The COVID-19 pandemic has been highly destructive to the world — and more specifically, to the hospitality industry and hotel business. According to the American Hotel & Lodging Association, hotel room revenue fell by nearly 50% across the U.S. in 2020. Room revenues for 2021 were expected to remain 34% below 2019 levels. This has resulted in the closures of many hotels as well as major layoffs across the industry.
While there are new hotels being built, many industry experts suggest that there still is a bumpy road to navigate. Of the hotels that closed or remain in economic gridlock today, many have mortgage debt in place. Often, banks are the recipients of these financial failures and receivers oversee the damaged assets.
Considering the state of the hospitality industry, there are inevitably going to be a lot of new owners of hotels. These investors will need debt. Commercial mortgage brokers and lenders need to know what to look for — and what to ask about — with these properties as the new owners request loans to renovate and refurbish.
Heart of the deal
When it comes to hotel financing, commercial mortgage brokers and lenders should realize that there are many factors to consider. One of the most important, however, is that many new hotel owners will want to become affiliated with a brand — such as Marriott or Hilton, to name two well-known franchises.
To qualify for a franchise license, newly minted hotel owners are going to need a property improvement plans (PIP). These are mandated plans that allow owners to bring their properties into compliance with a brand’s requirements. The PIP may involve updates on everything from plumbing and electrical systems to food-and-drink facilities and fitness centers.
One thing that new hotel owners and their mortgage brokers need to keep in mind is that, over the past two years, there has generally been little capital spent to keep hotels fresh and competitive. To acquire a property and have a brand, borrowers are going to have to complete repairs and update work included in the brand-mandated PIP.
One crucial aspect of a PIP is a “comfort letter,” which is a document signed by the lender and the hotel brand. This letter is a guarantee that if the borrower does not continue making payments for any reason and the property is foreclosed upon, the brand will allow the lender to continue using the brand affiliation under various contingencies — one of which is to complete the PIP.
Commercial mortgage lenders need to be sure that borrowers have the capital to complete the PIP. Because the money to complete the PIP is typically part of the loan, lenders may need to include funds to ensure the borrower is covered and can complete any needed improvements. If not, and the borrower fails, the lender may wind up in a position to have to spend the money anyway to keep the franchise in place.
As such, lenders that make hotel loans need to be in a defensive state of mind when considering these transactions. It is critical that they find out whether a PIP exists and what requirements are detailed in these documents.
When reviewing hotel loan requests that include a PIP, lenders should work with experts in the PIP sector. They must understand what is being asked of the hotel owner by the brand and whether it will suffice in making the property competitive. After all, the hotel is the lender’s collateral.
The lender needs to have the PIP priced by an expert in this field and consider their next steps, such as engaging a capital project coordination firm to put the PIP package together. And, of course, lenders need to be sure they have a comfort letter from the brand.
Sizing the loan
Usually, a PIP is only written during a change in ownership. Otherwise, ownership follows brand-mandated dates for spending capital on the hotel. The PIP can be detailed and costly. It’s the brand’s name on the building. They want the property to look great, and for the guests to feel comfortable and willing to use other hotels that brandish the same name.
It’s useful to remember that lenders consider the property they are loaning money on as collateral. And to some extent, so do hotel franchises. These companies are strict in their inspections of properties. Brands require owners to spend money at regular intervals and cycles. To pay for these renovations, hotels usually accrue money in reserves. These reserves — often amounting to about 4% of gross revenue — are used for normal capital expenditures.
The debt that is sought for the acquisition of a hotel includes the PIP as part of the cost to buy the asset. This is why it’s critical for the mortgage broker to know whether the borrower is asking for enough money to complete the PIP. If the plan is not completed, the franchise has the right to walk away.
The next year or two will be a volatile time in the hotel industry and many hospitality properties are expected to trade hands. There will be losers and there will be winners. There will be a lot of loans and, as such, a lot of PIPs. Commercial mortgage lenders need to protect themselves by seeking out third-party partners that are familiar with PIP programs so that they are covered no matter what may come. ●