FEATURE ARTICLE, DECEMBER 2005

HOTEL SECTOR ACCOMMODATES PLETHORA OF CAPITAL
The hospitality industry in the West welcomes investors en masse but does rush leave room for error?
James Merkel

Merkel

This flood of capital is the result of the convergence of several factors: new institutional players, such as REITs, and new investors such as tenant-in-common (TIC) groups; sideline lenders or temporary players who jump in when the market is hot and jump out when the water gets a little cold; relatively low yields on other commercial real estate asset classes — such as office, industrial, retail and multifamily transactions — when compared to yields on hotel transactions; and favorable reports from Wall Street analysts and industry consultants.

As lenders and investors begin to trip over one another, borrowers are taking advantage of higher leverage loans, thinner spreads and more flexibility in loan terms. Sellers are benefiting from more aggressive capitalization rates. Municipalities and consumers benefit from the development of new product. However, the more troubling side to this flood of capital is the deterioration of loan structure. This deterioration evolves through a decline in underwriting and investment discipline, and the decline in discipline impacts the entire industry.

Based on recent Fitch reports and other recent industry articles, there has been a notable decline in structural features such as amortization, reserves and cash-management practices across all asset classes. Underwritings have been more aggressive, predicated on future performance and based on borrowers with less experience as well as lower levels of equity in their properties. And many of these statistics are based on CMBS transactions, which are supposed to have controls in place to reject riskier underwriting. While delinquencies are down 42 basis points during the past 12 months, consider the following information recently reported by Fitch and others:

• Loan-to-value ratios have increased from 82 percent to 87 percent in the past 12 months.

• Debt service coverage ratios have declined from 1.28x to 1.22x in the past 12 months.

• The number of transactions that require real estate tax escrows are down 16 percentage points, from 88 percent to 72 percent, in the past 36 months.

• The number of transactions that require capital reserves are down 15 percentage points, from 79 percent to 64 percent, in the past 36 months.

• The number of transactions with a sub-debt component has doubled from 14.5 percent in 2002 to 29.3 percent in 2004.

• The speed with which lenders close transactions has tightened from approximately 45 days to often less than 30 days, even though transactions have become more complex in the past several years.

While we are arguably emerging from the bottom of the cycle in the hotel industry, we're not out of the woods yet. Operating costs will continue to rise as labor markets tighten, utility prices increase, consumers demand a return to a higher level of services, insurance costs escalate and brands increase their standards. This will ultimately impact flow-through.

The business traveler has yet to return in full force, and savvy travelers on both the business and leisure side are keeping rates competitive through the various internet venues.

The yield curve is flattening out. In a nutshell, the market does not currently anticipate a material rise in long-term interest rates, due in part to concerns over the economy's ability to grow substantially in the next several years. While rates may remain low, a lack of growth in the economy would prove to be troubling. Further, event risk is always on the horizon.

A material amount of industry investment is TIC-driven. Just as unexpected tax law changes in 1986 led to significant defaults, history could repeat itself with changes to current tax treatment of TICs, as Congress attempts to overhaul the tax code. Further, these groups often lack substantial hotel experience, and their structures often do not provide a meaningful mechanism to infuse critical additional capital into a transaction down the road.

History has proven that real estate works in cycles. The abnormal levels of capital currently chasing transactions will exacerbate this cycle. With more lenders and investors chasing transactions, marginal projects will be financed, and an abundance of new construction will emerge, dampening the recovery of many submarkets. Aggressive interest-only loans may not be readily refinanced upon their maturity, as traditional underwriting criteria return.

The economy will eventually slow or, at the very least, return to a state of normalcy. Defaults will increase, and inexperienced lenders and operators will unsuccessfully attempt to negotiate with one another, inevitably leading to distressed sales and providing attractive acquisition targets for opportunistic operators. Inevitably the natural, almost Darwinian, real estate cycle will go on, separating the proverbial wheat from the chaff, as the weaker assets, operators, lenders and investors are driven from the market.

History will repeat itself. And, at the end of the day, there will always be the same small yet consistent handful of lenders, investors and operators that understand opportunities in both up and down markets.

James Merkel is managing director of RockBridge Capital LLC in San Diego.

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