While a potential economic slowdown will have impact throughout the hotel industry, one of the areas poised to see the biggest challenge is the hotel lending market, according to several experts.
“While the signs [of an economic slowdown] point to a soft landing, if the economy goes into recession, it will put downward pressure on hotel performance,” said Michael Sonnabend, managing member and co-founder of PMZ Realty Capital. “The second significant risk is the expiration of interest rate protection on deals closed in 2021 and 2022. This may cause significant expense due to the continued rise in short-term rates during the past 18 months.”
Coverage Challenges
The number one challenge is that the benchmark rates have risen so quickly and cashflow from the hotels has not, said Loren Balsam, chief investment officer at Hotel Asset Value Enhancement (hotelAve). Many hotels right now are challenged with coverage. “A lot of the private hotel lending market is a floating-rate market. When the benchmark rates accelerated as quickly as they did, a lot of people were protected for some period because they bought interest-rate caps. They had one or two or three years of protection as those caps burn off. The cost to replace those caps has gone up tremendously,” Balsam said. “It's really, really expensive to hedge the benchmark rate now.”
Balsam also said the credit-market spreads have blown out because several lenders have pulled out of the market. “I think of the spreads like a pendulum—when lenders come into the market, the spreads come in,” he continued. “When supply of lenders pulls back out and fewer lenders are quoting, the spreads widen. The unusual thing is that the benchmark rates have accelerated quickly and the spreads have also widened. It's like the markets got hammered twice on the rates side.”
Jared Schlosser, SVP and head of hotel originations and CPACE at Peachtree Group Credit, noted a lack of liquidity compared to prior years. “There are 32 percent fewer lenders in the market today than there were 12 months ago. I think for borrowers overall, there are just fewer lenders that are out there willing to lend. When you micro that down to the hotels [market] specifically, it depends what you're trying to get.”
Schlosser said there are fewer people able and willing to do a construction loan today and often there's a lot fewer banks willing to lend on hotels. That creates an opportunity for private capital to come in and make hotel loans. “We have been extremely active this year,” he said, “and have taken a good chunk of that market share of people that have maturities that need to transact, people that are actually acquiring assets that have to transact, and people who want to build hotels.”
The overarching challenge is the dialing back of capital availability to the hotel sector and additional real estate sectors by banks and other institutional lenders, said Don Braun, president of Hall Structured Finance. “Deals are simply harder to pencil with the increase in interest rates and other costs. Borrowers seeking to refinance existing assets need to prepare to bring in additional equity to execute.”
Not everyone is as concerned about the lending market for hospitality today—in fact, some have said there is a “relatively strong lending market for hospitality right now.”
“Frankly, [the hospitality lending market] is much stronger today than it was 12 months ago—that might come as a surprise, but there's several reasons for that,” said Kevin Davis, Americas CEO of JLL Hotels & Hospitality. “First is that operating fundamentals in hospitality have continued to be strong and have strengthened over the course of the past year and, as a result, lenders are responding by lending in the space.
“If you look at some of the other asset classes like multifamily and industrial, they were on a tear [in 2021 and 2022], so there's a significant amount of debt capital that was being allocated to those sectors,” Davis said. “But those are highly rate-sensitive sectors. When the Fed started their tightening campaign in March of 2023, those sectors were adversely impacted. It's adversely impacted the capital markets as it relates to hospitality and values, but at the end of the day, we have the ability to reset rates every night. We could respond in an inflationary environment by increasing our ADRs as a result, our NOIs have held in pretty strong. You're seeing lenders being attracted to the space. A lot of the capital has migrated from other asset classes into hospitality.”
Market Risks
Coming out of the COVID pandemic there was a fair amount of pro forma underwriting—effectively underwriting a ramp-up scenario for hotels, Davis said. “Historically, lenders like to lend against existing operating performance, but because most hotels’ performance was significantly negatively impacted during COVID,” he said. “If you want it to be a lender in hospitality in 2021, 2022 and early 2023, you had to lend against income that wasn't there. In a lot of cases, the income came as a sector ramped up, but in some cases, assets didn't ramp up as expected. The challenge with some assets where the loan was made based on pro forma underwriting, the cashflow never reached the level in the business plan and the cost of debt has also gone up by 500+ basis points over the past 20 months.”
