Seen on ehotelier.com, August 31, 2007
By Cameron J. Larkin, First American Realty Associates
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.
Expansion's aftermath
Those who have lived through a full hotel cycle will recognize the
predictable outcomes during the mature phase of an expansion:
- Costs continue
to trend up as hoteliers face pressure on multiple fronts: energy, real
estate tax, labor, franchisor/brand standard enhancement and
construction costs.
- ADR and
occupancy growth appear to be easing with a lack of broader expansion
in the economy and growing supply of new rooms entering many markets.
- Spreads,
while still historically low, have edged up 60 to 100 basis points
after the April bombshell reports by the largest rating agencies
(Moody's, S&P and Fitch) put conduit lenders on notice that loose
underwriting standards would no longer be accepted.
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
While the residential and commercial debt markets are distinctly
separate, the bursting residential subprime bubble appears to have
spilled over into the commercial mortgage-backed security (CMBS)
market. Consequently, both the rating agencies and commercial bond
investors have begun demanding increased underwriting discipline.
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
Some of the most prominent challenges (and opportunities) are increasing guest demands and franchisor requirements.
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
Energy costs have risen dramatically over recent years. Double-digit
increases in utility costs represent the largest increase in a hotel's
profit and loss statement. A limited-service hotel with energy costs of
3.50% of gross revenue just three years ago could easily see 5.50% on
that line item today.
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
Furthermore, supply growth, the eventual death knell of all hotel
industry recoveries, is back in a big way. New hotel product is coming
online at a brisk pace after several years where room demand
significantly outpaced supply. Stick-built limited service and extended
stay hotels can be constructed very quickly, changing the dynamics of a
currently healthy market in short order.
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
Nevertheless, I'm very optimistic that we will see an elongated
stabilization period in the hotel industry through 2009. Numerous
factors buoy my optimism:
- Debt is historically inexpensive and available.
- Hotels
are increasingly viewed as a safer investment, due in part to abundant
data provided by the likes of Smith Travel Research, PKF, HVS
International and Lodging Econometrics - data not available a decade
ago.
- Investors can readily access these data to understand comparable hotel and market performance.
- Franchisors
employ increasingly sophisticated brand management to enhance guest
experience consistency, induce additional demand, vet new franchisees
and cull properties that no longer fit brand standards.
- Construction costs and lender lessons learned from past expansions both conspire to keep new hotel supply in check.
- Hotels
are increasingly managed by a professional class of owners who
understand that this is a management-intensive business with only
24-hour leases.
A return to more normal markets is probably a good thing. The hotel industry party is not over, just a bit more tame.
About the Author
Cameron
J. Larkin is Senior Vice President of Hospitality Financing &
Business Development at First American Realty. He has 15 years
experience in the financial services and management consulting
industries. Prior to First American Realty Larkin spent ten years
working across six of GE Capital's finance businesses in the US and
Europe. Prior to GE Capital he was a Senior Consultant with Andersen
Consulting (now Accenture) for 3 years.
A native Vermonter now
living in Dallas, Larkin earned his MBA from Columbia University and a
B.S. in Business Administration from the University of Vermont.
Email: cameron@firstamrealty.com
