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Hotel Financing: What are lenders looking for?

By Russ Reynolds and My PhungHotel Valuation • 28th February 2008

 

Historically, accommodation properties been considered a risky investment for most commercial lenders. However, the past few years have proven that the hotel industry is a lucrative and active market, and lenders – both traditional and nontraditional – have been increasingly more competitive for this business.

Who are the players in hotel financing?

Essentially, lenders can be categorized as either portfolio lenders or conduit lenders. The former represents the traditional lender who originates the mortgage loan and holds onto it on the balance sheet through the maturity of the term. On the other hand, conduit lenders or Commercial Mortgage Backed Securities (CMBS) lenders will originate the commercial mortgage with the intention of securitizing the loan and arranging it into asset pools, which are classified into different bond classes, with the final aim being to sell these pools to investors in the open market. Traditionally, portfolio lenders have been the primary players in the hotel lending market, however the usage of conduit lenders has continually increased and they now play an important and competitive role in long-term hotel financing.

Lending institutions such as national banks have traditionally been very conservative with hotel financing due to the perceived associated risks of a hotel operation. Factors that made lenders hesitant included the typically large amount of the loan, the relative unfamiliarity of a hotel investment compared to other commercial properties, the hotel market’s high sensitivity to external economic factors, and the fact that hotels were viewed more of a business as opposed to real estate. This was particularly true when it came to financing new construction. New construction of a hotel was definitely viewed as a higher risk and more speculative than the purchase of an existing hotel with a positive cash flow history. A borrower would most likely look at several separate lenders to finance the project at different phases of construction. This alleviated risk for the lender and made it more likely that the project would be financed.

However, with the accommodation industry proving to be a lucrative and extremely active market with its continual expansion and investment, lenders have become more competitive for this business in recent years. This has resulted in lower point spreads, higher loan-to-value (LTV) ratios and more flexible terms. Some people in the industry claim it is typical to see pricing in the range of 200-250 basis points over the corresponding Bank of Canada rate, which is on average 100 basis points more than other commercial real estate backed mortgages. LTVs, which were once 50%-55%, have increased to 65%-75% as lenders have become more familiar and confident in the hotel market in general.

In negotiating terms, mortgage lenders may drop the point spread and increase the LTV depending on the client’s relationship and financial status. Personal guarantees are almost always required and the lender will be seeking to expand services provided. For this reason, it often makes sense to approach the lender that handles the hotel’s day-to-day banking needs first. A 1% placement fee is typical on the principle amount of the mortgage.

What are lenders looking for when it comes to hotel financing?

First the lender must identify the type of hotel property they are looking at. Unlike other real estate investments, hotels range in size, type, and cash flow sources. Furthermore, there could be different ownership and management structures, which result in different lending terms. Here is a simplified breakdown of typical hotel properties found in today’s market:

Full service hotels – These are properties that offer a full range of facilities including food and beverage outlets, fitness centre, pool facilities, meeting rooms, and possibly a business centre and gift shop. Full service hotels have several income sources, thus lenders often see them as less risky because they offer income diversification. If not already flagged, most lenders will insist on a national chain before providing financing. LTVs up to 70% are available, although 65% is typical.

Limited service hotels/motels – These properties are primarily reliant on room revenue for the majority of their income. On-site facilities and amenities may include a breakfast room (complimentary breakfast offered with room), business centre, and in-room amenities such as a kitchenette. Overall, limited service properties are typically the most efficient of accommodation properties providing the highest net profit levels and a safe mortgage risk. A national franchise will likely be required by most lenders. LTVs up to 75% are available, although 65% is typical.

Beverage hotels – Beverage hotels are properties that have a strong food and beverage component that generates the majority of their revenue. There are some rooms available on-site, however, in this case they are considered ancillary to the main operation, which would be the food and beverage component. Typically the food and beverage facilities are liquor establishments such as pubs, nightclubs, and lounges. For lenders this property type is less desirable, commanding LTV maximums of 50% with higher interest rates. This property type is often not flagged and represents a high lending risk due to the large degree of non-realty business value. Lenders prefer that the non-room revenue sources are leased out to a third party.

