Is hospitality making a comeback within the capital markets?
For the past three decades, borrowers have been cautious about diving into non-recourse CMBS financing because they didn’t want to have to lock into the rate and terms for 10 years. This concern is no longer a barrier, thanks to renewed focus on five-year CMBS loans. These shorter-term, non-recourse loans aren’t only available to all borrowers, they’re also priced more attractively and include new flexibility. A good way to look at is when the market gives us lemons, Wall Street figures out a way to make lemonade. This five-year CMBS lemonade has been around, but because the loan originators were contributing five-year loans in a 10-year bond pool there was a pricing discrepancy. As today’s bond buyers embrace shorter duration bonds in an effort to avoid rate increases on their bond investments, five-year paper is in demand. This has translated into bond issuers putting together pools just for five-year loans.
INTEREST RATES & HOSPITALITY
The new interest rate environment is conducive for hospitality lending, in particular, because hotels have traded at higher cap rates historically than office, retail, self-storage, and multifamily properties. This current cap rate premium makes hotels one of the few asset classes that can still provide positive cash on cash returns for both owners and investors after putting on debt. As a result, capital markets are motivated to lend aggressively on hotels. The current inflationary environment bodes well for hotel owners, allowing them to push ADRs without sacrificing occupancy. This is helping push higher trailing twelve revenues and higher net operating incomes for most hotels, leading to higher loan amounts. The bottom line: Hospitality is one of the few asset types that can weather the inflationary storm.
There are other tailwinds helping hotels find capital in today’s market. At the top of the list is the demise of office. Due to a widespread change in corporate behavior post-pandemic – mainly pressured by employees wanting to work remote or hybrid arrangements – the need for office space continues to shrink. According to conventional wisdom, today’s office building will stay 20% vacant all of the time. This is bad news for office building owners, investors, and lenders, but it’s good news for hospitality, as lenders have capacity to seek riskier asset classes such as hotels.
HOW MULTIFAMILY IS BENEFITING HOSPITALITY
Multifamily real estate is suffering from what some would call a hangover effect. This is because there was too much capital chasing multifamily deals prior to the recent run up in interest rates. To make those deals work, many multifamily loans were underwritten using lofty assumptions such as 10% year-over-year growth in rent and exit valuation cap rates of 4.5% to 5%. Looking at the current landscape, it’s difficult to fathom that a multifamily deal would transact at a 5-cap rate. The gap between reality and expectation has pushed many lenders to shift their attention to hospitality and retail for deal flow.
Even life insurance companies that ignored select service hotels in the past are now considering good quality hotels with good quality sponsors at reasonable leverage. In today’s world, reasonable leverage for a hotel is 55% to 65% loan-to-value on senior debt. Good quality properties are those that have decent flags and sponsors willing to make capital expenditures to maintain the property’s overall health. A good quality sponsor has the infrastructure to own and manage properties, enough cash to weather a slowdown and the professionalism to deal with servicing of more complex loans.
INDUSTRY CHANGES ON THE RADAR
The biggest change looming will be from bond rating agency Fitch Ratings. The agency is re-inventing the methodology it uses to examine loans to reflect the new commercial real estate landscape, including risk ratings for CMBS loans. This will be the most significant adjustment in capital markets lending since the implementation of the Dodd-Frank Act. In the past, Fitch focused on only debt service coverage ratio to risk-rate loans. Under the new methodology, Fitch is including the significance of loan-to-values for loan-level risk analysis. This eases some of the leverage constraints that CMBS posed to borrowers because of higher interest rates. This new approach, combined with the advent of five-year CMBS loans, will lead to a massive CMBS loan volume issuance this year.
Pre-payment penalties have also been a pain point with borrowers seeking nonrecourse, fixed-rate debt. Five-year CMBS loans cure this issue since borrowers and sponsors are only looking at a 4.5-year prepayment yield maintenance. This is because, during the last six months of the loan, the debt can be pre-paid without any penalties. Lenders also are being more lenient when negotiating certain servicing language to make it easier for borrowers.
These collective changes position CMBS and life insurance lending as an attractive financing choice for borrowers seeking maximum leverage on their deals on a nonrecourse basis. This is especially critical as community and local banks continue to pull back on hotel lending after their terrible experiences with borrowers navigating COVID-19. Life insurance companies, debt funds, select banks, and credit unions, however, remain active in the hotel lending space. There will be plenty of liquidity available for well-performing assets as we move through 2023. Having an experienced intermediary with strong relationships with all types of capital sources will improve your options, remove obstacles, and provide certainty of execution.