United States hotels have been doing well. Occupancy levels have been shattering records and revenues remain strong. Given the solid fundamentals and favorable outlook for the hospitality sector, real estate investors want hotels in their portfolios. Commercial mortgage brokers can expect to see strong demand for loans to purchase and refinance hotels.
Hotels have some unique features, however, that you will need to consider. The varying types of hotels have different risk profiles and their locations also can be difference makers. These factors can affect your client’s financing options.
Given the growth in both leisure and business travel, hotels have become a highly sought-after asset class for investors. Occupancy levels and revenues were expected to grow in 2019 for the 10th consecutive year, according to reports from Marcus & Millichap and CBRE Hotels. Marcus & Millichap forecast that the national occupancy rate would hit a new record level of 66.2% this year, while CBRE Hotels predicted that occupancy levels through 2023 would remain at least two percentage points higher than the long-term average of 62.5%.
Before investing in a hospitality project, however, savvy investors must weigh three key factors: the type of hotel, the location of the asset and the financing, whether it be from a bank or a private lender. These considerations can help mitigate risks and maximize rewards.
Hotels types
Hotels are classified by the type of services and range of amenities they offer, and the main types are full service, select service and limited service. The experienced investor will research each hotel category to determine which best suits their needs.
Limited-service hotels, such as a Comfort Inn or SpringHill Suites, typically have the lowest operating costs due to their no-frills approach. Their modestly priced rooms appeal to travelers looking for a budget-friendly option. Amenities usually consist of a self-service laundry facility, swimming pool, a small gym and a conference room. Limited-service hotels remain popular with investors due to steady economic growth and growing performance metrics. These hotels tend to perform better in a down market, with modest upside in a rising market. In 2018, this hotel type had an annual increase of 3.3% for revenue per available room, according to Marcus & Millichap.
Select-service properties also have proven to be both efficient and profitable for investors. These hotels usually don’t have on-site restaurant and lounge options like full-service hotels, but they provide guests with similar in-room amenities at lower room rates. STR, which tracks global hotel supply and development, reported that these hotels accounted for 63% of the U.S. new-construction pipeline in 2018. Select-service hotels tend to be easier to finance than full-service hotels. Fewer luxury amenities and departments equate to fewer expenses. Popular brands include Courtyard by Marriott, Hilton Garden Inn, Hyatt Place and Clarion by Choice Hotels.
Full-service hotels, such as Four Seasons or The Ritz-Carlton, offer guests a wide assortment of services and amenities — including restaurants, spa services, elaborate banquet rooms and extended room service. As a result, full-service hotels have high operating costs and command higher-than-average room rates. More expensive rooms can result in better performance during a strong economy but weaker performance during a recession. Demand for luxury hotels has surged in key tourism markets, with occupancy rates averaging 74.6% for most of 2018, CBRE Hotels reported this past December.
Location matters
The strength of a hotel’s location directly impacts its occupancy rates, which in turn affects cash flow, sales prices and, ultimately, return on investment and financing options. Projects should be in highly trafficked areas with good visibility, easy access from main roads and highways, ample parking, and be close to retail and restaurant options.
Several cities have seen a boom in new-hotel developments. Take Philadelphia, for example. The city is projected to add nearly 2,700 new hotel rooms by the end of 2020, The Philadelphia Inquirer reported this past March. Similar urban markets such as San Diego, Orlando and New York City attract millions of visitors per year. These areas have burgeoning economies, providing commercial real estate investors with numerous investment and development opportunities. Hotel investors also have shown interest in emerging markets in the fast-growing Sun Belt region, which stretches across the southern portions of the country. Growing populations and healthy employment markets in these cities attract job seekers and employers from other areas.
In growing cities like Phoenix, Dallas and Austin, for instance, investors have embarked on hotel projects in opportunity zones, which are newly created zones intended to spur development in specific neighborhoods. Established by Congress in the Tax Cuts and Jobs Act of 2017, opportunity zones are designed to stimulate low-income and underdeveloped communities. Investors who participate in opportunity-zone projects are eligible for numerous tax benefits.
With the demand for hotels continuing to rise, this is an ideal time for investors to enter the market, which will translate into more financing opportunities.
Financing options
Mortgage brokers and investors financing hotel deals have to decide whether to borrow from a bank or a private lender. Banks are the more traditional route because they provide lower interest rates, but they have strict loan requirements and typically do not lend to small startup companies, individuals with poor credit histories or those with high debt-to-income ratios. Bank underwriters tend to focus heavily on the strength of the borrower’s finances and the ability to repay a loan in full. If any financial criteria are not met, the proposal will likely be rejected or the requested loan amount reduced, due to a bank’s unwillingness to take on higher risk.
Compared to banks, private lenders have proven to have greater flexibility with lending strategies. These lenders are more willing to overlook credit blemishes. Private lenders can usually accommodate atypical situations, offering borrowers greater flexibility. Unlike the one-size-fits-all approach set forth by banks, private lenders have the ability to structure repayment and collateral-release terms in ways that are mutually beneficial for both parties. Additionally, private lenders tend to offer borrowers a more streamlined process and often request less paperwork. Borrowers are put in direct contact with key decisionmakers who can expedite the loan closing. Overall, private lenders are more efficient and personalized, and allow borrowers to quickly obtain the necessary funding and begin working to achieve substantial returns on their properties.
Private lenders are asset-driven, meaning they are more open to granting nonrecourse loans in which borrowers use the underlying property as the sole collateral for the loan, as opposed to a full-recourse bank loan in which personal assets are included. Banks traditionally limit nonrecourse financing to 55% of the property’s value. Private lenders, on the other hand, may finance up to 75%. This flexibility is attractive for borrowers who are purchasing short-term investment properties.
Despite the hospitality sector’s strong outlook, traditional hotels carry risks for both investors and lenders. Consumer preferences change. Millennials, in particular, have grown accustomed to personalized experiences and service. As a result, hoteliers have had to develop new ways to attract and engage with customers, such as providing greater conveniences or special experiences that satisfy the need for “Instagrammable” moments. Hotel chains that can easily adapt will prevail.
Additionally, the hospitality industry has seen a spike in alternative lodging sites, such as Airbnb and Vrbo, which are platforms that allow homeowners or apartment owners to rent out space for overnight travelers. Owning about 20% of the U.S. consumer lodging market, Airbnb is continuing to compete for hotel customers and has become more mainstream in the hospitality sector. Although these alternatives have made a relatively small impact on overall demand for traditional hotels, Airbnb-like concepts will only continue to expand in the coming years.
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With the demand for hotels continuing to rise, this is an ideal time for investors to enter the market, which will translate into more financing opportunities. By carefully considering the type of hotel, its location and whether to borrow from a bank or private lender, you can help your clients reap the benefits of one of the most prominent commercial real estate asset classes.