Resorts – Resorts are basically full service hotels with more expansive on-site facilities including a larger health centre, full service spa, usually more upscale food and beverage facilities and perhaps larger banquet space. Location is the key to their definition as resorts with backdrops ranging from the mountains in Whistler and Sun Peaks to waterfront locations such as the Okanagan and Tofino. Resorts are considered somewhat higher risk with LTVs of near 50% and a slight premium in terms of interest rates.

Strata/quarter shares – These properties are sold as part of a strata/quarter share ownership structure, which basically allows for individual or proportionate share of the unit. There is typically a rental pool, which allows hotel management to rent out rooms. This structure is popular in resort destinations where many people would want to regularly visit, such as Kelowna and Parksville. Financing for these property types closely resembles typical residential loans, however, some lenders prefer not to lend to these property types because of the rental pool structure. LTVs and interest rates will be dependent upon the individual’s personal financial circumstances. Some developers offer short-term cash flow guarantees, however, most lenders pay little heed to the project’s incentives to purchase.

In general, the lender is looking for certain key elements, regardless of the type of property being considered:

Financial Information – Typically a minimum of three years of complete financials showing the hotel’s cash flow is required. The client must provide the lender information to support that they are solvent and the investment is sound. The lender wants to see that the hotel is in a good financial position with positive cash flow, or at least experiencing a positive trend with their cash flow. This is especially important for new hotels that may not be showing positive cash flows yet. Therefore, it is crucial for the lender to see that there is a definite positive trend and that growth is being experienced. A budget and/or proforma may also be required.

Location – Lenders will look more favourably at a property located in a busy metropolitan city than one situated in a quieter rural town. Hotels are extremely sensitive to traffic levels and business activity, therefore it is more likely that the same hotel would perform better in a metropolitan city as opposed to a quieter town. Furthermore, the economic status of a region in general will influence the lender. For this reason, Vancouver is always going to be a preferred lending environment for properties. The further your property is located from the city of Vancouver, or similar metropolitan city, the lower your LTV will be and the higher your interest rate will be.

Flagship/Branding – Is the property operating under a well known brand? The lender would be more confident in lending to a hotel that was operating under a well known flagship/franchise versus a non-flagged hotel. The flagging gives the lender confidence, knowing that the hotel has a strong marketing program with greater market exposure. It also provides some guarantee that the property’s physical condition will be maintained and meets a required standard consistent with the associated brand. In general, a franchise arrangement will result in a higher LTV and a lower interest rate.

Client relationship – The relationship between the client and the lender is an extremely important factor in the negotiation of mortgage terms. The lender is more inclined to work with a pre-existing client that may have other business with the bank than a new client. The lender has more incentive to offer competitive rates and terms on the hotel mortgage in order to keep the existing client happy and more importantly keep their business at their bank. Depending on the status of their existing accounts with the bank, the lender may be able to offer more favourable point spreads, longer mortgage terms, and even higher LTV ratios.

Client background – The client’s existing business could also sway the lender in either direction. For instance, if the client had several other solvent businesses that could cover the hotel debt, if there were to be particularly poor year, then the lender would be more confident to lend. However, if the other existing businesses were considered to be risky or continually “in the red”, the lender would be less inclined to lend as they could be considered as a money drain on the hotel. Of course, the client’s overall reputation is a key factor in the lender’s overall willingness to work together.

Hotel revenue sources – A hotel with diversified revenue sources is most attractive to lenders. Higher income sources could offset the lower sources during weak periods, essentially reducing risk in terms of overall cash flow.

Market value appraisal – Lenders will usually require an up-to-date market value appraisal by an accredited appraiser (AACI).

Other steps – The borrower should also be prepared to commission an environmental study and possibly a survey, depending upon the location and lender requirements.

If you’re considering purchasing a property or expanding/upgrading, be sure to do your homework first, understanding what commercial lenders are looking for, to negotiate the best deal possible.

 

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