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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   January 2014

Hospitality’s Hang-Ups

Check out lenders’ reservations to ensure smooth underwriting of hotel deals

In the past couple of years, the hospitality and lodging industry began to pick itself up from the doldrums of the recession and march ahead on the path to recovery. With this improvement, hotel owners, private-equity groups and various investors have accelerated efforts to refinance or acquire hotel assets, making due diligence a crucial step in lenders’ decisionmaking process. Commercial mortgage brokers should be aware of the trends that have shaped the hospitality and lodging industry’s recovery to be able to provide clients with realistic expectations regarding lenders’ due-diligence requirements.

Buoyed by strong fundamentals, a modestly growing economy and the relative lack of meaningful increases in lodging supply, hotels nationwide continue to ride the positive wave into this past fourth quarter. Here are a few significant examples that demonstrate the trend.

  • Market performance: This past September, PKF Hospitality Research expected a 5.9 percent increase in revenue per available room (RevPAR) for U.S. hotels in 2013, and further RevPAR gains of 7.2 percent in 2014 and 8.1 percent in 2015.
  • Commercial mortgage-backed securities (CMBS) originations:In the first six months of 2013, lenders originated about $12 billion worth of hotel CMBS, significantly higher than the $7.2 billion in deals completed in 2012 and the $4.6 billion originated in 2011, according to data from Trepp.
  • Transaction volume: The flow of capital into hotels has driven up transaction and dollar volume in the past 12 months. According to Jones Lang LaSalle Hospitality, U.S. hotel transaction mid-year volume for 2013 reached $8 billion, a 50 percent increase compared to the same period in 2012. Jones Lang LaSalle’s Hospitality Group expected that by year-end 2013, U.S. hotel transaction volume would reach $17.5 billion, a 10 percent increase over 2012 levels.
  • Low interest rates: A high percentage of the new deals has been on the refinancing side, as hotel investors have rushed to take advantage of historically low interest rates. The consensus in the industry is that even with the recent hiccup over the summer, rates are much lower than hotel investors could secure five years ago. This sentiment has resulted in an increase of refinancing deals.
  • Decline in delinquencies: CMBS delinquencies are continuing to follow a downward trend. Data from Fitch Ratings show that the hotel sector has been the best performer in terms of resolving loans. The delinquency rate in the sector has fallen from 21.3 percent in September 2010 to 8.04 percent this past July.
  • Lender flexibility: As they seek to increase their positions in the lodging sector, lenders are becoming more accepting of various lodging property types in secondary and tertiary markets.

Guarded optimism

With all this good news, is there a reason for caution? The answer is a resounding “yes.” The increasingly common refrain from hotel investors and lenders is one of proper due diligence. On the acquisition side, although hotel investors are seeing more potential deals, they are taking more time to complete the necessary due diligence. This is also true with lenders, as they are demanding higher standards of due diligence from their prospective borrowers and third-party diligence providers.

Key considerations among lenders include sponsorship experience, branding, market conditions, management, property condition, historical and anticipated property performance, and cash flow. Some additional points support the need for due diligence, as well, including:

  • Standards: After a hiatus in the lean years, lodging brands are pushing aggressive brand-standard upgrades and property-improvement plans (PIPs), which can be costly and impact how loans are financed.
  • Occupancy: Occupancy levels across most markets have exceeded previous peaks, and many markets now are considered stabilized. Overall RevPAR growth is being driven largely by average-daily-rate increases.
  • Development: As of this past September, the total active U.S. hotel development pipeline comprised 2,767 projects totaling 333,775 rooms. This represents a year-over-year increase of 15.6 percent in the number of rooms in the total active pipeline and a 29.5 percent increase in rooms under construction.
  • Growth drivers: The corporate and transient leisure segments have been the primary drivers of growth in the lodging sector’s recent resurgence. The group segment continues to lag, but indications point to the segment seeing more growth in 2014.
  • Lending trends: Lenders increasingly are structuring loans with interest-only components. Interest rates, although still low, are creeping up. Many significant CMBS loans for hotel and other real estate asset classes are set to mature by 2015, likely resulting in a flurry of refinancings and increased competition for available funds.
  • Uncertainty: It is likely that debacles similar to the recent government-shutdown will happen in the coming months, adding to broader market uncertainty. Markets with a traditional dependence on federal government demand already are feeling the impact of government travel cutbacks.

Checking in

When working on all underwriting due-diligence assignments, commercial mortgage brokers should ensure that there is close cooperation between the lender and borrower. This will enable a better understanding of the asset and the nuances of the transaction, and it ultimately will help ascertain potential risks that could impact the viability of the loan materially when reviewed by rating agencies for securitization and prospective B-piece buyers.

Lenders’ due diligence typically encompasses a detailed analysis of historical operating statements, a review of franchise and management agreements, a review of all third-party reports, reconciliation and understanding of taxes and insurance expenses, a review of historical and budgeted capital expenditures, and an assessment of planned PIPs.

In addition, expect lenders to have conversations with local market participants including appraisers and competitive property managers — and commercial mortgage brokers — to gain an understanding of local market dynamics. Lenders may conduct a site inspection and meet with property representatives to gain a firsthand understanding of the property, its position in the marketplace, major demand generators, seasonality, supply additions and other key pieces of information.

• • •

With lenders’ due-diligence requirements in mind, commercial mortgage brokers can prepare clients with the right documents and approach to respond to requests, and avoid common problems along the way. Brokers also will be able to capitalize on the recovery of the hospitality and lodging industry by guiding clients all the way to successful closings.  


 


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