At the 15th anniversary of the International Hotel Investment Forum in Berlin this March, CBRE Hotels hosted a round table discussion examining the current state of the hotel capital markets, emerging sources of new debt, and how debt will shape the landscape of hospitality investment in the coming months.
Moderated by HOTELS Editor In Chief Jeff Weinstein, the participants agreed that debt is changing the landscape and that fundamental new ways of doing business are now starting to be sought that will improve the climate of the industry.
Participating in the discussion were Derek Gammage, managing director, CBRE Hotels EMEA; Peter Norman, senior vice president, Hyatt Hotels Corp., Puneet Chhatwal, executive vice president and chief development officer, The Rezidor Hotel Group; Tim Helliwell, head of hotel finance, Barclays; and Christof Winkelmann, managing director, Aareal Bank.
Here are transcribed excerpts from the discussion:
Jeff Weinstein: What debt sources are available today and if the fluidity in market forced them to find different sources of debt for each new deal?
Peter Norman: With the increasing scarcity of debt for new build hotel opportunities, more developers are turning to hotel operators for financial assistance. This assistance can take a variety of forms such as guarantees and key money, but more often mezzanine debt is requested to bridge the lending gap from the senior lender. Hotel companies are also taking the opportunity to explore offers for existing hotels with no lending contingency, thereby providing the vendor with a level of comfort/certainty that is not provided by another potential purchaser that requires a level of lending to make their offer work.
Derek Gammage: But that means there is still a lot of equity you have to put out. How does ‘upstairs’ handle this on the balance sheet and surely their constraints make your ability to deploy this equity neigh on impossible?
Norman: It is all dependent on the strength of a company’s balance sheet and its strategy towards development in this current climate. The stronger and more aggressive groups will be able to take advantage of the current situation where the lack of lending knocks a number of potential purchasers out of the race for an opportunity. There is an increasing demand from developers to secure guarantees from hotel operators to maximize the lending they can secure from the banks in an attempt to maximize leverage.
The discussion then turned to loan guarantees.
Tim Helliwell: When you look at existing guarantees, historically they barely cover more than 20% of the overall debt service. If you actually had to call on one of those guarantees you would have been so far through the finance at that stage that you’ve already ‘busted through’ all your interest covenants.
Have leases come back into play?
Norman: This is why in Western Europe the first thing a developer/owner will ask is “can I have a lease,” but today this is increasingly less tongue in cheek. A lease helps provide the lender comfort, but potentially caps the upside for the owner on exit, creating a catch-22. Ultimately, good deals with sensible economics and partners will have a much greater likelihood of finding that mutual ground to close the deal.
The participants acknowledged that a lot more hotel companies are offering leases again but that the industry seems to be at a crossroads.
Puneet Chhatwal: The banks need certain levels of cash flow and these have been negatively impacted by the current downturn. After 2008, most of the successful deals have been driven through the franchisees and no longer through highly leveraged developers. I also think that the hotel pipeline has become less important. Today, it is the opening that is important and we are very much focused on it. The relevance of the emerging markets for Rezidor has mitigated the issues of debt availability as in those markets deals have always been done with 40% to 50% of equity (unlike Europe).
Gammage: Everything we talk about now is driven by the fact that there isn’t any debt. I don’t want a guarantee because I want performance based income, but if I don’t get a guarantee how do I get my debt? I’m trying to figure out where the new sources of debt are going to come from. If I talk to my CBRE colleagues in a wider context, there are lots of new debt sources emerging in the American model – pension funds, life finds, high net worth, etc. In short, funds such as Lonestar, Starwood Capital, AXA, etc. We’ve only ever had balance sheet lenders here in Europe unlike the U.S. model – which has to be a good thing in the medium term.
Norman: And if you look at the attendees at this year’s Berlin Hotel Investment Conference, there is no evidence of these potential new lenders you mention. So even though this may be an emerging market elsewhere, it has yet to appear on their radar screens in Europe.
In Germany, the larger insurance companies are starting to look at real estate acquisition loans.
Winkelmann: The reason why insurance companies are tapping the market is not just because banks have restraints on lending, but also, because new regulations coming in somewhat incentivize insurance companies to invest into debt rather than equity. The additional competition will result in increased liquidity, thereby having a fundamentally effect on the supply of credit.
Helliwell raised his concern that this is where things had gone wrong in the past.
Helliwell: When things are good, lenders with a real estate background started issuing real estate loans, but when things get complicated those lenders don’t understand how to solve problems.
Gammage: You are right, there is an issue with some of these sources not understanding hotel assets. I spend a lot of time talking to pension funds, and when I say “hotels” they immediately lose interest. They will be interested at very expensive levels, levels that make hotels more attractive to them than office buildings, but the sad correlation about that is that the price an investor can pay for the hotel asset in terms of equity yield remains unchanged and so what gives – the entry price.
