Jones Lang LaSalle Hotels

07/13/2001  

Real Estate in a Slow Motion Economy

By Anwar Elghonemy
Jones Lang LaSalle Hotels
Miami office

The high-tech craze of late 1996 to March 2000 left real estate an all-but-forgotten asset class.  Now, investors are interested once again in real estate as an asset class that holds its own while stocks and bonds suffer, as a refuge in a slow motion economy. 

In 2000, real estate securities returned 26.8%, while the S&P 500 and NASDAQ indices fell by 9.1% and 39.2%, respectively, exhibiting the quality of property as a defensive asset class.  While most other asset categories continue to dip, the real estate sector managed to return 0.8% for the period ending May 31, 2001, while the S&P 500 composite indicated a decline of 1.6%.

Unlike stock and bond markets, where large amounts of publicly available information can change sentiment instantaneously, investors in real estate have usually provided capital despite underlying market conditions.  In fact, U.S. real estate markets continued rising after the stock markets crashed in 1987. 

As an asset class, real estate is generally detached from other investments, but increasing demand from investors in quoted real estate securities (both debt and equity) has introduced transparency into a previously un-transparent market, allowing the sector to respond to shifting market conditions almost as quickly as markets for securities.  This is also due to the increasingly public-market arena in which real estate is acquired, sold and financed at the property level.

The most recent data from Standard & Poor’s brings to light that in the first quarter of 2001, delinquency rates on commercial mortgage loans (repayments of interest and principal more than 30 days late) reached close to 1.1%.  At first glance, this rise suggests that borrowers are not receiving the rental income necessary to repay their loans, but it is well below the peak in the last recession of 6%.

Demand for better loan information has risen considerably since 1998, when Russia’s default on government bonds sent tremors through the debt markets.  The market for commercial mortgage backed securities (CMBS) dried up quickly, and when it resumed, investors demanded more lucid information on loans behind large CMBS issues.  In addition, demand for more and higher quality information has prompted the rise of sophisticated techniques to monitor market conditions by real estate investment banks, such as instant-feedback, E-mail-driven investor sentiment surveys.

Focusing on the lodging sector, although there has been a slight fall in demand for hotel rooms across the nation, it is important to be aware that demand for lodging space was so strong in 2000, it was obviously unsustainable, so some attrition is warranted.  It is more likely that the demand drift-off represents so-called “demand shock,” as hotel guests are becoming increasingly cautious and cost-conscious. 

Data on delinquent hotel loans from 1991 to 2000 indicates that default rates decreased in the past 10 years, and the lodging industry is positioned conservatively in terms of debt, so that any further slowdown in the economy should have minimal impact.  In other words, hotels are not the real estate gambles they are considered to be by most ratings agencies.  According to Salomon Smith Barney and John B. Levy & Co., hotel delinquencies have jumped from 1.39% at the end of 2000 to 2.31% for the first quarter of 2001, which is still very low compared to the high of 16% in 1992.

  Source: Standard & Poor’s, the Lodging Industry Mortgage Report, Salomon Smith Barney and John B. Levy & Co.

The debt service coverage ratios, now averaging nearly 1.5 times, are high and the leverages are around 65% of value.  In addition, capital expenditure reserves of 5% make the overall risk profile much lower, while improved operating efficiencies by hotel companies in recent years have made the most tangible difference in their ability to tap into cash flow to pay debt service.

In today’s jittery capital markets, and apart from private equity/entrepreneurial sources, there is still financing available for strong properties with strong sponsorship.  For the most part, lenders are not usually concerned about the spreads and lower interest rates.  Rather, what sparks the deal-making process is basically whether the deal shapes up as a strong one or not.  Nonetheless, if interest rates keep declining, there should be some straight refinancings occurring, provided that the assets involved have the underlying ability and resources to cut the deal.  Regarding capital tailored toward new builds, renovations or repositionings, such lending decisions will always be made on a case-by-case basis.

Alternatively, a hotel investor may have the opportunity to acquire another investment, and is considering refinancing an existing hotel to take advantage of the opportunity.  Throughout, the fundamental question must be asked: Does the present value of the savings (benefits) exceed the costs of refinancing?  In terms of hotel debt refinancing, and especially in light of the lower cost of money, it is worthwhile to be aware of the following very basic tax rules.

1. Costs of placing a mortgage against a hotel are not deductible in the year paid.  They must be amortized on a straight-line basis over the life of the mortgage as a deduction against ordinary taxable income from operations.  If a hotel is sold (or refinanced) prior to the maturity, the unamortized amount is deductible in the year of sale (or refinancing).

2. Borrowed money is not taxable income.  Therefore, the net amount of equity liquidated as a result of refinancing is not taxable income.

3. Prepayment penalties are deductible as interest in the year of sale (or refinance) against ordinary taxable income from operations.

Looking ahead, a change in hotel financings is expected to occur in 2004 and beyond, when the majority of loans reach an age that enables mortgage holders to refinance.  Starting in 1994, the majority of hotel loans were made through conduit vehicles, which had restrictions on refinancing for 10 years.  When 2004 arrives, many of those loans will probably be refinanced and leverage levels should decrease.  Even then, there is little reason to expect that underwriting standards will be eased, as that would jeopardize the originator’s ability to resell the loan in secondary markets.

The Achilles’ heels of real estate are too much debt and overbuilding – the former is under control and the latter has subsided considerably.  Weighing all variables equally, it appears that to be truly diversified in today’s nervous and confused capital markets, investors would be unwise to overlook the real estate sector.  That would be accentuated since the opportunity cost of not benefiting from lesser volatility and appreciation of invested principal is much higher in 2001.

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