Are dark clouds ahead for commercial mortgage-backed securities?

0

Hotels are increasingly turning to CMBS loans for funding. Here are the pros and cons you need to know.
by RAHUL PATEL

Much of the fuel that has propelled the hotel building boom over the past several years has been commercial mortgage-backed securities (CMBS) or commonly referred to as non-recourse, an alternative to conventional or SBA bank lending. No doubt many of the readers of this magazine have likely, at a minimum, researched or looked into it.

There are plenty of valid reasons to tap into the CMBS financial pool. With some $823 billion in outstanding CMBS debt as of late 2017, according to Reuters, it’s obvious that a lot of borrowers in the commercial real estate world are going down the CMBS path.

Last year alone saw $95 billion in CMBS volume, “much higher than most analysts predicted and higher than 2016 volume by approximately 27 percent,” according to US Hotel Advisors.

All is well, it seems. New properties are getting the financing they need, existing projects are being refinanced and investors are getting relatively low-risk securities for their portfolios or properties. There don’t appear to be any dark clouds in the clear blue CMBS sky.

Or perhaps those storm clouds are just slightly beyond the horizon.

Consider the latest U.S. CMBS delinquency report from Trepp, a leading provider of information, analytics and technology to the structured finance, commercial real estate and banking markets. Trepp’s Feb. 5, 2018, press release noted that the month of January continued the downward trend in CMBS delinquencies that Trepp had reported over the second half of 2017.

But the hotel industry bucked that trend in January. “The largest increase (in delinquencies) of the month was noticed in the lodging sector, as hotel delinquencies increased 69 basis points to 4.51 percent,” Trepp reported.

Granted, one month of rising delinquencies is not enough to push the panic button. But there’s more to consider ­– recent market trends, historically low interest rates, prime plus floating interest rate loans and the real possibility that the new supply is greatly outpacing demand could be the first signals of a CMBS storm. Couple that with an unprecedented period of explosive growth, new brands by hotel giants, infiltration of Airbnb and online booking, and we could be in for a big change in the market.

CMBS financing clearly has its charms. A big one is the absence of a personal guarantee. Yes, the lender has the means to collect on its debt, but taking your personal property isn’t one of them.

Rates on a CMBS loan may be fixed as well as lower than conventional loans; another plus. The CMBS loan may also be assumable, allowing a hotel owner to sell their property and transfer the debt to the buyer, thus avoiding what usually are hefty prepayment penalties on CMBS loans. And the financial requirements established by the CMBS loan tend to force fiscal discipline on the borrower, which is generally a good thing for any business.

You know what’s coming – the “however” side of the equation.

For one thing, that same fiscal discipline can also be very demanding and ruthlessly unforgiving. The CMBS loan requires the borrower to create a highly structured cash management process so that loan payments are prioritized above other financial obligations. That’s how the investors who buy these securitized loans reduce their risk.

This is a stark difference from many hotel owner’s current operating process and this should not be treated lightly. Money brokers often downplay this important aspect.

It’s no big deal as long as the hotel is doing well. The lender will be paid automatically, and the borrower will have the cash flow they need to fund other operating expenses. But if the hotel suffers a downturn, the lender essentially takes control of cash flow until it returns to pre-set levels.

In short, the CMBS borrower gives up a lot of control over the property’s finances. And let’s be honest – giving up control over the money, even temporarily, is like handing over the keys to the car and switching from the driver’s seat the passenger seat. You are simply no longer in control.

Again, not much to worry about as long as times are good and the money is flowing. But if the hotel market really has reached a state of overdevelopment, or if the economy cools just a bit, a slight dip in revenue could trigger the lender to step in as described above.

Another worry in the event of a downturn in revenue is that unlike a bank loan, simply making the payments on a CMBS loan is not enough. Look at it this way: under a bank loan, the bank generally stays out of your hair as long as you make your loan payments on time. You might have a few off months that cut into your cash flow and you might even have to operate in the red for a period, but the bank’s typical principal concern is getting their payment on time. Otherwise, they don’t truly meddle in how you manage the rest of your cash.

But a CMBS loan not only requires those on-time payments; it also demands a specific debt service coverage ratio, or DSCR. You might be making your payments even as your DSCR has fallen a little under the required level, which puts you in default. This is something that most who are new to CMBS don’t consider.

Given that many CMBS loans are highly leveraged at up to 85 percent loan to value, even a slight blip in revenue can throw the borrower into default because of the DSCR threshold. On a variable rate CMBS loan, the DSCR trigger could also be only as far away as a slight uptick in the interest rate.

Certainly, we’ve all seen what can happen when excessive optimism mixes with excessive leverage. The CMBS lending boom is several years old now and approaching a trillion dollars. A big chunk of that total is tied to hotel properties.

The U.S. market is glutted with both old and new properties, and the juggernaut of virtual travel companies is hammering the traditional lodging industry in ways no one imagined only a few years ago.

Put it all together, and it’s clear that hoteliers would be wise at this point to consider funding channels that are more suited to the world of 2018 than the one perfectly acceptable in 2012.

Share.

Leave A Reply