Chhatwal: The consultancy firms need to find more high net worth individuals, such as Sahara who purchased the JW Marriott (Grosvenor House Hotel).
Gammage: I disagree. All-equity buys the Grosvenor House Hotels in London, but that’s not a solution for most assets. All-equity does not buy the Radisson Blu in Glasgow.
Chhatwal: One issue is the lack of available debt, but there is another thing to it. Norman mentioned that industry construction cost for select-service hotels is approximately £110,000 (US$176,966) a key, but then you see that you can buy the Rad Blu Glasgow for £100,000 a room for 250 keys. So if I was a debt provider, why would I lend to a new construction and take on development risk when I could lend on existing assets, with trading history, being sold at 50% to 60% of replacement cost?
Winklemann: I actually like the fact there’s little construction because when we were in the last cycle there was this huge layover of construction still coming in and being finished. This time around there wasn’t much construction going on which is helping the industry. That for us, as a lender sitting in certain markets, is quite good.
As far as the corporate banks are concerned the challenge for capital has really focused people’s minds. In the boom, hotels competed for capital just amongst the rest of the real estate industry.
Helliwell: The entire real estate sector is competing for capital against corporate Europe. Real estate has always been at the higher end of the risk spectrum, and now frankly, it’s just not going to win as many as it did before. The key point is that as liquidity has tightened, the assessment of where to allocate capital has got far wider and therefore this is where the industry struggles, not just on specific things like construction finance but indeed on mainstream hotel finance generally. This is what the industry has to get its head around. The other point is that the business model for banking has completely changed – lenders don’t make much money from lending debt today. The only way they actually make their capital returns is by a far wider portfolio of products.
Gammage: So in order to find a way to access more capital, are people like you starting to interface with pension funds saying ‘we can become the conduit to place your money?’ Surely that must be the way to go?
Winkelmann: “Correct, this is one of the likely ways forward. It’s interesting how hotel debt moves with the cycle. At the bottom of the cycle when capital is limited, everyone wants to put loans in assets with the least perceived risk, like office. But eventually lenders are seeking higher returns as competition builds up and make their way to hotels, so at the end of the cycle you end up with a bunch of people who know very little about hotel real estate making hotel loans. But if someone with industry knowledge can pair up with sources of capital seeking a return, like life insurance- and pension funds, that dynamic could be a longer term change.
Helliwell: We have to be very careful with larger transactions where you are multi-bank, with the dynamics of the deal and how the voting rights can have an impact on the decision. Which way is the right way to go can be hugely destabilised and this is before we even start talking about putting mezzanine debt into it. Game changing stuff is happening – we’re starting to see incumbent lenders taking a far more realistic view of where their position is, we’re starting to see brands become more aggressive with their balance sheet for transactions that they want to do and actually putting some meaningful debt support behind transactions. The industry is showing signs of re-positioning itself.
The participants agreed that how permanent this change would be is difficult to determine and would be very much on a transaction by transaction basis.
Norman: The demand is there and you guys, the banks, are adapting slowly to be able to tap into the opportunity.
Winkelmann: As I understand it, the pure meaning of this is that things change within very short timeframes – but no, it doesn’t work like that. Things may change drastically because of unforeseen incidents, but they always somewhat re-adjust. Saying that, there are fundamental changes happening that will become the new way of doing business, but change for good needs time.
Gammage: 50% of the debt in the U.S. has been from non-balance sheet lenders so if there is s a paradigm shift, that’s the one. With any luck, we’re going to let all these insurance companies come into our market and stay there.
Helliwell: Somewhere like the high yield market is where, certainly for larger transactions there’s some opportunity but of course that’s subject to having some confidence and liquidity in the markets.
The discussion led to RevPAR.
Chhatwal: With the exception of London and a few other key markets, RevPAR has fallen by 20% on average. If the banks were to see RevPAR going back up, then you’ll get the returns you need and you’ll underwrite it, and also debt re-financing will come back to the hotel market, at least partially. We see significant growth. In Dubai, for example, we have seen volume reach the same level in the past two/three months that it had two/three years ago. It’s just the rate that needs to follow now. This is typical of our industry. RevPAR will bring normality and debt will follow.
Helliwell: We covered approximately £1.4 billion (US$2.25 billion) of debt last year purely on the hotel sector, predominantly in the UK – of which approximately 50% was new. There will be a selective focus within Europe this year and are more likely to place deals around our network. We will continue to manage and oversee them and will additionally rely on local support to aid the transaction, which works effectively.
The group rounded off with the view that while debt is out there, it is now a case of pushing forward with these changes that the banks are already starting to make head way on.