In a November 8th, 2008 article by Bloomberg, analysts from RBS Greenwich Capital estimated that approximately $88 billion in commercial real estate loans will come due in 2009. A significant portion of these loans are for hotel assets. As the national economy continues through a recession that began more than a year ago, and as credit remains constricted, the options for hotel owners with loans coming due will be limited. Refinancing risks may also be compounded by the fact that hotel values have declined due to lower leverage and reduced cash flows, as lenders become more conservative and markets experience deteriorating demand.
This article outlines a series of possible options owners may consider if their hotel loans are scheduled to mature during these distressed times.
Extending Hotel Loans
Extending or rolling over an existing loan on a hotel may be the best option if it is available. The availability of this option depends on the performance of the existing loan and the lender's current capital needs. Assuming the lender has sufficient capital, the lender will try to determine whether the hotel's operations can be expected to produce ongoing cash flows sufficient to make loan payments in the future. If the cash flows appear strong enough under new lending parameters, then a lender may be willing to extend the existing loan.
However, it is important to keep in mind that lenders are investors and they have the goal of making loans for a profit. Like any prudent investors, lenders will evaluate the loans they make in the context of any "opportunity cost" that may be associated with committing their capital to a certain asset or project. That is, a prudent lender will evaluate the expected yield of extending your loan versus originating a new loan. Given the high degree of competition for loans in today's credit environment, owners should anticipate some changes to the existing terms of their loans. These changes are likely to include adjustments to interest rates, some equity payment to reduce the outstanding loan balance, and payment of extension fees.
Refinancing Hotel Loans
If an existing lender needs capital and is not willing to extend a hotel loan even though cash flows are expected to be adequate to service the loan, the borrower will likely need to refinance the existing loan with a different lender. Because the number of lenders actively seeking to make loans on hotel properties has declined in recent months, only the best-performing assets have this option available to them. Even then, owners are unlikely to find a new lender willing to refinance a loan with the same leverage and interest rate that applied to many hotel loans issued during the 2004-2007 peak of the industry cycle.
When refinancing a hotel, a new lender will require the property to meet certain performance benchmarks. Any expected decline in cash flows will make meeting these benchmarks more challenging. On average, loan-to-value ratios are likely to be in the range of 50% to 65% rather than the higher 70% to 85% leverage levels available in recent years.
With the exception of hotel assets with very strong cash flows or very low debt levels, most borrowers will need to deleverage, given today's tighter lending parameters. Moreover, today's lower loan-to-value ratios will be applied to the hotel's current market value, which may be 10% to 30% lower than its market value was when the existing loan was underwritten, assuming the asset is performing well enough to produce a positive cash flow. Taken together, these two factors can create a substantial cash "shortfall". The following example illustrates what this shortfall might be:
Hotel Operating Performance ($000)
|Change in Value||18.7%||-9.8%||-17.7%|
The table shows historical operating performance for a 200-room, full-service hotel and a forecast for operating performance in 2009. Performance figures reflect the ongoing national economic recession as well as severe tightening of the credit markets. In 2006, the hotel achieved an annual occupancy of 75% and an average rate of US$210, which produced a net income of US$3.4 million. By applying a capitalization rate of 8.5% to the net income, the resulting value would be US$40.6 million. A loan-to-value ratio of 75% would have allowed the owner to take out a loan for $30.5 million in that year.
In the second half of 2007 credit began to tighten and the national economy entered a recession in December, 2007. As a result, net income declined in 2008 and is expected to decline further in 2009. At the same time, capitalization rates increased as buyers perceived more risk in commercial real estate investments. Moreover, loan-to-value ratios declined substantially. When the hotel's loan comes due in 2009, the owner would potentially face a shortfall of US$10.8 million needed to refinance the hotel, or roughly one-third of the original loan amount.
Due to the decreased leverage now available for financing hotel investments, exacerbated by lower market values, owners of highly leveraged assets should be prepared to increase the amount of equity in their hotels. One obvious way to accomplish this is for such owners to invest more of their own money to pay down a portion of the debt currently held in these projects. By increasing the equity in a hotel and reducing the debt, an owner will decrease the lender's risk and capital commitment. This will allow the owner to attract a broader range of lenders willing to consider financing the debt when it comes due; however, it will decrease the owner's return on investment because leverage is reduced.
For owners with enough liquidity in their balance sheet, paying down and injecting new equity into their hotel investments may not be a huge undertaking. In fact, this may be an opportunity to reduce borrowing costs. There have been transactions in the recent past involving early retirements of hotel notes. In exchange for owners paying down loan balances, some lenders are offering discounts to entice certain owners to do so. Unfortunately, this is not the case for most hotel owners.
Finding an Equity Partner
Injecting a large sum of money into a hotel may not be a viable option for some owners, especially during distressed times. One alternative that owners may consider is to seek equity partners who have cash and a willingness to invest it in hotel assets. The primary advantage of this strategy is that it does not require owners to use their own funds to pay down debt on maturing loans. The primary disadvantage of this strategy is that equity partners are often costly and they may be very selective, especially in desperate times.
Currently, equity partners are seeking yields in the range of 20% or more. One thing to bear in mind is this level of yield is a function of the equity partner's cost of capital, as well as the yields offered by other alternative investments in the market. This level could go up or down, depending on how soon the economy and debt markets improve. Currently, most market indicators and experts' opinions would lead one to believe that this yield level is not likely to decline substantially in the near-term.
Finding a Second Lender
If an owner is not able find, or willing to seek, an equity partner, another option is to seek a second lender. So-called "mezzanine" lenders seek to provide an additional loan, which would be subordinate to the owner's original loan. Because this second loan is subordinated to the original loan, it is riskier and requires a higher interest rate than the first loan. The interest rate is likely to be lower than an equity partner's yield requirement. A second loan may allow some owners to finance shortfalls, like the one identified in the previous example, without using additional equity. However, the availability of such financing in 2009 may remain limited.
Selling the Hotel
If none of the previous options are available or acceptable to a hotel owner with a loan coming due, then the best remaining option may be to sell the hotel. Selling a hotel allows the owner to obtain cash, assuming the hotel's value exceeds its current debt burden. While selling a hotel is the ultimate exit strategy for most owners, selling during an industry downturn is likely to yield a lower price than owners anticipated.
Furthermore, when owners near the date of their loan's maturity they may come under extreme compulsion to sell the asset. There may be limited time to market such assets before the loans mature if owners wait too long, in hopes of extending or refinancing existing loans. These conditions describe two of the key parameters in the definition of "liquidation value". A hotel's liquidation value is likely to be significantly lower than its "market value", which requires typically motivated buyers and sellers. If an owner of a highly leveraged hotel waits too long to de-leverage or sell the hotel, then the seller's motivation may become distorted by a compulsion to sell the asset in a short period of time before the existing loan matures.
As maturing hotel loans come due in 2009, owners will have to determine which, if any, of these strategies are likely to be available to them. Planning sooner rather than later can help maximize an owner's options.
One of the first steps in evaluating potential strategies is to evaluate the likely future operating performance of hotels with maturing loans and to obtain an unbiased determination of market value. With a realistic understanding of market performance and market value, both owners and lenders can create and achieve realistic goals for their hotel investments. If a loan extension or refinancing is an option, owners should approach and start talking to lenders early. Negotiations are less successful when the parties are under duress and subject to unrealistic time pressures. Additional materials and resources for hotel owners and lenders are available in the HVS Library and on the HVS website.