More lenders are tempted to take the plunge despite sector’s volatility, reports Al Barbarino.
Resorts are a highly cyclical segment of the real estate market, their success and profitability more dependent on weather conditions, the economy and geopolitical factors than any other type of commercial property.
Be it a sun-filled coastal property or a mountainous ski lodge, resorts are highly profitable when such conditions are favourable, but highly susceptible to losses when they are not. Like a surprise snowstorm, swings in profitability can be almost instantaneous as a result of shifting, interconnected weather patterns.
“I was working on a resort deal in the Caribbean and the general manager said: ‘It’s amazing, as soon as the snow hits the [US] Northeast and Midwest, our bookings immediately jump’,” recalls Kevin Davis, a JLL executive vice-president who raises capital for resort owners and developers.
Instances of heavy snow might bring that manager plenty of new crowds and profits. US ski resorts rejoice at such times, but the adverse impacts of bad weather – or a lack thereof – can be devastating. Without snow you can’t ski; without sun you can’t sunbathe; and a faltering economy and its impacts can sink any resort into deep water.
As the US economy nearly collapsed during the recession the “AIG Effect” was coined after American International Group spent $440,000 to send executives to a luxury resort just days after receiving an $85 billion cash infusion from Congress.
Embarrassment caused by the incident put the broader problem of companies continuing to send top staff on lavish excursions during periods of great hardship for average Americans under the microscope. To avoid looking foolish as many Americans lost their jobs, companies cancelled such getaways for management and top clients. The impacts on both domestic and foreign resorts lasted for years.
“That had an adverse effect on a lot of luxury destination resorts,” Davis says. “But that effect has worn off and companies are saying: ‘Our guys are doing really well, let’s go ahead and send them on a trip to the Ritz Carlton in St Thomas’.”
Highly cyclical markets
The most cyclical of commercial real estate assets include beach resorts and ski resorts. Within those categories are degrees of cyclicality that make some riskier than others. For instance, a beach resort in New England is even more cyclical than one in South Florida, as the region has a much shorter period of acceptable beach weather.
A deep underwriting analysis goes into any decision to lend on these assets, with a plethora of considerations coming into account that are not the norm for most other commercial real estate assets.
The returns are significantly higher than those on other asset classes – even higher than hotels in major cities’ top tourist districts, experts say. But they generally carry much more risk, and those risks are built into the loan structure.
Resorts are typically financed with floating-rate loans, structured with an investment-grade piece, then B-notes and perhaps mezzanine that will be sold off into private placement. “Resorts are apt to use floating-rate markets because cash flow can fluctuate more than other lodging properties and generally these changes in cash flow correlate to Libor-based debt,” says Mark Owens, head of hospitality for CBRE Hotels.
“Especially in a rebounding economy with discretionary income increasing, the benefit of resorts is that they can change and adapt very quickly. In a downturn, staffing and offerings may be reduced and in upturns owners can really capitalise on flow-through efficiency created by streamlined operations.”
Owens notes that the correlation between GDP, Libor, discretionary spending and resort property net operating income is very strong – much more so than with more year-round assets. “In good times, when the market is recovering, you have a lot more flow through, which is a huge benefit when Libor increases,” he says. “In a down market, Libor can drop dramatically, which cushions an owner’s debt service payments.”
In the current economy, this means lenders view resorts favourably, with particularly robust liquidity coming from Wall Street investment banks, debt funds and mortgage REITs, experts note.
These groups are drawn to the lodging industry’s strong fundamentals and high returns. Between 2014 and 2015, average revenue per available room (RevPAR) for all US hotels – urban, suburban, interstate, airport, small metro/town and resort –
was up 7.2 percent, and up 7.3 percent for resorts alone, according to a report from CBRE-owned PKF Hospitality Research.
Resorts logged the strongest performance after suburban and urban hotels. PKF-HR anticipates that the sector will enjoy above-average RevPAR growth through 2018.
“The employment and income forecasts we rely on to prepare our estimates of future lodging supply, demand and average daily rates (ADR) remain strong,” says R. Mark Woodworth, senior managing director of PKF-HR, in the report. “The probability of a downturn in hotel industry performance remains remote.”
During periods of expansion, US lenders also become more willing to lend on assets in resorts off the US mainland, Owens notes. As the economy started to improve after the recession, Wall Street investment banks, funds and REITs began flooding into these foreign destinations.
“Caribbean properties are often financed by overseas banks, many of whom own local lenders, because they are often the cheapest and most willing to lend because of their local presence and their understanding of the market dynamics,” Owens says. But when the market rebounds, other groups move in – like the conduit market that has been financing resorts not just in US markets but overseas as well.”
In one notable large transaction, Deutsche Bank, Morgan Stanley and Citigroup led the August 2014 CMBS deal BHMS 2014-ATLS Mortgage Trust, which priced $1 billion of securities backed by a single loan secured by the Atlantis Resort hotel in Paradise Island, Bahamas.
“A lot of financing is driven by a search for yield amid more competition across other asset classes,” Owens says. “If you compare a resort market versus a Midtown Manhattan hotel, there’s a spread premium. Whether it’s 25, 50 or 100 basis points all depends on what’s going on in that particular market.”
Strict underwriting standards
The underwriting standards on resorts tend to be stricter than for other commercial properties and hotels, so leverage levels are frequently lower and the debt yield is typically higher. Cash reserves are typically structured into the deals.
“You have to structure a lot of reserves to even out cash flow throughout the year,” says Robert Russell, Greystone’s head of CMBS production. “Those debt service reserves and cash flow reserves will cover you when it’s not ski season.”
Most lenders originate loans on resorts at up to 70 percent loan-to-value ratios and most owners aren’t objecting. “If you push leverage beyond 70 percent it gets pricey,” says Mike Nash, head of Blackstone Real Estate Debt Strategies. “Most owners don’t want the incremental leverage at a higher price, because they figure they are probably better off having less debt if something were to happen in the economy.”
Travel routes are an especially important part of the underwriting analysis, particularly for destination resorts Americans travel to from the US. When the economy slowed, some carriers stopped services to Puerto Rico, for instance. If you’re lending on Hawaiian resorts, you want to analyse the Japanese economy, as Hawaii is a popular tourist destination for the Japanese.
“In destination hoteling we need to be aware of airlift into the market, so the first level of analysis is which carriers service that market and whether any are looking to expand or contract there,” Nash says.
The underwriting analysis will also take into account things like different tax laws, insurance in the event of a natural disaster, and energy and freight delivery costs that are included in the operating expense analysis.
In the Caribbean, for instance, utility costs are comparatively high because resorts lack the infrastructure to deliver them in a cost-effective manner, something “we take for granted in New York City”, Nash notes. “When building hotels in remote locations, you often import materials and labour to build sophisticated parts of the property.”
These intricacies mean resorts can be the most rewarding asset class in the best of times but the most daunting in the worst of times. Lending in this area requires rigorous underwriting and a deep analysis of the property, the sponsor, the location, the weather, the economy… the list goes on.
However, much like lending on any other asset type, there is no rule book etched in stone, so ultimately, experts say, the rationale to lend or not lend becomes much less technical. As one lender puts it: “You just have to go with your gut.”