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Hotel market factors shifting - loan tightening just the most recent
Occasionally the capital markets change so quickly that printed news is already dated when it hits the mailbox. Such was case with a related article I'd written for this month's edition of Commercial Mortgage Insight.
During July alone we witnessed pricing on hotel conduit loans increase by .50%. The first two weeks of August saw spreads widen further, and several conduit lenders stopped quoting on hotel loans altogether. Both the recent capital markets and cost of debt are changing faster than magazine print cycles.
Still, hotel deals are getting done and the capital markets should calm over the next few months. Despite signs of change in the hospitality industry, the sector's current strength should continue for another couple of years - and even then, the run is not expected to end as abruptly as past expansions have.
Absent a jarring shock such as a terrorism event or similar unpredictable catastrophes, I suspect there are still good times to be had in the hospitality industry. In fact, the shrewdest hotel operators will likely keep succeeding well past the time when nontraditional hotel investors have been forced to exit the industry.
The easy money has been made already in the hotel sector. Rising valuations make it difficult to find acquisitions that spin heady yields. Turnaround properties with a story can be mined for gold, but this is an arena for practiced developers.
After rising steadily for five years, average daily rate (ADR) growth rate started a predictable decline late last year. Similarly, occupancy growth began trending down in 2005 and is expected to fall in absolute terms this year.
This industry report is not dire. Moreover, the hotel industry has never been more resilient. Signs are evident we're simply moving toward more normal markets and entering that time in the hotel business cycle when experience and prior planning distinguish the winners from the losers.
The realities of the next phase will test the soundness of past decisions -such as choice of franchise and segment, market, capital improvements, lender, type of financing and equity partners - but going forward, decisions may be even harder.
To understand the current hospitality lending environment, we need to first understand today's challenges associated with owning and running a hotel.
Rising Cost of Debt
Not only are lenders less willing today to lower spreads just to win deals, but also the easy days of extended interest-only periods, phased-in furniture, fixture and equipment escrows, 80% loan-to-value, rate lock at application, and other exceptions are generally over for the time being. Exceptions are still possible, but skilled loan presentation and negotiation are more important than ever.
Overall, the changed underwriting climate over the past two months is palpable: Underwriters are questioning more, document requests are up, deals are taking longer to get done, and negotiating every item is more difficult. In just a few short months we've gone from a borrower's market to one where lenders have regained their traditional leverage.
As recently as three months ago, we were securing spreads on top-notch limited-service hotels in the mid-to-high 90s basis point range. Fast-forward to today, and the same deal is priced nearly twice as high (e.g. 200 basis points). The question is how long the current tightening will last. What appears certain is that we will not return to 90-130 basis point spreads on hotel loans for the remainder of this year.
Costly Guest/Franchisor Demands
Hotel guests continue to demand better (and free) services such as wired and wireless Internet access, hot and bagged breakfast options, up-to-date business and fitness centers, and 24- hour lobby coffee service, to name a few.
These services merely meet customer expectations these days, and only luxury hotels appear able to charge for them. Still, in order to justify steadily increasing ADR, owners need to continually bolster service levels and amenity offerings.
Similarly, guests demand product improvements that quickly become expectations for which they are unwilling to pay a premium. Franchisors such as Hilton, Marriott, Starwood, Intercontinental, Wyndham and Choice respond by ratcheting up standards in efforts to win the coveted business traveler: cozier beds, flat-screen TVs, upgraded linens and duvet covers, ergonomic desk chairs and tasty new breakfast options housed in a constantly redesigned breakfast nook.
These expensive upgrades are increasingly frequent now that franchisors have largely sold off company-owned properties and no longer directly feel the economic pain of their own brand requirements.
Franchisors are bent on differentiating their brands based on quality and consistency. Property owners out of sync with required improvements are being cast out of the network in greater numbers. Re-flagging a bumped hotel with a lesser brand can be disastrous to ADR and occupancy.
Increasing Energy and Tax Costs
Hefty year-over-year increases are, at minimum, a near-term reality, as energy costs are largely uncontrollable. Whether the push for a green hotel promises future savings is yet to be seen.
Real estate taxes are also on the rise as local governments catch up with reassessments based on prior or acquisition- year valuation.
The recent frenzied transaction environment, improved business conditions and significant property renovations since mid-2003 have resulted in real comparative data that municipalities are using to rationalize significant assessed value increases. Shrewd hoteliers will work to control increases through the appeals process.
New Room Supply
Yet according to Smith Travel Research Research, supply is expected to grow by only 1.4% this year (versus long-term average growth of 2.2% per year) with nearly 120,000 rooms under construction as of April of this year.
Lodging Econometrics, however, states that the total construction pipeline - which includes projects in the planning phase - now sits at 4,281 projects and a total of 568,318 guest rooms at the end of the first quarter of 2007. That figure puts the hotel development pipeline about 15% higher than the peak reached in 1999.
Steadily increasing construction costs are holding back unbridled development for now. And according to Smith Travel, the average length of time it takes to open doors on a new hotel development has increased from 12 to 19 months over the past six years. New supply will predictably degrade existing hotel profitability, but mitigating factors appear to be dampening any sudden impact.
A More Resilient Industry
A return to more normal markets is probably a good thing. The hotel industry party is not over, just a bit more tame.
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