management fee of 4% to 5% and a capital expenditures reserve of 5%. We're writing loans 10 to 15 years and we want to make sure that the borrower is going to invest sufficient funds into hotels to keep the properties competitive."

Currently, about 70% of Nomura's hotel activity is refinancing, with the remainder acquisitions. What's driving this market is that balloon loans are maturing and owners need, to refinance. "We started a small loan program here 2 1/2 years ago and we were getting a little flow," he continues. "Now the industry has recovered such that even though rates are up, it's still a low interest rate environment and business is strong."

Anthony stresses that Nomura will finance where cashflow supports the loan amount. "We look at historical cashflow, not just 12 months, to make sure we're not just underwriting on crazy numbers," he continues. "Hotel cash flows are volatile, and you have to take that into account. We're very cautious, but we're a consistent lender in market. We've gotten fairly well known and continue to sustain our volume."

Existing high end easier to finance

While financing is available, "it's still not very aggressive, but it's clearly unlike anything we have seen in the early-'90s," notes John M. Elwood, chief financial officer of Prime Hospitality Corp. in Fairfield, N.J., which operates 95 properties. "You still have to have a substantial slug of equity, and financing for new development is difficult, but right now it's easier to finance an existing full-service hotel, or upper- to mid-scale than a new or an economy end hotel. Most of the lending community are less comfortable with A:, low end than they are with the more upscale and full service. They still believe in barriers to entry like those that exist in the full-service sector as a result of the discount to replacement cost."

Last year, the average transaction price per room for full-service hotels was probably $60,000 to $80,000, Elwood adds, compared to building a room in a new property which "was well north of $100,000 a room. So the thought on the part of upscale lenders is that they can be relatively certain during the life of loan there's not going to be a new influx of competition."

In contrast are the budget hotels, where the cost of replacement is nearly equal to the cost of construction. "At that end of the business, it costs just as much to build, and the lender says, 'Is it possible that new competition will enter into my marketplace and compete with the hotel I'm lending on? The answer is that it is possible at the lower end, where most of new construction is coming on line," he points out.

Rory Brown, managing director of West Palm Beach-based Ocwen Financial Corp.'s real estate finance group, says that over the past year, he's seen an increase in the number of people who want to finance, on the equity and debt side. "More equity funds are available and an increasing number of lenders are coming into marketplace," he says. "Because the overall performance of the industry has improved, it has become much easier to raise equity for investments in hotel properties."

The only sector where large amounts of financing are not available is new full-service construction, Brown says, adding that while few full-service properties have been built over the past five years, some are under construction now, primarily in stronger markets.

Ocwen concentrates on unique transactions that require more time and effort to closing as well as properties it believes are undervalued, he says.

Traditionally tenders will finance existing cash flow stream, he notes, while Ocwen will finance an asset that where value creation will occur over time by either a turnaround or repostioning, or rehab.

"You can still purchase full-service properties below replacement costs, and we look at those types of properties below replacement costs where there are barriers to entry by others," he says. "One of our recent transactions was The Whitehall in Chicago, a luxury property without a flag that had been closed for several years. It's very unusual to provide financing for the start up of a closed property, but we provided financing to restart operations. It has outstanding physical assets for a fraction of replacement costs."

While financing is becoming more available, it is mostly focused on limited-service new construction or the financing of hotel acquisition of newer properties that don't require a lot of physical rehab, says Paul Novak, president of the Dallas-based fund Bedrock Partners.

"Every week I see announcements of someone new having capital available for financing of those type of products," Novak continues. "We're not seeing any financing available for construction of fullservice hotels. My sense is that there is some financing available, but lenders are going to need two or three years of improving performance before they can justify construction that would warrant financing. The cost of developing full-service hotels is substantially higher than what the performance would economically support. Cashflow will be required, at least 1.3 to 1.5 coverage, and today, they couldn't support even 1.0 coverage."

Backed by the financial muscle of Nomura, Bedrock Partners closed on 16 hotels in the past two years and expects to close on another five by June 1. The company undertakes projects that are akin to building from the ground up: Buying a hotel that has seen its better days, shutting it down, rehabbing it, and rebranding it to a higher level.

"We're taking assets and totally repositioning them at a higher quality level than what they were at," Novak continues. "That's the equivalent of new construction, for all practical purposes, and the economics of projects tend to be supported from a start up basis. Our projects tend to be more of a full-service nature, usually in excess of $10 million, and it's not something lenders have an attraction to."

