While the hotel asset class generally falls into one of the top five food groups, along with multifamily, office, industrial, and retail, it is the one that is most often most misunderstood, and perhaps feared, by commercial real estate lenders. A new hotel deal is more likely to elicit a groan than an outburst of excitement from a commercial bank, life company, conduit shop, or specialty finance company. So why does hotel lending generate such a dispassionate reaction?
The most obvious reason is that it is harder. A lender is essentially financing an operating business, rather than the underlying real estate. Understanding the intricacies of how the day-to-day business works and the various ways a hotel can make and lose money are paramount to evaluating the historical and prospective cash flows and determining value. This, in turn, dictates the level of debt the property could support.
While there are probably 100 examples of why hotel lending is different, there are two key elements on which to focus. The first is the fact that a hotel effectively releases itself every night. Contrast this with an office building, or retail center. In each of these instances lenders are looking at one of two variables: existing leases that have term, which requires evaluating the probability of a tenant paying rent through the duration, or vacant space, where the evaluation is where rental terms are in today’s market environment and what a landlord can lock a tenant in for long term.
The hotel market is always changing. Operators have to constantly adjust to factors or risk missing the market. As a lender, understanding those market forces and properly accounting for them in the underwriting, is incredibly challenging.
Hotel lending also is different because it involves understanding the inherent operating leverage associated with the product type. While all asset classes have a mix of fixed and variable expenses, the mistake many lenders make is underestimating the impact of a hotel’s high operating leverage on performance. When the market is in an upswing and more revenue falls to the bottom line as a result of operating leverage, the result is more often than not a high net operating income. As a lender, whose only job is to get paid the stated interest rate and get principal back, I will accept this mistake as it just means that the property has done better than projected.
However, a down market is where the trouble can start. With a hotel’s high operating leverage, decreases in revenue can cause net operating income to disappear quickly. In this most recent downturn, many hotel loans were unable to be refinanced as net operating income decreased 50 to 100 percent due to revenue losses that were much less than that on a percentage basis. Therefore, understanding the impact of high operating leverage on the hotel that is being underwritten is critical to developing an accurate forecast of performance and properly structuring for any decrease in performance.
These factors illustrate why lending on a hotel is different than lending on other asset classes. As a result, the following advice should be heeded. To lenders: don’t make hotel loans unless there is someone in-house that understands the business. Even then, make sure you are comfortable tolerating volatility in cash flows over the term of the loan. To borrowers: only take hotel loans from lenders that understand the business. In a compressing yield environment, hotel loans sometime look attractive to lenders as the rates they can charge are higher than that of other asset classes. This sometimes creates entrants to the business that are just chasing yield as opposed to having a full understanding of what they are getting into. With a product type that displays a significant amount of volatility, it is worth having a lender who understands the intricacies of the business and can work with you in creating a thoughtful loan structure.
Raphael Fishbach is a principal with Mesa West Capital, a Los Angeles and New York-based real estate finance company.