Anyone who has secured a commercial loan is familiar with the formal process referred to as Know Your Customer or “KYC.” Lenders request due diligence materials on a potential borrower to develop, among other things, a comprehensive understanding of their overall business focus, track record and operational expertise. This practice helps lenders assess whether a borrower can fulfill their debt obligations. I encourage hotel owners to engage in a similar, albeit informal, process of their own — reverse KYC — particularly in today’s lending environment.
The arrival of the generalist lenders
The number of groups extending credit to hotel owners has increased in recent months. While more capital is generally a positive signal for the industry, many of these new entrants are "generalist" lenders who move in and out of the lodging sector depending on the prevailing capital market conditions. For a sponsor, it is critical to understand why these groups have arrived, how they influence the current lending environment and how they have behaved in previous cycles when conditions turned murky.
Over the past few years, generalist real estate lenders have faced increased competition in their target markets, principally in multi-family and industrial sectors. As the supply of debt capital in those sectors increased, rates to borrowers compressed, along with lender returns. In search of higher yields, these lenders have looked toward other real estate asset classes and rediscovered the hotel industry.
This influx of liquidity puts downward pressure on rates. Not only is more capital available, but these newer entrants generally have lower yield expectations compared to the hotel industry’s incumbent lenders. The interest rates being offered to multi-family and industrial borrowers are significantly lower than those to hotel owners. As a result, generalist lenders can offer rates to hotel borrowers that are (i) higher than those in their target market, fulfilling their desire for higher returns, and (ii) lower than those being offered by incumbent hotel lenders. This dynamic has led to overall rate compression, which, on the surface, appears to be a tremendous surplus to hotel owners.
Hotels are unique
The appeal of lower borrowing rates is obvious. The only way a borrower truly benefits from tighter rates, however, is if the lender remains a steady, predictable partner from origination through maturity. Due to nightly leases and the heavy operational component, a hotel investment is inherently more intricate than investments in warehouses or apartment complexes. Additionally consider the variety of project types borrowers undertake, whether it’s new development, brand conversion or heavy property improvement plan (PIP), the "journey" to the end of a business plan often looks different than initially underwritten.
A borrower must assess whether their financial counterparty understands and has experience with the unique characteristics of hotel investing. The borrower’s assessment will help it determine whether its lender will act as a collaborative partner or a rigid adversary when challenges arise. Lenders observe how borrowers react to adverse environments. Savvy borrowers should learn how prospective lenders have reacted to the same.
Lessons from the past
Generalist investors have visited the hotel sector in prior cycles. However, when times got tough, many found that asset-managing a hotel loan was more involved than managing a "rent-roll" asset class. In the past, this lack of subject matter expertise has led to rather immediate "de-risking" by lenders looking to cut their losses. This behavior has manifested in several ways:
- Funding hurdles: Advancing committed funds to complete critical projects, such as construction or PIPs, may slow or stop entirely.
- Loan sales: Lenders may sell the loan, sometimes without the borrower’s knowledge.
- Aggressive restructuring: Lenders may opt for changes to key terms and conditions including securing additional collateral.
When a lender enters the hotel sector simply because the returns on their alternatives are temporarily unattractive, they may just as quickly abandon the sector when realizing returns takes more effort. At that point, the initial rate benefit the borrower received becomes irrelevant.
Your reverse KYC checklist
The benefits of partnering with a lender who understands the nuances of hotel investing may outweigh the basis point savings offered by a generalist. To ensure you are partnering with an experience hotel lender, consider asking potential lenders the following:
1. Portfolio consistency: What is the size of your hotel portfolio, and how has it expanded or contracted over the last decade?
2. Asset expertise: What is the specific hotel experience of the credit and asset management teams? Do they have seniority and tenure with the firm?
3. Historical behavior: Have you sold hotel loans in the past, and under what circumstances?
Conducting a reverse KYC process is about ensuring the lender and terms you sign up with will be with you throughout the life of your current project and those in the future. Conduct one to increase your confidence in your lender’s background, capabilities and approach to handling things when the winds shift. It will reveal the character of your financial counterparty.
Ankur Shah is the chief financial officer of Access Point Financial, a $3 billion hotel-focused real estate credit firm.
The opinions expressed in this column do not necessarily reflect the opinions of CoStar News or CoStar Group and its affiliated companies. Bloggers published on this site are given the freedom to express views that may be controversial, but our goal is to provoke thought and constructive discussion within our reader community. Please feel free to contact an editor with any questions or concern.