In the world of aviation, whether upon taking off or on landing, the longer the runway a pilot has, the more options there are to handle challenging and even unforeseen conditions and make the necessary adjustments for a smooth transition.
Similar considerations apply to the hotel industry. Many of the loan maturity challenges the industry now faces are not entirely unfamiliar. However, the Carter-era inflation of the 1970s, spiked by the oil crisis, and the more recent 2007-2008 recession are, for the most part, fixed in our rearview mirrors.
The hotel industry operated in a low-interest-rate environment for a decade and a half: markets were stable; debt was relatively cheap. Quarter-after-quarter RevPAR gains were consistent and gross operating profit similarly dependable. As a result, it was relatively easy to consummate deals: new development, investment sales, refinancings and more. Moreover, even during the pandemic, most lenders cooperated with owners to keep properties solvent, understanding the unprecedented circumstances.
Today, it’s a different environment: persistent inflation prompted the Federal Reserve to maintain high interest rates, which is impacting operating costs (insurance, utilities, taxing authorities, basic supplies, etc.), as well as the availability and cost of capital. In the wake of the pandemic, labor—both in availability and wages—has also been flexing its muscle, further vexing operations. At the same time, a wide range of hospitality loans will mature in the next year or two.
Three questions now burn hotel owners’ ears: How long of a runway is there before considering a refinance? How much runway is available before considering a sale? What are the best possible exit strategies?
PERFORMANCE PARAMETERS
Five years ago, starting to seriously analyze prospects for a sale or refinance six to nine months in advance was more than doable. Today, we recommend a much longer view given the current rate environment, availability and cost of capital and the undeniable impact that higher interest rates are having on valuations. It is now advised to begin evaluating your options 12 to 18 months in advance of loan maturity, even as the industry as a whole continues to perform well. In fact, according to a recent Daily Lodging Report, STR’s global update as of November 11, 2023, showed 79% of markets with growth in RevPAR compared to 2019. However, for 2024, STR forecasts industry growth of 1.0% in occupancy and 3.0% in ADR for 4.1% growth in RevPAR, compared to its 2023 forecast of 4.8% growth in RevPAR.
Forging a loan maturity strategy starts with a comprehensive, realistic look at a prospective 12 months of performance. Consider how your market and comp set are doing, the physical state of your property and potential, attendant CapEx requirements, expected top-line performance and current debt balance. Do you have strong cash flow and profitable operations? If you think you can continue to hit those numbers, you may be able to stay the course and reassess in the future.
If cash flow and profitability are flat or deteriorating, it may be time to speak with lenders, keep them in the loop and discuss refinancing options; or, prepare for a sale, even if only to test the market waters. Also, having the right advisor on your side to continuously review your hotel portfolio and provide current market feedback is extremely helpful in today’s market situation. The earlier a property can be assessed, the better.
Hazard warning: In a strong market with excellent profitability, sellers were often able to command higher buy prices based on future prospects, although some would suggest leaving something on the table for the next owner, even in flush times. Right now, we are seeing fewer buyers willing to “contribute” to the perceived upside potential of a property.
ENTER THE CAPEX KICKER
As if interest rates weren’t enough of a pre-flight hurdle, when hotel owners are looking to refinance, many lenders will ask about the existing franchise term and pending brand PIP and CapEx requirements. Any refinancing or change of ownership may be contingent on concluding a new franchise agreement and committing to executing a property improvement plan. At the present time, the major brands are working with vigor to enforce the property improvement and other brand standards that were relaxed during the pandemic.
Adding a mandatory CapEx expenditure to the existing debt balance can change the transaction equation markedly. For example, a $14-million property with net operating income of $1.8 million results in a 12.8% debt yield. Add a $3-million PIP per brand requirements and the debt yield is now 10.6%, which is inside the debt yields we are seeing drive the most efficient loan terms. Though still important, these factors are increasingly pushing the traditional “basis-per-key” selling point down the list of important factors.
We are advising owners with less than five years left on the franchise agreement to at least request and price-out the PIP as any transaction (investment sale or license extension) will require it. As the owner, you will have an opportunity to negotiate the PIP, as well as establish relationships with designers, contractors and building materials suppliers. In doing so, you will be better prepared to work with a lender or potential buyer. It’s time to price that PIP.
ON RATES
We cannot—and will not—try to be interest rate prognosticators as to “how high or how long.” However, as with wildfires, just because inflation looks like it is under control, it doesn’t mean we are in the clear and can start cutting interest rates—we need to know the fire is truly out. If we learned anything from the turbulent 1970s, inflation at one point appeared to be tapped out, but came raging back. However, once the financial marketplace feels that the Fed isn’t moving rates any longer, we don’t expect lending rates to come down (quickly, anyway), but we do anticipate terms to improve.
So, it is important to recognize that rate is just one component of the cost of capital. In many respects, terms and with whom you do business are equally—or more—important. Theoretically, excellent cash flow and low-rate debt implies more options, while poor cash flow portends less attractive options, but there is always more to the story.
Regardless, whatever the financial markets hold in store, now is the time to be flight aware. Take full advantage of the runway ahead to optimize existing operations, survey the transaction marketplace more closely and establish or re-establish brand and investment banking relationships, maximizing your options as your loans mature.
Andrew Broad is a managing director of RobertDouglas, alongside SVP Andrew Heilmann. RobertDouglas is a real estate investment banking firm.