By Todd McNeill
In recent times, the Limited Service Hotel sector’s reputation has steadily declined in the eyes of the finance industry. Once the darling of the hotel sector for lenders, limited service hotels are, for the time being, a less desirable class of assets.
Firstly, construction lenders have reduced the leverage on all construction requests, specifically impacting limited service hotels, due mainly to overbearing regulation put in place after the Great Recession of 2008. In most cases, construction lenders are reducing the loan-to-cost ratio of hotel development to a maximum of 55%. Gone are the days of 65% and 75% leverage on ‘to-be-built’ limited service hotels, which was the typical leverage for regional banks signing with experienced hotel developers. However, there are several banks that simply will not consider any development in the current environment, let alone an asset class where: (a) your rent-roll “rolls” every night; (b) real estate is closely attached to an operating business; or, (c) a high fixed-cost structure offers a narrow margin. However, despite the negative perception, seasoned and well-capitalized hotel developers are still able to secure construction financing, albeit at lower leverage levels (maxing out at 55% loan-to-cost ratio).
Secondly, the market has scaled back on permanent financing for any newly completed hotels with no operating history. There are many new hotel property projects that are still sitting in construction loans because the permanent lenders require seasoned operating results. Several of our Wall Street CMBS shops have disclosed that the rating agencies saw 2013 as the peak performance year for the limited service hotel sector. However, lenders are underwriting loan metrics from 2013 P & L’s for loan sizing purposes and Wall Street has been hammered by the rating agencies, most notably Fitch. If a the hotel has, therefore, continued to increase its bottom line from operations since 2013, it will have a difficult time getting any lender to give it credit for the increased cash flow. To reiterate the point, a typical Wall Street shop sizing for limited service hotels will consider the 2013 P & L sized to an 11% debt yield, which should not exceed a 65% loan to value. A recent permanent loan request in our shop was sized to these metrics and resulted in a 14% debt yield, as well a 45% LTV on actual trailing-12 operating statements! Additionally, the conservative loan sizing metrics used by the Wall Street lender did not allow for this particular loan request to even cover the construction loan payoff without an equity infusion to account for the delta!
One may think that this scaling back is an excellent opportunity for preferred equity and mezzanine lenders to swoop in and fill up the void in the market created by the banks and permanent lenders – however, the sheer volume of limited service hotel request in the market has caused both group to “fill up” on hotel collateral. Lenders are now “cherry picking” the hotel deals they want to do and leaving the less desirable deals at the bottom of the stack.
Given that there has been a tremendous amount of limited service hotel construction since the recession, the capital markets are reacting with their version of supply control. By dialing back leverage across the board, they make the sector less attractive for investment. This fundamental pull-back is based on the most basic economic principals of supply and demand. In the last 2 to 3 years, there have been significant construction and permanent loans written in the limited hotel sector. Now the capital markets are hitting the pause button to allow the new supply to stabilize. On one hand, it doesn’t take a PhD to figure out that if the sector maintains its solid fundamentals the capital will slowly start to trickle in. On the other, if the capital markets’ perceptions are accurate, there could be a correction in the fundamentals of limited service hotels on the horizon.
To secure financing on limited service hotels in today’s market takes careful and exhaustive outreach to a deep bench of lending institutions. Many times, multiple lenders are required for one deal and this is not something that can be achieved with a “few phone calls”. MCA has numerous clients in the development and acquisition business of the hotel sector. We have developed a deep understanding of how to assess and efficiently place successful requests. For inquiries on your next hotel deal, MCA can be a valuable ally in securing the most efficient funding sources for your deal.