Hotel lending: a snapshot of the market.
These were some of the points made by three leading NYC-based investment bankers whose specialties include financing the hotel industry. They spoke during a panel discussion at The Lodging Conference in Arizona, moderated recently by this writer.
"The industry has done very, very well, and the industry is now being rewarded with cheaper capital," said Dan Abrams, managing director for commercial real estate with Nomura Asset Capital Corp.
Lance Graber, of Credit Suisse First Boston, said the tightening of spreads on plain vanilla permanent financing has been "very dramatic." Spreads have moved, he said, from 250 to 300 basis points over Treasuries a year ago to as low as 150 basis points today, sometimes even lower. And all the lenders in that market are "getting pretty dam close to the same kind of pricing."
It is an "incredibly efficient" marketplace, said Abrams. Both Abrams and Graber said they believed tighter spreads in the subordinated securities market - a reduction of as much as 300 basis points in the last year or two - had driven the tightening of permanent loan spreads. Abrams also pointed to re-entry into the market by traditional lenders such as insurance companies and commercial banks.
Spreads aren't going to get much tighter, according to Abrams, because there isn't much further for them to go. He also said the lodging industry is doing spectacularly well right now. Industry performance, he said, has far more room to move down than up.
In the industry-wide enthusiasm to make more hotel loans, have lenders been willing to lend more and to cut comers on underwriting? John Cavanagh, a vice president at Salomon Brothers, said hotel lenders still generally look for 70 to 75 percent loan-to-value, with a 1.40 debt service coverage ratio, for plain vanilla long-term first mortgages. But, Cavanagh said, lenders can sometimes be flexible on some of the numbers.
For example, until recently many hotel lenders rigidly required a 5 percent FF&E reserve, a 5 percent management fee, and a 5 percent franchise fee in their underwriting. Today, with base management fees sometimes as low as 2 percent of gross, lenders may be willing to move downward from some of those benchmarks, particularly for large full-service product. The result: higher underwritable cash flow, hence greater loan proceeds. All achieved even with a 1.40 debt service coverage ratio.
With properties that are new, well-located, and well-positioned in their market. Cavanagh said he has recently seen hotel deals with a coverage ratio a bit below 1.40. Abrams said he has seen the same, but with conservative underwriting of cash-flow, perhaps the flip side of the more liberal approach to cash flow that Cavanagh described.
As permanent financing has become a commodity, lenders have become more willing to make loans that aren't quite ready for securitization, but just need some time. The easiest example might be a recently renovated project that doesn't yet have the trailing earnings the rating agencies want to see, but has a promising future.
Until recently, Graber said, Wall Street capital sources would have been willing to finance this kind of project, if at all, only on a short-term and relatively expensive floating-rate basis. Today, he said, competition for good loans may drive lenders to finance projects like these - and "size" the loan - as if it were long-term financing on a stabilized building. Lenders who do this realize they may need to hold the loan for a year or two while it seasons.
Cavanagh acknowledged that while all lenders prefer to underwrite based on actual demonstrated trailing cash-flows, they are more willing than before to look at projections. If a lender "sizes" a loan based partly on projections, Graber said, the loan documents may provide for a "reverse earn-out." A piece of the loan would convert to mezzanine financing if actual cash-flows fell short of the borrower's projections after a certain period. After that conversion, the remaining first-mortgage piece of the loan would be "plain vanilla" and securitizable after a seasoning period in the lender's hands.
Panelists identified the growth of "mezzanine financing" as a major recent development in real estate finance. In a "mezz" loan, a lender provides most of the financing as a traditional, conservative first mortgage. The lender then provides a bit more financing on a subordinated basis.
Because the rating agencies hate subordinate mortgages, "mezz" financing is often secured instead by a pledge of partnership (or "membership") interests in the borrower. As another option, the lender might receive some form of "preferred equity." In each case, the "mezz" lender has no direct claim on the real estate. Instead, the lender has a claim to part of the value of the real estate only through the borrower's equity structure.
