There has been much talk of capital on the sidelines poised for hotel investment; but what many hoteliers want to know is how they can actually secure the financing they need now, as continuing concerns about pandemic variants, a tight labor market, and rising construction costs are joined by those about inflation and the higher interest rates intended to tame it.
Offering the lender’s perspective on how hoteliers can best wade into these murky waters are Michael Harper, senior vice president, Stonehill, a direct hospitality lender, and Michael Sonnabend, managing member, PMZ Realty Capital, a provider of capital to the hotel and lodging community. These experts discussed underwriting considerations, how they have applied lessons learned from the pandemic, and their advice on how prospective borrowers can improve their chances of successfully securing the funds they need.
Calling the current state of hotel lending “uncertain,” Harper mentions macro events occurring in the global economy that complicate the underwriting process, which typically bases lending decisions on forecasts. “Escalating inflation and rising interest rates make it hard to predict what things will be like in the next three to five years,” he says.
Yet, according to both, in the absence of reliable forecasting, lenders can take comfort in somewhat more stable factors, such as a property’s local market dynamics, data on how it performed before the pandemic, and the track record of the borrower. “Underwriting for a particular property is really about getting a sense of what’s going on in real-time. Is there real growth going on in that market or is it just recovery from the many months of COVID? It’s also about the integrity and competence of the borrower. Lenders need to know that they’re committed to their asset, that they have equity in it, and will do the right thing time and time again,” says Sonnabend.
Saying “the real objective of lenders is to set up borrowers for success,” Harper explains that Stonehill’s initial response to the turbulent pandemic period—to underwrite a year of interest reserve into every deal—was meant less to protect the lender than to insulate the borrower from default during a relatively small disruption, like when the Omicron variant hit late last year. However, because it soon became evident that different markets recovered differently, he says, “That blanket approach has evolved to more of a case-by-case basis for underwriting. Most lenders—ourselves included—are getting a lot more thoughtful about what each asset needs in the near term.”
Between Borrower and Lender
Sonnabend says companies like his, which represent large institutional clients to independent owners and operators, understand what their client investors want and can help appropriate prospective borrowers gather and present the information lenders need to make their “thoughtful” decision in favor of the borrower. “The job of the hotelier is to run their own hotels, but our job is to be out in the markets financing hotels for different clients,” he explains. He agrees that there are many lenders seeking opportunities to put capital out in hospitality, but says it’s not one size fits all. “Each lender has different things that they’re looking to do and looking to avoid. You have to know who’s doing what so you can find the right checkbook for the specific asset; because we know what our own clients are seeking, we can position things in a way that will interest them in making the loan or investment.”
Post-Pandemic Value Considerations
Sonnabend calls the ability to value assets the key to making loans or investments. Harper says hotel asset valuation is market-specific, and reminds that the expected fire sales of distressed properties did not occur over the past two-plus years. “Other than a couple of true distressed trades in the summer of 2020, after people were able to buy time—whether with PPP funds or rescue capital—values came back quickly.”
Like Harper, Sonnabend says a cookie-cutter approach will not do in the current environment, where the activity from one market to the next can differ so dramatically. He says the great lesson of the pandemic for both lenders and borrowers is not only to be prepared for predictable headwinds, such as recessions and weather events, but to think in terms of the long game. “I think it’s important to leverage your assets to a reasonable level to be prepared for some downturn in the market,” he explains, adding the disclaimer that, “nobody [could have been] prepared for a global pandemic.”
Harper observes that hotel buyers are not basing their purchases on a trailing cap rate. “At the end of the day, buyers are not buying a historical stream of cash flows; they’re buying a future stream of cash flow.”
Sonnabend agrees that investors are looking to the future without forgetting the lessons of the pandemic. “They want strong sponsorship and a good business plan, including a way to get things ramped back up, but they’re looking more to prospective activity in the future, and lending off of that, coupled with what happened pre-pandemic.” He points to the brands that successfully weathered the pandemic as being best bets for lenders in general. “Strong brand properties that have a reasonable overhead are the assets that in the long run are going to do well. It was the middle-market brands, especially extended stay, that bounced back quickly, mainly because they had higher margins and lower overhead, so there was more flexibility to operate without a lot of the revenue that hotels weren’t able to generate.”
Sonnabend further notes that in PMZ’s own niche—largely select- and full-service hotels in secondary cities, drive-to markets, college towns, or those with a lot of leisure traffic—the market is strong to the extent that “the valuations are really back to and surpassing pre-pandemic valuations for many assets.”
Although interest rates are indeed rising, both Harper and Sonnabend point out that they are still lower than they’ve been many times in recent history and that there are plenty of lender investors who are interested in the hotel space.
Sonnabend, who describes PMZ as “exceptionally busy” now, expects the level of activity to be even higher this year than in 2019 due to pent-up demand. “Our clients have needed the money during the last couple of years, but now that hotel performance is better, potential lenders and investors are more comfortable, so there’s more of an appetite among those writing the checks to actually make loans and investments.”
Harper says activity is definitely picking up at Stonehill as well, which he says is particularly “bullish” on new-construction lending despite rising construction costs due both to increases in wages and materials. “We like that when they’re newly built, you’ve got the newest, nicest collateral.”
The Road Ahead
Harper expects the lending environment to be challenged in the near term, although there will continue to be capital in the space. “It will take time for the scars to heal; a lot of lenders were burned through the pandemic, so they’re not diving head-first back into hotel lending, or if they are, they’re not providing the same leverage or terms that they were pre-pandemic.”
Sonnabend believes the travel business will improve—even within the corporate segment—mainly because people like to travel and gather. Yet, he also thinks there will be adaptations. “I think that some hotels will be switched to different uses, which will keep the supply down. We’ve already seen lots of conversions of hotel to residential, and I think you’ll see more of that, especially in center city locations.”
Sonnabend expects drive-to markets to remain strong as travelers continue to stick closer to home. “While people are flying more, neither leisure nor business travelers have been flying as much.” For this reason, he says, lenders have been interested in assets that have a drive-to capability. He also mentions how consumer demand for soft-branded hotels has correlated to investor desire to finance them. “Guests like to stay somewhere that has some type of story while knowing that it’s still affiliated with a brand where they can earn and redeem their points. Investors, too, like the flexibility of having that brand affiliation without having to adhere to standards as in a lot of core brands.”
Advice to Loan Seekers
Sonnabend’s advice to those in the market for financing is basically to be reasonable and realistic about their own needs and expectations. Noting that many franchisors are now requiring that owners invest more in their properties, he says, “Hotels require a lot of investment, and owners don’t always plan effectively for that. You have to take a step back and be rational about your expectations of what your hotel is, what you’re projecting for the economics of the deal, and what you’re projecting for the capital side of the deal.”
Harper’s advice to hoteliers seeking financing correlates to his “know thy counterparty” rule. “Beyond being able to provide the latest and most complete information about the asset, they need to have good credit, a good track record, and a good reputation in terms of their integrity. This is not a huge industry. The borrower that did the right thing through COVID will have a leg up on anyone who gave back assets or walked away from things during the pandemic.”