Author of www.HotelLawBlog.com
7 January 2007
Hospitality Lawyer on hotel finance in 2007. We recently featured our annual expert panel talking about “How will you finance your hotel project in 2007?” Today, I am delighted to present the thoughts of Patrick O’Neal, one of the industry’s’ real lender icons, whether in workouts or CMBS loan production. Patrick has been a great friend and client for more years that either of us probably care to count, but I have always found Patrick’s thoughts, to be unnervingly candid, full of humor and remarkably “spot on” in terms of their accuracy. PNC Real Estate Finance and the hotel world are very lucky to have him! So what does Patrick have to add to the perspectives we have just enjoyed?
For all of our www.HotelLawBlog.com readers, and those who would like to meet Patrick — and our other leading hotel industry capital providers — you will want to join us for the 17th annual Meet the Money® conference on May 3, 2007 in Los Angeles. Sign up now.
The importance of hotel finance.
Debt and equity financing of hotels and hotel mixed-use projects is critical and can be very challenging. Our clients take hotel financing seriously, and so do we. That’s why we host the annual JMBM Industry Outlook Roundtable every January and our Meet the Money® conference every May. With the legacy of 17 years of Meet the Money® conference propelling us forward, and our annual hospitality industry Outlook and Roundtable, we usually have some practical financing contacts and perspectives.
If you are either a provider or consumer of capital for hotel-related financing, this is important. As a provider of capital to hotel projects, contact Jim Butler now to get on the program of more than 100 top financing sources. If you are a consumer of capital, then sign up now for the 17th annual Meet the Money® conference on May 3, 2007 in Los Angeles.
I am greatly indebted to Patrick O’Neal for his participation in our hotel finance analysis for 2007. Patrick is the National Products Manager/Hotels for PNC Real Estate Finance. With more than 25 years of experience in hotels and commercial real estate, he has been involved in hotel management, commercial brokerage, real estate syndication, mortgage banking, loan & REO asset management, and commercial lending. PNC offers non-recourse fixed rate long-term CMBS financing on mid to upper-tier limited service, select service and extended stay, full service, and upscale boutique hotels in the U.S. PNC closed over $445 million of these hotel loans in 2006 and looks to increase that to as much as $600 million or more in 2007. Contact Patrick O’Neal at firstname.lastname@example.org or (913) 253-9623.
Jim Butler: Patrick, you have been through more than one industry cycle as a lender. Tell us what is going on from a capital provider’s perspective?
Patrick O’Neal: In JMBM’s annual outlook roundtable last year, I predicted that 80% loan to value or “LTV” at 1.30 debt service coverage or “DSC” on 30 year amortizations would become “the norm” for 2006. And that has pretty much happened . . . All of those parameters are fairly readily available on higher end product in better markets, but I would have to admit that it is not the norm across the board. For lenders, margins have become very thin with average pricing hovering around the level of 115 to 120 basis points. Very high quality deals are even priced at less than that.
Jim Butler: Please tell our readers why that causes you concern.
Patrick O’Neal: Well, the market perception on this product type is very positive, but it has now been hyped to the point where people on all sides of the equation have lost sight of the fact that hotels are a very unique real estate product. It has become very popular for debt and equity investors — but it “violates” most of the basic precepts of commercial real estate.
Jim Butler: But loans and investments are still being made at a record pace, so what do you see as the consequence of all this?
Patrick O’Neal: You are right that loans are being made at a record pace. The CMBS “rollover” or “takeout” of lender debt, combined with a continuing strong equity market and the introduction of a higher level of recently-constructed hotels will continue to fuel both the refinancing and acquisition financing pipelines. I would not expect much further compression of spreads, with notable exceptions for trophy assets. The question is whether or not we have the self-discipline as an industry to avoid the same mistakes we made in 1998 — when “underwriting” became a non sequitur or oxymoron. Greed and fee income became the driving force behind lenders’ decision-making in approving loans.
Jim Butler: I remember the 1998 market very well. At our Meet the Money® conference in May 1998, Larry Shupnick made some opening remarks on how “It doesn’t get any better than this!” And, unfortunately, he was prophetic! It couldn’t have been a more accurate prediction. Please remind us about the loans made in 1998, Patrick.
Patrick O’Neal: If you check the default rates for deals done in 1998 versus any year thereafter, you can only conclude that something “strange” happened that year. Just ask special servicers — they have been scratching their heads trying to figure out what in the world the underwriters and lenders were thinking when they made some of those loans!
I don’t know what caused the problem.
Ignorance or stupidity? “Everybody else is on the hotel band wagon, let’s jump aboard — we’ll figure it out as we go?”
Greed? “We need this deal to make our bonus, so make it work.”
Ego? “The production levels are so high and the rating agencies and B-piece investors are so busy, this loan will likely just slip through?”
Or something else?