Just as market pressures have driven rate reduction and flexibility in underwriting for permanent loans, "mezz" financing is a different animal today than it was a year ago, panelists said. Graber said lenders are being "more aggressive" both in absolute dollars they will lend on a mezzanine basis, and in the terms of those financings. For instance, he said, "Historically mezzanine financings were always self-liquidating, and often involved a cash flow trap... It paid itself down in a [three to five] year period. Now we are seeing interest-only mezzanines, we are seeing eight-year mezzanines with 15-year schedules... I think Wall Street is being very, very creative in terms of accommodating that mezzanine need."
As another way to steer away from commodity pricing, Wall Street lenders now look harder at pure "interim" loans - loans secured by projects that may need more than just a year's seasoning before they can be securitized. These projects may be turnarounds, repositionings, or properties with intrinsic (or ultimate) future value but limited cash-flow today.
An interim loan may, for example, need a substantial interest reserve because the property is not yet cash-flowing enough to cover interest expense, but is projected to do so after a stabilization period. Interim loans vary wildly. Each property has its own story to tell.
"There are no boxes. You've got to look at the deal, what makes sense, the strength of the market, the strength of operations, the sponsorship," said Abrams. Even if an interim loan is non-recourse, Abrams said, an interim lender will place great weight on the depth of the sponsor's pockets. If the project needs money, will the sponsor have the ability to provide it, even if the lender can't legally force them to do so? Practicalities may be more important than legalities.
When lenders provide interim financing, they definitely assume greater risks. But this kind of financing gets them away from the crowd, and they charge for it.
"As the risk level goes out and the leverage level goes up, the pricing can change very dramatically, all the way to a point where we are taking a profit percentage as part of our compensation," said Abrams.
This portrait of current lending to the hotel industry, and to real estate more generally, suggests a few questions and comments:
* If spreads are so low and so consistent that permanent mortgage loans are priced as commodities, is any room left for lenders that aren't looking ahead to a securitization as their ultimate avenue to a profit?
* How can lenders who originate plain vanilla securitizable permanent mortgages distinguish themselves and their product from their competition?
* A partnership interest pledge, the typical security for a "mezz" loan, is very much less than just another form of mortgage or a second solid bite at the real property collateral.
One cannot be totally sure the courts will take seriously these pledges, and any resulting transfers of equity. In a recent bankruptcy case, for example, a lender had taken a pledge of the borrower's stock. Even after the lender foreclosed on that pledge, the borrower's principal (former principal?) remained actively involved in the bankruptcy. The court did not seem overwhelmingly convinced that ownership or control of the borrower had actually changed. (Of course, the decision in that case may have been merely the tail end of "a long story" with unusual facts, signifying nothing.)
Even if a court honors an equity transfer pursuant to a "mezz" lender's foreclosure sale, the "mezz" lender is not taking over real estate, but merely a position in an ownership entity, with all the grief that may travel with it.
For example, the "mezz" lender's claim is automatically "subordinate" to all claims of all creditors against the real estate owner.
These possible issues regarding a "mezz" lender's collateral represent risks for which a "mezz" lender needs to be compensated. And a "mezz" lender will need to think strategically about how to maximize the value of its rights and remedies under a security structure - the operation of which is not yet routine. A "mezz" lender may, among other things, need to review its treatment of nonrecourse carve-outs:
* If tighter spreads on subordinate bonds have pushed down pricing in the origination market, and originators of loans destined for securitization are far more willing to hold this paper than they were two years ago, aren't loan originators significantly exposed to the risk of a change in tastes among subordinate bond buyers? Would such a change be gradual or sudden? Would a few loan defaults be enough to trigger it? Presumably the pricing of interim deals reflects these risks, along with the underlying real estate risks.
* Lines blur between real estate and corporate securities, and in how these two areas do business and close deals. Participants in the real estate side of this world need to match traditional real estate closing procedures and issues with demands for timing and execution more typical of the securities markets. That may be one of the largest challenges faced today by those providing services to real estate loan originators.
(Joshua Stein, a partner in the real estate practice group of Latham & Watkins' New York office, represents primarily lenders. He also chairs the Practising Law Institute annual seminar on commercial mortgage finance, next scheduled for May 11 and 12, 1998 in San Francisco and June 15 and 16, 1998, in New York).
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|Title Annotation:||Insider Outlook|
|Publication:||Real Estate Weekly|
|Date:||Nov 19, 1997|
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