REPORT FROM THE U.S.—While 2009 would have been the best time to renovate a hotel because occupancy was at its lowest trough and renovations would have disrupted fewer guests, owners also were struggling to find capital at that time. In fact, many were struggling just to make their debt payments.
So now that operating cash flow has returned in most cases, many hotel owners are in the midst of CapEx refurbishings and renovations.
“We’re in the second year of heavy investment in renovations,” said Naveen Kakarla, president and CEO of HHM, which manages more than 110 hotels. “We formed a five-year plan in 2010 when we started to see occupancy stabilize.”
Most brands require franchisees to set aside furniture, fixtures and equipment reserves of around 4% or 5% of revenue for normal expense items, such as new soft goods, new case goods, replacing carpet, etc. Lenders typically underwrite those FF&E reserves into a hotel loan so that, if structured properly, a 10-year, fixed-rate mortgage will provide enough capital that regularly scheduled maintenance is self-sustainable.
But often times hotels require bigger CapEx projects, whether the owner is facing a property-improvement-plan deadline, attempting to reflag or reposition the hotel, or a brand is rolling out a new standard that requires construction.
For example, HHM looked to further enhance the position of the Rittenhouse Hotel in Philadelphia, which was already performing admirably. They suggested the owners add a lobby bar, five suites and update the spa and fitness area. Also, at The Graham Hotel, the newest hotel in Georgetown, HHM recommended the owners shut the hotel down for a year to do “a heavy lift,” including the addition of the only rooftop bar in Georgetown.
Most of the time, larger repositioning projects are embarked on when a hotel’s loan is maturing and the owner is seeking new financing, said Jeffrey Bucaro, senior VP of business development at Aries Capital.
“Let’s say you’re looking for a $7-million loan and the brand is requiring a PIP and let’s assume the budget for the PIP is $3 million. Usually what an operator will do is ask for a $10-million replacement loan to cover the PIP,” he said.
Alternatively, there are specialty financing companies that finance only renovation work, Bucaro said, however it’s “not the cheapest money in the world.”
“You might be looking at an 8% coupon amortized over five years,” he said. “It gets paid off rather quickly.”
Bridge loans also come into play when owners are looking to reposition or significantly enhance their property. Bridge loans, which help take a property from point A to point B, are often the right fit for poor or marginally operating assets.
“Let’s say you’ve got a lower midscale hotel with a so-so flag and you’re going to come in and do more of a substantial renovation,” Bucaro said. “In some cases, the hotel could be shutdown; you might be adding rooms or putting an addition on or you might be gutting the hotel down to the shell for a major HVAC overhaul.”
Bucaro said bridge lenders are much more focused on the “exit,” or how the owner expects to recoup the costs.
“Getting the money back out is what differentiates a lender from a good lender,” he said. “How do I get taken out of this deal in three years? We’ll do the back-end exit analysis.”
Kakarla said most owners he is working with end up dipping into existing reserves or looking to the balance sheet to finance renovations. But for more costly projects, such as adding a tower to an existing structure, “bridge financing is back,” he said.
“Non-recourse bridge loans are one of the most interesting outcomes of the past 12 months,” Kakarla said. “That has paved the way and will pave the way to more value-add positioning.”
Interest rates rising
For borrowers who could secure debt over the past few years, it often came at record-low costs. Over the past few months, however, interest rates have driven the cost of capital up a bit.
In May, the 10-year interest rate swap was at an all-time low of 1.82%, Bucaro said. He lumped borrowers into three categories and detailed the cost of capital for permanent debt just a few months ago. ‘A’-rated borrowers could secure a loan at 180-200 basis points over the 10-year swap; borrowers looking at a select-service hotel with a good brand in a secondary market were looking at 220-240 bps over the 10-year; and ‘C’ properties with a mediocre flag but still solid demand generators were securing debt at 250-270 basis points over the 10-year.
Fast-forward to July, when the 10-year swap broke 3%.
“You’re talking about a 120-basis-point jump,” Bucaro said. “And that’s just what you you’re your price off.”
He said rates in July were 1.2% higher than they were just two months prior.
“In addition, because of uncertainties, the actual credit spreads also blew out and widened,” he said. ‘A’-rated loans previously priced at 180-200 over the 10-year might have widened to 210-230 over and so on.
“If you do the math, the best deal on the best property is much closer to 5%,” Bucaro said. “C-properties are much closer to 6%.”
However, “you’re still talking about 10-year, non-recourse money at low to upper 5s, which is absolutely phenomenal,” he continued. “The bad news is you missed the bottom, but life goes on and you still have great money, so take it and run.”
When looking at bridge loans today, the cost of debt really depends on the scope of renovations. Banks are getting back into the game and they’re offering inexpensive money, around 3.5% to 4.5%, Bucaro said. However, personal guarantees are typically involved.
“Mortgage REITs are doing bridge loans on a non-recourse basis but you’re going to pay for it,” Bucaro he said. “You’re lucky to get something that starts with 5 and might go up to 8%.”