Getting a hotel deal to the closing table a challenge

Looking to purchase a hotel in today's market is certainly a challenge. Getty Images

Looking to purchase a hotel in today's market is certainly a challenge. On the one hand, asking prices for property are relatively high simply because low interest rates and the glut of cash chasing income streams do that to asset values of everything. On the other hand, the twin impacts of tightening lender underwriting and increasing franchiser property modernization demands unquestionably impact sales price valuations. 

Getting to a balance of meeting everyone's needs is, naturally, what produces the end result of a successful deal. That goal is probably getting a tad more difficult to accomplish these days. Why?

1. Lender underwriting for mortgage debt is seeing stress-testing valuations at interest rates that are often 25-percent+ higher than today's levels. This, combined with more conservative trending debt-service-coverage ratios generally produce loan offers in the 60-percent loan-to-value range. That means buyers must come to the table with heavy doses of equity in order to secure a loan, though offering the lender a modestly higher interest rate, and/or qualifying for a commercial-mortgage-backed securities loan, can get you closer to the 70-percent LTV range.

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2. Franchisers are (wisely) requiring that their systems' individual properties meet today's, and often tomorrow's, customer product expectations. What that translates into are property improvement plans from the more valued brands that often require significant doses of capital expenditure investment. This means that to maintain, let alone increase, current hotel profit levels requires lots of additional capital expenditure. And, that reality adversely impacts the existing hotel building's value.

3. Today's capital gains tax levels impose a relatively heavy selling cost on the seller. This usually translates into a higher gross asking price in order to result in an acceptable net after-tax result. That often results in over-pricing the asset being sold, reducing its salability.

4. Sellers tend to richly value their current net income streams, that not being unique to today's market.

5. The cost of canceling one brand franchise contract to go to another from a different company can often be quite expensive.

The result of the interplay of these forces is that the more tradable hotels today are ones that 

(a) are well located and better branded, or brandable, midrise properties with dependable current earnings and moderate CapEx upgrading requirements, 

(b) are in modern buildings, with secondary but upcoming brands, that are available at a significant discount to replacement value, 

(c) qualify for Small Business Administration financing (since a borrower can often get higher LTV debt and secondary financing is usually permitted.)

(d) are owned by sellers who are either retiring or repositioning their portfolios.

One purely tax-related factor impacting property values to the upside is the amount of equity capital available in the market by reason of buyers seeking to reinvest funds generated by their having sold a property and seeking a tax-free exchange. The IRS tax code permits a property seller to defer an otherwise payable capital gains tax by reinvesting the proceeds from the sale of one property into another like-kind for property, not property for, say, stocks or bonds. 

So, for many hoteliers that intend to remain active in the lodging industry, there is a natural tendency to use the generated cash from the sale of one hotel in order to buy another. The tax benefits of doing a tax-free exchange are significant and the equity generated by the sale of property A provides sufficient equity to buy property B, even with a very conservative new mortgage loan level. Tax-free exchanging provides an important source of liquidity to the real estate market but almost assuredly distorts property valuations to the upside and to the benefit of the seller.

Taking all the variables discussed above into consideration, is it any wonder that it's so challenging getting a hotel deal to the closing table?