The answer probably is: none of the above and all of the above. Just like a defaulted borrower, sometimes good lenders do strange things under unusual circumstances. Some of those loans were probably the result of a pervasive production wave over a very short period of time by an entire industry.
Jim Butler: Do you think we seeing a repeat of this epic?
Patrick O’Neal: Future trends will depend on the individual situations, egos and common sense — or lack thereof — of the mortgage banking and borrowing community. Consider this scenario: someone underwrites a loan based on next year’s “forecasted ADR” and an optimistic (or some might say “imagined”) increase in occupancy. Such optimistic projections are usually accompanied by a miraculous improvement in expense controls. But with these favorable assumptions, a loan can “underwrite” to an 80% LTV and 1.30 DSC like clockwork.
Oh, I forgot to mention that loan being underwritten is a 5-year deal with 3 years interest only.
So not only is the actual LTV probably closer to 90-95% or higher on an actual or historic basis, but the reality check on DSC showed almost no real DSC even at the “interest-only” level. This is a time bomb. Some of these loans will ignite. With a partial interest-only loan, there are now two “refinance” thresholds and scheduled potential events of defaults (instead of “just” maturity), because this hotel has to meet ALL of the forecasts just to meet the ridiculous minimum DSCR underwritten. What we now have is a deal that is essentially a 3-year deal with a 2-year grace period. The amortization may not be fast enough to keep pace with a market that reverts to higher interest rates, 25 year amortizations and 70-75% LTV.
Jim Butler: Earlier in the 2007 Industry Outlook Roundtable discussion, Mark Lomanno, President of Smith Travel Research, said that we will likely see the first $100 ADR in the history of the U.S. hospitality industry. How do lenders react to that information?
Patrick O’Neal: Lenders depend on good appraisals of properties, and appraisers are struggling considerably in this market. They are simply not used to seeing a market where the ADR is rising so rapidly and is so much larger than the averages shown in the HOST report or PKF Trends. So, some try to apply the same expense ratios that those reports show for a hotel at a $75 ADR to one which is demonstrating a $115 ADR. As a result, they may miss the actual value of the hotel by as 30% or more. Once a hotel has surpassed breakeven and moved into the profit zone, each additional $1 of ADR achieved can produce more than almost 80% of profit that flows through directly to the bottom line (after management and FF&E reserves). The result is that while the some line item expenses will increase, the actual expense ratio will drop as gross revenues rise, sometimes significantly. This requires the appraiser to cross check the expense ratio against the POR and PAR standards, at which point it is much easier to accept the lower expense ratios.
Jim Butler: And how do appraisers deal with the value per room?
Patrick O’Neal: For those appraisers stuck on the concept of value per room as a basis for their sales comp conclusions, I would submit that that analysis and concept is not coincidental with the investment analysis which occurs in a rapidly accelerating market. The only hotels being sold — or receiving financing primarily on a cost per room basis — are run down, turnaround opportunities where the total cost of a renovation and re-flagging results in a cost that is well below replacement cost. However, strongly performing quality assets are not being sold or bought on a “price per pound” basis. At this stage, the cost of bread is only limited by the amount of pleasure derived from purchasing the bread. These assets are being bought based on YIELD — with cost per room only being viewed as a secondary consideration. It doesn’t matter whether that is a prudent or rational approach. It is the reality of what is going on.
Jim Butler: But don’t appraisers also rely on information from lender interviews?
Patrick O’Neal: Yes, but you have to wonder who are the sources for this! By far, the vast majority of long-term non-recourse hotel loans being done today are being funded by the CMBS industry. So, how is it that the surveys that Korpatz and others provide, continuously indicate maximum amortizations of 20 years (once in a while 25), with maximum LTVs of 65-70% at interest rates clearly 100 to 150 basis points higher than market? Who ARE these people talking to and why are they providing this invalid information to the entire appraisal industry, only to confuse them?
Jim Butler: What will it take to get back to more accurate appraisals and more prudent underwriting?
Patrick O’Neal: At our current levels, it won’t take a “tornado weather forecast” to disrupt the environment. A slight increase in the wind velocity caused by any one of a myriad of outside influences, or an unexpected change in the direction of the wind, could be enough to flip one of these oak trees we call hotels on its side. At 80% LTV and 1.30 DSCR, there is not much room to wiggle and the weather change may create a change in the barometric pressure of these hotels to the point where the meter is in risk of bursting.
Jim Butler: You and I have been around long enough to know that bad loans can seriously derail some highly leveraged borrowers, even when their projects are sound. And of course, these loans come back to haunt the lender that made the bad call in the first place.
Patrick O’Neal: True, but bad loans aren’t just bad for greedy lenders and foolish borrowers. They affect the entire industry. The biggest concern is that somebody will make a loan, probably a large loan, which will be so ridiculous that it will create industry-wide criticism of the hotel underwriting standards across the board. The loan will get kicked out of a Wall Street securitization and the lender will lose its shirt on the deal. But the very concept that it was presented will put both the rating agencies and B-piece investors on heightened alert. It will make it that much harder for everyone else to deal with them on more prudent hotel loans — loans that might otherwise not receive any negative response.
