After a few tumultuous years, hotel financing is back in a big way, but borrowers ready to take the plunge should be prepared to navigate mindfully.
With more buyers chasing assets, values are going up and capitalization rates are going down. There’s more money chasing the financing of those assets, and more leverage is being applied to them — putting pressure on rates. When the rapids subside, hoteliers might see fewer returns and higher leverages on overvalued assets: in other words, they might see a bubble.
Over the past years, overall transaction volume in the Canadian hotel market has been strong. Surprisingly, 2012 saw the highest traditional transaction data ever posted with $1.2 billion changing hands on hotel trades. And, with hotel financing having a direct impact on the liquidity of hotel assets in any given year, those statistics strongly suggest financing is drawing from the very deep end of the pool.
More than ever, hotel transactions are characterized by an emphasis on quality, says Edward Khediguian, SVP, Franchise Finance, with Montreal-based GE Capital. Quality properties, borrowers, assets and relationships are now the focus, with lesser buys relegated to the shallow end. Robin McLuskie, VP, Toronto-based Colliers International Hotels, agrees. “The better the asset, the better cost and terms you’ll get for a financing opportunity,” she says.
This isn’t the first time the industry has enjoyed such excess. Leading up to 2007, there was also a lot of available money along with a loosening of underwriting toward the tail end of the cycle. But that scene was rewritten in the recession that followed, with the dollars not dribbling back into the market until recently. And, although the cost of capital has gone down significantly, the levels of underwriting haven’t loosened the focus on quality, high-level relationships. It appears the stronger both the relationships and the borrowers are, the more access they have to an enormous amount of funds.
Still, financing for construction start-ups was tapped out through the cycle and past the close of 2008. With Loan-to-Value equations (LTVs) clocking in at 50 per cent, because operating results were more depressed during that timeframe, lenders were unable to achieve the ratios they needed and paid cash on a lower-leveraged basis. Some of the major debt providers, the bulk of which are based in the U.S., simply disappeared. Today, money is coming back across the board though, with The Business Development Bank of Canada (BDC) stepping up to provide financing for newly developed and unstable assets in the interim. Traditional hotel transactions have returned to financing at more conventional 55- to 65-per-cent LTVs.
The explanation for this “revised reality” is simple. Indexes such as Government of Canada bonds have been pitifully low, so there’s been a lot of capital parked in cash and low-risk instruments such as treasury bills and GICs, waiting out the next stage of the investment cycle. But investors have been getting anxious because their money isn’t earning them much. The scenario explains the push toward real assets, such as real estate.
The stock market’s recent state of frothiness, as investors pursue yield, has created momentum for the current flow to businesses, or asset classes, that have real assets behind them. And, in the public sector, it’s really the REITs that enable the public market to invest in real estate. That means more REITs have formed and more investment money is flowing into them. “The REIT market in the non-hotel space has exploded in Canada,” says Khediguian. But, because there’s a finite number of REITs and margins for real-estate lending in the traditional asset classes have diminished in the last six or eight months, investors that have typically competed for assets in those fields have moved into higher-yield assets such as hotels. And so, too, have buyers and financial institutions that can’t make money off traditional real-estate classes.
INDUSTRY WEATHERED STORM
And, why not? While the Canadian hotel industry certainly took a hit, along with virtually every other industry over the widespread economic downturn, it’s fared better than most, asserts Khediguian. “There have been very few bankruptcies or stress closures,” he explains. “It’s a relatively stable market.” So, while the American hotel market contracted by 35 to 40 per cent during the dip, its Canadian counterpart might have suffered a drop — at the very lowest point — of only approximately 12 per cent. Khediguian says the market has bounced back, thanks in part to the enormous range of performance variability posted over the cycle and the new efficiencies mid-market operators achieved at its nadir. Speaking broadly, the Canadian hotel industry has demonstrated an impressive survival instinct.
Among the flurry of transactions currently underway, most of the financing is taking place in the middle of the road. Deals valued between $4 and $20 million are getting the most pickup, with fewer lenders chasing assets that exceed the $20- to $25-million mark. One segment that may find financing a bit trickier is the resort sector. “But anything in a market that’s a multi-demand generator, is branded and has ownership that’s breathing, has access to capital right now,” Khediguian declares.
As for who is behind this capital, the marketplace is ripe with many mid-market lenders across industry sectors. The majority of them come from three principal groups: credit unions, regional banks and private institutions. For the most part, private lenders lurk on the fringes of real estate where the more challenging assets or borrowers live largely off the radar screen. But the likes of RoyNat, government-sponsored lenders like the BDC, Canadian Western Bank and ATB are in full flight. The schedule-A banks also have money to lend, but their arrangements are generally based on established relationships. This picture has evolved only recently, when more commercial-backed mortgage securities, public-equity investors and U.S.-based groups were sniffing for hotel assets in these parts. Now, says Colliers’ McLuskie, it’s regional banks and financial firms such as GE Capital that are gaining traction. In the last several months, GE Capital signed on to finance — among a host of private deals — the acquisition of two Alberta properties: the Radisson in Fort McMurray, Alta. and the Hilton Garden Inn in West Edmonton.
THE FUTURE: INVEST WISELY
“Right now is a really sweet spot,” says McLuskie, whose Toronto-based real-estate investment advisory firm is involved in “a bunch of hotel-financing projects.” Still, she advises restraint for both sides of any transaction. “The hotel industry remains a small, specialized industry, and it’s traditionally a small wonderpool,” she says. “Even though it’s strong now, it’s always relatively small. And, while there are lenders coming back, you’re not seeing a ton of new lenders. It’s a harder business to understand.”
The trick, says McLuskie, is for lenders to maintain a conservative underwriting approach and not underwrite massive increases in performance. She advises potential owners in Canada to take a lesson from the negative-equity situation in the U.S. when many deals failed, because lenders forked out more money than the properties were worth. “It’s about making sure lenders don’t over-project the next couple of years of performance,” she warns.
Indeed, agrees GE Capital’s Khediguian, who believes no matter how smooth the waters in the financing pool might be today, with asset prices escalating and cap rates compressing, lenders are investing with an anticipated return that’s balanced over a longer period. “You don’t want to talk about a bubble,” he says, “but that’s always a risk. The whole economy was overvalued in 2007, so it happened. It’s a machine, after all, and every individual investor has to adjust its underwriting policies to avoid getting caught in that.”