More players returning

While more players are beginning to come back into market, they have stringent underwriting criteria, points out C. Gregory Newman, vice president/ Southeast originations manager at Heller Real Estate Financial Services. Loan-to-value ratios rarely surpass 65% to 70% and debt service coverage ratios vary from 1.4 to 1.55 depending on the property type and type of lender. Funds are primarily allocated to projects managed by companies with a proven track record and which are affiliated with an established lodging chain, he continues.

"Life companies are looking to get back into the market, on a conservative basis, and, over the next 18 months, more lenders will come back in," Newman continues. "Lenders are not aggressively leveraging up transaction; they're conservative. We've been seeing some refinancing, with a lot of deals going to conduits."

Wall Street, in fact, is providing much financing for hotels. Coopers & Lybrand reports REIT IPOs and secondaries increased from $79.6 million in 1993 to $1.7 billion last year, while c-corp equity offerings nearly doubled, to $957 million, during the same period.

As of summer 1995, hotel REIT capitalization hit $2.4 billion, which was 5.3% of the total REIT pie, according to statistics from New York-based Salomon Brothers. Furthermore, REIT IPOs gained significant momentum later in the year, Valuation International Ltd. pointed out in its Viewpoint 1996 report, with the IPOs of Hospitality Properties Trust and Patriot American Hospitality exceeding $200 million and $350 million, respectively.

The institutional investment community has had good experience with hotels, says Hanson of Coopers & Lybrand, since the hotel companies have outperformed expectations. "That's a great way to create a great impression with investment community," Hanson says. "Investors have learned a lot about the hotel industry, and they know that if occupancy is high, rates will grow greater."

Hanson adds that both the equity and debt markets have been active, including secondary offerings for Host and Studio Plus. In addition, Wall Streeters say Equity Inns is in the midst of a road show, while other companies reportedly investigating IPOs and REITS include Interstate, Wyndham and Choice (IPOs), and American General Hospitality, Boykin Management and Capstar (REITs).

Less stringent debt

"Barring any unforeseen catastrophes in the next six months, I think we'll continue to have capital available at reasonable rates," says Dana Michael Ciraldo, senior vice president of Hodges Ward Elliott, an Atlanta-based hotel investment banking and brokerage firm. "What we're seeing in the debt market won't spur big jumps in construction, but the trend is debt terms are getting ever less stringent, and if that trend line continues, we'll see a spurt in new construction."

Buyers are now able to be more aggressive on pricing, using more debt, he adds, and lenders are willing to do participating mezzanine-type debt to participate in the potential upside. Seller financing seems to be disappearing from the scene, he reports. "We used to see a lot more in the 1990s," he continues. "Maybe the perception on the part of sellers, is that, given today's capital markets, they don't need to provide that. That means, so a seller willing to provide that can gain a leg up because it's an attractive option."

Ciraldo says he is also seeing higher loan-to-value (LTV) ratios, trending up from 60% to 65% to 75%-plus. "People have short memories, and there's a desire to place capital, which has been driving whole industry," he adds.

In the industry, direct capitalization still leads valuation techniques preferred, although its share has declined somewhat reports Winfree of PKF Consulting. More importantly, discounted cash flow analysis has moved into a strong second place and is utilized by 50% more of the survey participants. Meanwhile, cash-on-cash methodology has fallen out of favor, losing over half its adherents.

"The improved performance characteristics of hotel properties has made net cash flow a much more volatile figure, lessening its appeal as an indicator of value in today's market," Winfree explains. "Equity yield analysis has vaulted to third place among the participants, although I doubt that many deals can be consummated at the elevated rates furnished by these same participants."

According to PKF, the overall cap rate moved downward by 0.2 points to 11% between 1994 and 1996. This is in contrast to a 0.7% decline from 1992 to 1994. The discount rate drifted downward just 0.1 point to 14.6% over the same period.

Analysts say that with rising occupancy rates, increased average daily room rates and a dearth of construction, particularly in the full-service sector, hotels will continue to attract capital.

But one thing is certain, say those in the hotel financing industry: Realizing that many properties in the 1980s and 1990s were underwater for awhile, the financing pipeline isn't expected to turn into a gusher anytime soon.

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