Imagine a world in which interest rates are the lowest in decades, lenders’ treasuries are bulging with cash looking for a home, and your hotel’s net operating income is looking pretty good, pulling away from the worst months of last year and making your mortgage lender crack a smile when she looks at the positive outlook on your debt coverage cushion (which my not have existed a few months ago).
Now imagine that these hotel lenders have almost no new hotels to finance since fewer are being built these days than at any time in the last 10 years. What do they talk about at their weekly project meeting? Apartments? Retail? Office buildings? The answer is usually “show me the numbers.” But their discussion always returns to their first love, hotels, and the buzz of refinancing, which are beginning to show themselves in recent months. The reason for this long standing love affair with hotels is that they have historically provided the highest risk-adjusted returns among different real estate types. So for hotel owners this rare, nearly-perfect line-up of circumstantial “stars” appears to add up to hog heaven for them and their bottom lines. After all, they know very well that company earnings growth is three pronged, depending historically on rooms inventory pipeline growth, operating profits, and financial leverage (including cost of capital).
But all may not be quite so rosy in the eyes of the lenders, who have been spooked by a squirrelly economy and painful stock market, to say nothing of the bad press and defaults in their favorite investment category. Remember, they are uncomfortable at best as visionaries, even in light of solidly improving current bottom lines - so they peer steadfastly at “T12 NOI’s” (the last twelve months net operating income) on refinancing applications. In addition, they have been fortifying themselves against any unforeseen creatures from the hospitality “chamber of horrors” by insisting upon a lower risk profile for the same required rate of return on their investments. These include requiring a higher spread over interest rate benchmarks, taller debt service coverage ratios, shorter loan-to-value ratios, credit enhancements, or a combination of these and other factors.
The mission becomes clear for the savvy borrower despite this apparent belt-tightening: to secure the current bargain basement interest rates now without having to wait another 3-4 months before the disquieting months between September ‘01 and, say, March ’02 are excluded from the T12 NOI calculations (as of the beginning of the fourth quarter of this year, interest rates on a permanent first mortgage for hotels were 50 to 150 basis points lower than a year ago). Can the borrower possibly convince a lender to do a little forward looking based on his steadily brightening T12 NOI’s and improving forecasts? The answer is often “yes” - when these two positives are viewed in concert. The resonance of these two factors is hard to resist if the deal can make it through the lender’s other “gates” (and the account executive has that weekly meeting to think about). When the lender begins to see daylight on your deal based on a passable history and brighter prospects, you are nearing what we call the “Sweet Spot”.
Due to the fact that most of today’s T12 NOI’s fall short of what is required to service the desired loan amount, the key to getting to the Sweet Spot is to creatively compensate the shortfall in T12 NOI in arriving at what is known as the lender’s “Underwritten NOI”. The main premise of the Underwritten NOI is that it reflects stabilized and sustainable operating performance, not just a snapshot at one point in time during the loan term. In a typical hotel and resort refinancing, loan amount is determined by, among other factors, Underwritten NOI meeting certain debt-service-coverage-ratio (DSCR of 1.50 to 1.65 times) and loan-to-value level (LTV of 60% to 70%).
What can be done when T12 NOI’s do not quite make it to the lender’s established minimum debt service coverage and loan to value ratios? There are a series of steps that should be followed:
Assess or “size” your borrowing prospects based on a worksheet analysis that uses the underwriting criteria of several institutional lenders. This initial “sizing” is an extremely valuable step in finding the Sweet Spot, as it helps identify the potential borrowing/underwriting issues.
Once the underwriting issues are identified, the challenge is come up with alternatives to address these issues before the transaction goes to market. Once a lender has said “no”, it is harder to turn him around to say “yes”.
Here are some of the ways to address these underwriting issues:
-Creatively structure the right "capital stack"- choose among the variety of financing formats and options available.
-Make sure the solutions are "risk/adjusted" - fine tune risk and reward tradeoffs and structure preferences for both borrower and lender.
-Utilize appropriate credit enhancements - if necessary, capitalize on the strengths of the borrower.
It is most important to remember that there is nothing to be gained by delaying the first step. There is a lesson to be learned from the current state of the residential refinancing markets, where early applicants (in what is now a deluge of paperwork) got great deals and latecomers are seeing higher spreads or long delays based on what is now bulging demand facing limited processing resources.
Mark Earle
Emil Iskandar
HVS Capital Corp.
1777 South Harrison St.
Denver, CO 80210
303-758-3100
303-691-3799
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