5 new normals of hotel financing

Major events in our culture often are the impetus for significant changes in behavior. Whether it is adjusting to new security measures after 9/11, long-term deployment of troops during the recent wars in Iraq and Afghanistan or, on a personal level, a death of a loved one, we adapt our lives to the “new normal.” Today is no exception given the continued uncertainty in the U.S. economy.

While the weakening housing market, an unemployment rate stuck close to 10 percent and a dangerously low inflation rate make it seem the economic doldrums will be with us for the foreseeable future, the hotel industry has turned a corner. Revenue per available room is projected to increase this year due to higher occupancy, transactions are up and debt more available. But even with this good news, there have been changes in hotel financing that will remain even as the industry rebounds.

Reality of financing today

Although there are signs of a favorable comeback for the industry, lenders have not returned to the go-go days of 80 percent loan-to-value and easy construction financing.

What we see today is debt financing for acquisition and refinance projects. While there are a few exceptions, construction financing is not projected to return in earnest for another three to four years.

Loan-to-value ratios are between 50 percent and 75 percent, with the sweet spot between 60 percent and 65 percent. Lenders want equity to remain in properties and debt service coverage around 1.40x.

Interest rates have fallen between 7 percent and 8 percent, although lower rates are available on lower-leverage projects. Borrowers need to be financially strong, with all sponsors willing to personally guarantee the loan.

While money is available for hotel projects, there is a smaller pool of lenders. Banks have failed, lenders have distressed assets on their books, and even those with performing loans don’t have room to do additional hospitality deals.

Five “new normals”

While you might think that once the industry’s recovery is in full swing we’ll see a return to the days of easy money, we project some of the more stringent underwriting guidelines remaining in place.

Which ones have staying power?

1. Low leverage – We expect loan-to-value ratios to remain low as lenders continue to be selective with their underwriting. This will lead to a significant decline in supply growth in the short-term. On refinance projects, many owners will be required to contribute additional equity in order to meet loan-to-value requirements. If additional cash isn’t available to do this, borrowers will need to take on additional equity partners or work to convince their lenders to extend the terms on existing loans.

2. No cash out – Equity partners will need to be patient about getting money out of their hospitality investments. No longer can hotels be viewed as piggy banks. Owners need to get used to making money on the performance of the property rather than through its sale or refinance.

3. Strong borrower financials – Borrowers will continue to need to have strong personal financials with ample liquidity and high net worth. Personal guarantees by all sponsors will remain a requirement. According to an April 2010 HVS Career Network survey, financial stability, good credit history, capital, access to equity and high net worth are critical borrower characteristics and ones we believe lenders will require in the future as well.

4. Higher interest rates – With still much economic volatility and declining hotel values, lenders will continue to require a premium on hotel investments. Interest rates will remain in the 7 percent- to 8-plus  percent range, with lower rates available on low leverage (50 percent loan-to-value) deals. Projects with high cash equity; owners with hotel experience and a proven track record; a strong management team; risk strategies and policies; and a respected brand will have the best chance at securing competitive rates.

5. Fewer lenders – There will continue to be a more limited number of banks and private lenders making hotel loans. Lenders are watching their existing hotel loans decline in value, others have loans on their books that will need to be refinanced during the next three to five years, and still others are preserving their capital for different uses. These factors will continue to limit the availability of debt financing in the hospitality sector.

With signs that the industry is on the upswing, now may be a good time to consider refinancing an existing property or, if you have available cash, making an acquisition. Whatever your next move, it is important to consider the “new normals.”