As a result, there are situations where the asset is unable to support the debt service because it hasn't ramped up in accordance with the business plan, Davis explained.
Another risk in the lending market right now is those deferred PIPs, Schlosser said. “Hotel owners have survived COVID but deferred their PIPs, and they've put a lot of capital into these deals to survive until now,” he said. “Instead of putting that capital into the actual asset, they've put that capital into carrying it for two or three years.
“The industry will have a lot of borrowers who simply don't have any money left and they're going to throw the keys at the lender. If your borrower wasn't well-capitalized to get through COVID, they've been carrying an asset for a lot of years and will have a big PIP that's due. It is going to be pretty difficult for them to be able to do it. Either it has value and they will sell it, or they are going to give the keys back to the lender.”
In terms of new originations, the risk is simply that interest rates are higher, Schlosser continued. “If you've got a nine to 13 percent debt and you're only able to size to a 10 percent debt yield, then you got a loan that's never going to be cashflow positive,” he said.
Sonnabend said the industry economic risks will be mitigated the old-fashioned way—"making sure that we are putting loans on strongly positioned assets owned by borrowers who can weather the short-term risks that may occur,” he said. “The most important thing for the users of capital to understand is that they need to have realistic expectations. Unfortunately, interest rates and underwriting requirements are not the same in the 2020s as they were in the 2010s.”
In many respects, Braun expects the 2024 hotel debt market to play out much like 2023. “The pulling back by banks and other institutional lenders will be more pronounced than it has been building throughout this year, creating a larger need and opportunity for private lenders and other alternative financing sources to fill the void,” he continued.
Braun expects private lenders to play a more critical role in filling the capital void created by the pullback by banks and other institutional sources. “There is a real opportunity to provide hotel construction financing in 2024, as we believe this is an attractive time for developers to look at the prospect of delivering a new hotel in two to three years when it is likely we will see a dramatic reduction in new supply coming online, and at a time we may very well be in a somewhat of a lower interest rate environment,” he said. “We also see continued opportunity to partner with C-PACE lenders in selective instances to provide combined loans that can be highly cost efficient compared to a single source loan alternative.”
Tips for Finance Seekers
The debt markets are absolutely open for business, Davis said. There's strong liquidity. “I'd say the pricing is approximately 5 percent higher than it was 20 months ago, so borrowers may not like the pricing but there absolutely is liquidity for hotel debt,” he continued.
There's selective liquidity for ground up construction—it is among the harder asset types to finance right now, Davis said. Generally, a borrower needs to have a substantial amount of experience in development. They need to have a strong balance sheet, and they need to look for fairly moderate leverage to get a construction deal done.
In terms of PIPs, given the fact that many assets have been underinvested over the past several years, there's a real need and the brands are certainly demanding that owners invest in PIPs, Davis said. “As a general matter, it's not a PIP-specific loan. It just gets rolled into a loan against the property,” he continued. “We've certainly seen borrowers able to take out money in excess of their existing debt to cover the cost of a PIP. The underwriting on that will be a function of the loan relative to the value of the asset, post-renovation, and also what the current in place cashflow is on the loan and what the pro forma cash flow will be post-renovation.”
Schlosser’s biggest tip for hoteliers is to get ahead of maturities and PIPs due. “I can't tell you how many times we have people who wait until the last minute with a hard maturity,” he said. “In this environment, you don't know what your lender is going to do if they have a matured loan. I get that people want to see if interest rates are going to be lower. But even the cost of refinancing 18 months from now might be a better solution than getting into a jam.”
Hall Structured Finance is looking for hotel developer partners who have demonstrated the grit and determination to stick with a property, Braun said. In addition, the ability to secure and bring in fresh capital will be essential to securing new financing in the current market.
Most owners understand that the financial markets are very challenging right now, Balsam said. “They know that they have a debt maturity in the next 12, 24 and 36 months, they're up against very challenging refinancing. I think those owners are spending a lot of time with their operators and leaning in on operating margins, trying to tighten the belt on expenses so they can maintain margins,” he continued.
“While 2023 was a pretty good year for revPAR growth, I don’t know if we’ll have as robust of growth in 2024,” Balsam said. “I think we’re hoping that will happen, but in order that to happen, owners will need to control their costs. I think there will be a laser focus on operating costs, labor efficiency, all to help improve the health of the property."