US private equity players, Asian capital from mainland China and Middle Eastern investors are all checking into European hotels.
“A consistent undercurrent of growth is pushing excitement generally in the sector, as people are able to underwrite income growth,” says Mark Wynne-Smith, JLL’s global head of hotels. “They were reluctant to do that in earlier years.”
The debt market has also thawed, making acquisitions and refinancings easier. “It was hard to get debt in secondary markets 12 months ago, but now there is a choice of local lenders and alternatives,” he says.
“A lot of funds and insurance companies have gone into this space because there was a void left by UK and Irish banks that were very active prior to the downturn.”
However, funding hotels is a fine art, as many real estate lenders discovered to their cost in the financial crisis. “Hotel and commercial real estate lending are different things,” says Peter Denton, head of European debt at Starwood Capital. Starwood not only provides funding, but is a major hotel operator in its own right.
Few branded hotels now have fixed-rent leases. Instead, operators run hotels for owners under 30-year-plus management agreements, typically getting a base fee (around 3% of gross revenue), plus a percentage of operating profits. The owner handles maintenance, capital spending and employee costs, receiving all the profit. There are also hybrid arrangements.
Says Denton: “We focus on management, business planning and the way a hotel is run. For example, are results driven by the market getting better or management doing something to improve the hotel? We want to focus on businesses driven by the latter, as they create inherent protection for you as a lender if they add value. If you’re just riding the market, it is a different story.”
Christof Winkelmann, head of Aareal Bank’s hotels team, adds: “You need to understand where cash flow is going and the impact of new construction, conference cycles, airport arrivals, or, for example, the Olympic Games.”
The hotel industry has its own metrics, such as revenue per average room rate (RevPAR) and average vacancy rate (AVR). Earnings before interest, taxes, depreciation and amortisation (EBITDA) help gauge the impact of a downturn.
“In a down market you still have minimum fixed costs to run a hotel,” Denton says. “In a market doing really well, rising room rates and occupancy levels go straight to your bottom line. So swings in EBITDA can be extreme. That’s the nature of the beast.”
Branding is also crucial. Denton says key questions are: “Is it a flag? Is it franchised, managed or leased? Is the hotel’s vacant position possession value greater than the incumbent flag, and will that flag be around for two, five or 10 years?What are the contract terms allowing you to replace an operator for poor performance?”
Lenders are reluctant to talk about the nitty-gritty of loans, claiming each deal is a unique blend of location, management and real estate. It is true that hotels don’t lend themselves to cookie cutter financing, but they generally command higher margins than office or retail, which is the risk premium for volatile income. Plus, there’s an extra dollop for the lender’s expertise.
Redefine International recently refinanced a UK portfolio with a six-year senior loan, priced at 227.5bps over Libor.
Know-how is needed
“You get a higher margin, but need more know-how,” Winkelmann says. “You need a large network, to know where the industry is going and to constantly look at data. The costs are higher; you need a team.”
Senior debt loan-to-value ratios also tend to be lower, in the 40-60% range. “In a very business-driven, stable city with a good location, you might go a bit higher,” says Winkelmann.
Wynne-Smith adds: “Senior LTVs are creeping up to 60% and mezzanine costs falling significantly. If you’re looking for 5-10% on top, there are a lot of willing mezzanine lenders for the right assets.”
Denton believes that while “some aggressive lending might be starting, I feel the market overall is pretty sensible”. But he also points out: “Hotels are not just about rooms.” Starwood has just provided £99m in a two-year, floating-rate loan for a new W hotel being developed in Amsterdam.
“We try to understand their business plan not only with regard to rooms – realistic average daily rate, occupancy levels, the ramp-up and cost base – but also things like the food and beverage of restaurants, their branding and how they work.”
Winkelmann says: “Clients need a bank that understands hospitality, and that it goes in cycles. If something goes wrong, some lenders might pull the plug and take over. But we’re not in the loan-to-own business.”
The next challenge, according to Denton, “is not distress but doing something new. In Holland we’re backing a fantastic operator with a huge track record. He’s very happy with his financing, but what he wanted to do is in a more rarefied market than might have been a few years ago.” ■
Cross-border capital seeks European stay
“Europe is the number one target for crossborder capital,” says Mark Wynne-Smith, JLL’s global head of hotels. “We’re in a good place, having more acquisition capital than product.”
EMEA investment will grow another 20%, to $16bn this year, JLL predicts, with first-half transactions already at $8.5bn.
JLL’s latest hotel investors’ sentiment survey found them “extremely confident” that trading performance will accelerate. “Things are improving,” says Christof Winkelmann, head of Aareal Bank’s hotels lending team. “Construction has been limited, demand is ramping up and numbers are slowly improving. That’s a very healthy mix.”
Investors’ EMEA average leveraged return requirements fell 100 basis points in the half year to 12.7%, well below the 15.5% long-term average, JLL says. Their enthusiasm has pushed yields to an all-time low of 6.8%.
London and Paris are below this, at 5.3% and 5.8% respectively. “As assets there are so tightly held, secondary markets have been getting more attention,” says Wynne-Smith. “There’s more confidence of income recovery in Madrid and elsewhere in southern Europe.”
Starwood plays on both sides of the sector
Starwood is a big player in hotels, both operating and financing them. Starwood Hotels and Resorts has eight up-market brands, including Sheraton, Westin and Le Meridien; it owns, operates and franchises hotels.
Starwood also lends on hotels via US mortgage REIT Starwood Property Trust and, in Europe, Starwood Capital and Starwood European Real Estate Finance (SEREF).
“We tend to focus on one-off hotel situations and occasionally, as with the Maybourne financing, a small collection of hotels,” says Peter Denton, head of European debt at Starwood Capital.
“Portfolios of budget hotels, for example, are interesting, but you don’t see them very often.”
SEREF goes beyond senior debt into mezzanine and doesn’t stop at pure investment lending; the W hotel it has funded in Amsterdam is a former telephone exchange being redeveloped by STAG Europe.
“Our mortgage REIT has a large exposure to hotel lending generally and one of the things we benefit from is that we have very strong in-house experience that assists us in evaluating hotel lending projects,” says Denton.
Aareal explores beyond Europe’s big cities
Aareal Bank’s eight-strong hotel team works with its country offices in three continents. Head Christof Winkelmann describes the bank’s €5.3bn portfolio as well-spread and “very granular”.
“We are active in Paris, New York, London, but are looking at other cities and opportunities. Everybody likes the glossy five-star assets in the best locations, but those don’t necessarily deliver the best risk-adjusted return,” he says.
Last year, Aareal originated €2.2bn of hotel finance, 21% of its new business, and hotels make up a similar proportion of its balance sheet.
As a pfandbrief bank, senior debt is Aareal’s focus, mostly lending to single four- to five-star hotels in major European CBDs. But it can go wider on portfolios and considers three-star hotels on a portfolio basis. Winkelmann says it does not fund development: “It’s difficult to project a new-build hotel. As balance-sheet lenders we have to live with loans for a while!”