Jim Butler: So what should lenders response be to these market conditions?
Patrick O’Neal: The opportunities in 2007 should be plentiful for both refinancing and acquisitions. The challenges will be to find those submarkets that are not being over-pressured with new construction — a situation we have not faced regularly in recent years. Lenders should look for projects that can actually sustain the income and net cash flow levels that exist not only today, but also are being forecasted for the near future. First it was condo hotels and now it’s water parks…
Jim Butler: Those funding opportunities could be for the next generation of hotel-enhanced mixed-use properties — something way beyond condo hotels and water parks. We are involved this kind of next generation project, with hotels that enhance shopping centers, sports arenas, residential developments and casinos. We see this as a significant trend, with opportunities for both lenders and developers. Thanks for your sharing your perspective, Patrick. See you at Meet the Money® in May!
One of the most interesting challenges I have as a hotel lawyer is helping clients get their deals done — at every stage of the “hotel cycle.” That means working with top people like you. It means providing a gateway of hotel finance — the bridge between providers and consumers of capital. We facilitate the flow of capital with our legal skill, hospitality industry knowledge and ability to find the right “fit
” for all parts of the capital stack. I look forward to continuing to work with you all in 2007 and beyond!
Getting consumers and providers of capital together.
It is so ironic. Consumers of capital think that they have a problem. And they do. They have to find a suitable capital source or their deal will not go forward and be successful. But providers of capital have a problem too! They have all this capital from investors that they need to deploy on good projects, or they won’t be able to provide the returns they need.
The quandary is: How do consumers and providers of capital meet and find the appropriate partner? More often than not, it is fairly random, particularly in specialty financing as for hotel product. Sometimes it is a referral process, which can be good, but often referrals are not much better than random selection. You can hire a mortgage broker, and that can be very helpful if you find the right one who will take your deal and treat it with the importance you attribute to it. But how do you meet and explore any of these opportunities?
If you would like to meet the expert panelists from the Outlook Roundtable – plus representatives from another 100 capital providers — please join us in Los Angeles on May 3, 2007 for the 17th annual Meet the Money® conference.
If you are an ACTIVE provider of debt or equity financing for hotel-related projects, or a consumer of capital, mark the date in your calendar and sign up now. This conference is custom tailored to help providers and consumers of capital find the right match. Many delegates are signing up already to take advantage of the early bird registration and to secure a seat.
If you can’t wait for Meet the Money® 2007, you may want to get a copy of the Directory of Hotel Finance and materials from the May 2006 edition of the leading hotel finance conference in the U.S.
Our Perspective. We represent developers, owners and lenders. We have helped our clients as business and legal advisors on more than $50 billion of hotel transactions, involving more than 1,000 properties all over the world. For more information, please contact Jim Butler at email@example.com or 310.201.3526.
Jim Butler is one of the top hotel lawyers in the world. GOOGLE “hotel lawyer” or “hotel mixed-use” or “condo hotel lawyer” and you will see why.
Jim devotes 100% of his practice to hospitality, representing hotel owners, developers and lenders. Jim leads JMBM’s Global Hospitality Group® — a team of 50 seasoned professionals with more than $50 billion of hotel transactional experience, involving more than 1,000 properties located around the globe.
Jim and his team are more than “just” great hotel lawyers. They are also hospitality consultants and business advisors. They are deal makers. They can help find the right operator or capital provider. They know who to call and how to reach them. They are a major gateway of hotel finance, facilitating the flow of capital with their legal skill, hospitality industry knowledge and ability to find the right “fit” for all parts of the capital stack. Because they are part of the very fabric of the hotel industry, they are able to help clients identify key business goals, assemble the right team, strategize the approach to optimize value and then get the deal done.
Jim is frequently quoted as an expert on hotel issues by national and industry publications such as The New York Times, The Wall Street Journal, Los Angeles Times, Forbes, BusinessWeek, and Hotel Business. A frequent author and speaker, Jim’s books, articles and many expert panel presentations cover topics reflecting his practice, including hotel and hotel-mixed use investment and development, negotiating, re-negotiating or terminating hotel management agreements, acquisition and sale of hospitality properties, hotel finance, complex joint venture and entity structure matters, workouts, as well as many operating and strategic issues.
Jim Butler is a Founding Partner of Jeffer, Mangels, Butler & Marmaro LLP and he is Chairman of the firm’s Global Hospitality Group®. If you would like to discuss any hospitality or condo hotel matters, Jim would like to hear from you. Contact him at firstname.lastname@example.org or 310.201.3526. For his views on current industry issues, visit www.HotelLawBlog.com.