While the winning streak of hotel performance is expected to plateau within the next year, hotel financing availability is expected to endure, but shift.
“I expect that the lending landscape will evolve a fair amount over the course of 2017,” said Kevin Davis, managing director at Jones Lang LaSalle.
He pointed to treasury yields that are at their highest levels since last December, driven by rising inflation expectations and the market’s expectation that the Federal Reserve will raise interest rates this month.
Watching interest rates is a primary concern, said Peter Nichols, first VP and national director, national hospitality group, Marcus & Millichap.
“We need to focus on the spread between the long-term average on the 10-year treasury note and the long-term average cap rate on transactions,” he said. “Until that gap starts to narrow, there is still opportunity in the marketplace. I’m more optimistic about the length of the recovery, that we’re not at the end of cycle, but you have to be very disciplined in where you’re looking.”
Cap rates have been increasing in the hotel sector during the past year, according to Real Capital Analytics. Full-service hotel cap rates were at an average 8 percent in October, up 40 basis points year over year. In the limited-service segment, cap rates were up 20 bps, year over year, at 8.8 percent.
The average spread for cap rates between the limited-service and full-service hotel segments is around 100 basis points. The spread narrowed to 70 bps early in 2016, but as cap rates have increased, the relative pricing is moving closer to long-run trends, according to Real Capital Analytics.
“For the foreseeable future, investors are likely to focus on the potential impact of higher interest rates, lower corporate taxes, a stronger U.S. dollar and visa restrictions,” said Daniel Lesser, president and CEO, LW Hospitality Advisors.
CMBS Loses its Luster
Given the high level of commercial mortgage-backed securities coming due in the next 18 months and increased regulations, there should be more interest in alternative forms of financing, according to the hotel advisors.
This is because the originators have potential exposure under the risk-retention rules, which might make it difficult for some smaller origination firms to remain active in CMBS, according to Davis. “If there is a smaller pool of lenders offering CMBS loans, lenders would likely have more pricing power.”
Additionally, CMBS securitizations after Dodd-Frank are in the early days, so pricing based on “skin in the game” requirements are still unclear, he said.
The Dodd-Frank Wall Street Reform and Consumer Protection Act’s risk retention rules deadline is just around the corner. By Dec. 24, CMBS sponsors must comply with this new skin in the game regulation.
“There have been several securitizations done that were floated as ‘trial balloons’ to see how regulators would respond and how bond markets would react,” Davis said. “They priced exceptionally well because the collateral has been very good. Now, as you get into a run-of-the-mill conduit deal with medium- and lower-quality collateral, it’s hard to say how the market will respond to those.”
Nichols pointed to several alternative-funding options, such as real estate investment trusts, investment funds and pension funds.
“The CMBS debt will get done by smaller local and regional banks,” he said. “Borrowers are going back to their relationships with their local lenders.”
Lesser said REITs have made headway: “S&P Dow Jones Indices and MSCI moved stock-exchange listed equity REITs and other listed real-estate companies from the financials sector into a new 11th headline, real estate sector, within the Global Industry Classification Standard. This move marks a major step in the growth and recognition of REIT-based real estate investment, which obviously includes hotels, as a fundamental part of portfolio allocation.”
Development Squeeze
Checked supply growth throughout the recovery means that lending is disciplined, but available for the right markets in 2017, according to hotel insiders.
“Overall, the pace of development is still very measured in terms of new construction, but what we are seeing is a slowdown in availability of funding for new projects,” Nichols said. “Lenders are being much more disciplined. They have lived through previous cycles.”
The rules on high volatility commercial real estate loans are significant to development lending, Davis said.
“Any loan that meets the definition will be assigned a higher risk weighting, which means that the bank will have to hold more capital against HVCRE loans compared to other loans,” he said.
A major requirement to avoid being characterized as an HVCRE loan is that the borrower must have invested 15 percent cash or land of the “as completed” value of the real estate, Davis said. So more capital is required in either situation.
Meet the New Boss
While the hotel lending experts had differing opinions on the biggest concern for the next 12 months, they all agreed that a pro-business president-elect is good for the economy.
“Regardless of whether one agrees or not with the path the country may now be headed, the prospect that we now have the beginnings of a direction, one that at the moment implies lower taxes, fiscal stimulus and reduced regulation, seems to be what investors are now focused on, or at least hoping for,” Lesser said.
Nichols shared a similar sentiment.
“If you look at the current cycle, we still have record-low interest rates, availability of capital, we’re not overbuilding, there is strong business demand and positive [gross domestic product] growth,” he said. “The expectation is that [Trump] is pro-business and has said GDP growth will be up, or his agenda is towards that. There is not a lot of headwind coming at us. It’s more like a light breeze.”