On Jan. 1, U.S. banks are required to adopt new underwriting criteria based on Basel-3 guidelines, which will sharply increase the capital banks must hold in reserve against “acquisition, development, or construction” loans above 80 percent loan-to-value (LTV) and where up-front capital contribution is less than 15 percent of the project’s “as completed” value. Where banks typically reserve at least 8 percent of loan balances, a new 150 percent risk-weighting will raise capital requirements to 12 percent—increasing lender costs and limiting capacity on these loans. Although the 15 percent threshold is based on the estimated value of a project—not construction or acquisition cost—regulators have yet to clarify if “as completed value” is at project completion or stabilized value. In the meantime, lenders will likely avoid being caught short and underwrite to the higher stabilized value.
Because lenders already consider hotels riskier than other commercial real estate, banks require higher equity and underwrite hotel deals more conservatively. Value-add acquisitions will attract additional scrutiny, especially projects with significant upside through non-capital improvements in management, sale & marketing, customer service, flag changes, etc. And because equity must remain invested until loans are paid off or refinanced, lenders will put limits on cashing out excess loan proceeds.
The full impact of Basel-3 is still uncertain, but new regulations historically prompted hotel lenders to mitigate added risk with lower LTVs, higher recourse/personal guarantees, deposit requirements, and tighter underwriting, while banks inexperienced or uncomfortable with our industry will reject hotel deals completely. Considering today’s robust deal pace, fewer willing lenders with less money available may do just what we do in our hotels: raise rates.
What can you do? If you have deals working or in the pipeline, close them by year-end. Work with brokers and lenders who know the hotel business and have money allocated to hotel deals. Clean up balance sheets and partner with strong investors: high net worth and liquidity are valuable credit enhancers. Refinance stabilized assets with non-recourse debt—reserving recourse and personal guarantees for construction and turnarounds. Hotels in better markets with good historical performance and stronger flags always attract more lenders and better offers. And finally, consider a little lower leverage to mitigate the lenders’, and your own, financial risk.
John Svec is managing director of Largo Capital’s Hospitality Finance Group; jsvec@largocapital.com.
