It might be the sixth inning or it might be the ninth. We know for sure that it’s not early in the game anymore. The hospitality capital markets have been incredibly strong since 2011. With low rates, strong leverage, aggressive underwriting and heavy volume, we’ve seen highly favorable market conditions for a long time. The questions are: why will the market turn down, when will it shift, and what should be done in the meantime?
1. Why will the market turn?
All credit cycles are, of course, cycles. Given that, and given current hospitality industry dynamics, we can infer where we are in the cycle by looking backward. Early in the cycle, lenders were extremely cautious. The financial crash of 2008 required this. By 2013, the market was so strong that every deal was based on [trailing 12-month] underwriting, almost nothing was being kicked from [commercial mortgage backed securities] pools, and essentially all deals were financeable. By 2015, lenders started dialing back the underwriting (smartly so), yet deals were still highly financeable despite bumps here and there. Now in 2017, underwriting remains similar to where it was 2015, despite hotel operating performance having improved.
2. When will it shift?
It’s clear that a credit cycle is playing out in textbook fashion, and although we could carry the current environment forward for a long time, I think it will turn within the next couple of years.
The biggest micro-threat to the hotel industry is Airbnb. The homesharing service looms over our heads, but it’s still an underappreciated threat. Other hotel market threats include increased supply, high construction and [property improvement plan] costs and expensive valuations. But besides those worries, we have more traditional macro-threats, such as stubbornly low rates set to scream higher for a few reasons, including Federal Reserve tightening, a bond market bubble that will pop and $4.5 trillion of assets set to be sold by the Fed. The economy has been growing steadily since 2009, and expansions don’t last forever. The writing is written on the wall from a micro and macro standpoint.
A more nuanced observation shows that borrowers have become accustomed to steady rates, aggressive underwriting, and improving hotel performance, and in turn, have shifted a significant amount of borrowing away from low-risk, long-term nonrecourse loans. That positive market trends have rung true for a long time does not indicate that they will continue in perpetuity. This shift in psychology and the associated change in borrower behavior presage a negative evolution in the market. When long-term nonrecourse loans are being taken for granted, we have a problem, and that’s happening.
As a hospitality investment bank, this change in borrower sentiment is concerning. The hotel industry faces its biggest set of risks in 20 years, yet many borrowers are happy with five-year recourse bank loans because their rates are low and their structures are simple.
While I understand the reason for the sentiment (given how well the market has performed over the past eight years), it’s also a predictive indicator of what’s to come. Financial markets throughout history tend to shift when participants become complacent and underestimate risk. Borrowers should not assume rates will stay low and trends will remain positive.
3. What can I do?
If you’re a borrower, be aware and borrow long maturity nonrecourse debt before the credit cycle turns the corner. You don’t want to be stuck with a maturing recourse bank loan five years from now when rates are higher. Many borrowers dislike the rigidity and the closing process associated with CMBS loans, but they’ll sleep better with nonrecourse debt. Borrowers should lever-up if their loans are nonrecourse. Otherwise, borrowers should focus on low-leverage financing in order to avoid problems down the road.
Fortunately, the market for nonrecourse debt is strong. Competition among a recently narrowed field of lenders is fierce. Rates are still historically low, though the threat of rising rates is real. Available leverage is high. The bond market is functioning smoothly, driving the strength in the CMBS customer-facing market, as bond investors and B-Buyers have come to recognize the strength of CMBS credit.
Lenders have been smart in this credit cycle and are taking the right actions to mitigate risk as the next cycle looms. Reserve structures are well funded and underwriting is not over-extended. Conduit lenders must recognize, however, the need to ease up on overbearing requirements in loan documents, which is a turn-off to prudent borrowers.
The market is likely to turn, but that doesn’t mean we should expect a disaster like we had in 2008. Given the relatively reasonable borrower and lender behavior during this cycle, it could be a healthy cycle through and through. Whether it is or it isn’t, both borrowers and lenders will benefit from understanding where we are in the cycle and preparing for the next one.
Zak Selbert leads overall strategic initiatives at Vista Capital Company. He has engineered, negotiated, and closed approximately $3 billion of real estate transactions on behalf of clients.