Cap rates, inflationary pressures, and financing strategies when funding brand-mandated PIPs
Against a backdrop of sustained higher interest rates and the fed’s resolve to break the back of inflation, we’re seeing a plethora of changes in the commercial real estate markets. Because real estate is a highly leveraged asset class, it’s more sensitive to interest rate fluctuations. While there are levers that can be activated to determine asset valuation, the most important metric at the end of the day is capitalization rate. Cap rate is the measure of every dollar of net cash flow from an asset that investors demand for the value of the asset. Historically, hotels have experienced higher cap rates than those of other real estate food groups, such as industrial or multifamily.
Now, within the higher interest rate regime, cap rates for trades of other asset types are increasing more than those for hotels. This phenomenon occurs mainly because inflationary pressure is inducing higher projected revenues for hotel assets and sellers are commanding higher valuations. In addition, because of higher post-COVID construction rates, the replacement costs for hotels also are higher. Hence, there’s a mindset that existing hotels should garner a higher price than what a buyer is willing to pay in the current market. This imbalance has created a bid-ask spread in the market for buyers and sellers of hotel assets.
SELL VS. REFINANCE
An average SBA loan – once historically used the 5% interest rate range – is now available between 8% and 9% (all else being equal). An average bridge acquisition loan from a debt fund that allows buyers to acquire assets, perform capital expenditures, and stabilize the asset now starts at an interest rate of 8% on a nonrecourse basis and – depending on the in-place cash flow of the asset and quality of the asset – goes all the way up to 12%. This is an opportune time for owners who have pending mandatory maturities or financings to refinance.
FINDING THE FINANCING
Many community and regional banks have paused granting new credits for new clients because of regulatory pressures and market headwinds. This creates space for alternative debt sources, such as five-year CMBS, life insurance companies with slightly higher risk tolerance and debt funds to take on a bigger role in the market. At the same time, performance improvement plans (PIPs), and COVID-deferred maintenance requirements are now coming due. The brands have a fiduciary duty to their shareholders to maintain and enforce their brand standards, and owners are running out of time and excuses to avoid implementing capital expenditures (CapEx). Owners who haven’t capitalized their PIP budgets are now rushing to find lenders that will provide the CapEx needed to finance PIPs.
CHOOSING THE RIGHT FINANCING STRATEGY
There are two courses of action for owners financing brand-mandated PIPs. One strategy is to use a three-year bridge loan with interest-only payments to buy time to implement CapEx plans, bring assets up to brand standards and renew hotel flags. Once stabilized, the interim financing can be refinanced into a fixed-rate permanent loan via a conventional loan, CMBS, or life insurance company loan.
The second PIP-financing strategy is to utilize permanent financing immediately in the form of a non-recourse, five-year fixed rate CMBS loan at a rate of 7% and 8% with interest-only payments. For these shorter term CMBS loans, properties must already be stabilized as lenders make their decisions based on the RevPAR penetration/index of the property. To qualify, a property must perform at or near 100% of the RevPAR index. It’s also important to understand that if the asset is performing at this level, it’s difficult to push a bridge loan higher than 65% loan-to-cost. Since the asset is already capturing its fair share of the market revenue, projections cannot prove there’s still room to grow the revenues.
A unique feature that can be structured for these five-year permanent loans, however, is that a small portion of the PIP can be future-funded during the life of the loan. As a result, owners can pay for some of the CapEX from the cashflow, as long as they capitalize most of the PIP budget at the outset of the loan. Lenders won’t take a flyer on a loan thinking the borrower will come up with the money for the PIP on their own in the future; it has to be calculated, budgeted, and structured for upfront at the time of loan closing. The only loan product on the market that gives a borrower flexibility to self-fund a PIP in the future is a conventional loan from a community or regional bank that’s full-recourse with an unlimited guarantee from the borrower.
Regardless of the PIP-funding strategies borrowers choose to pursue, as we enter a fed-induced economic slowdown, now more than ever before assets need to be associated with a brand to be effectively financed. Independent hotels can be financed as long as they are truly boutique in nature and have a track record.