Heartland Real Estate Business

FEB 2018

Heartland Real Estate Business magazine covers the multifamily, retail, office, healthcare, industrial and hospitality sectors in the Midwest.

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www.REBusinessOnline.com Heartland Real Estate Business • February 2018 • 21 opportunity for Paramount in the full-service realm, as these deals tend to have more challenges and owners can benefit more from the expertise of Paramount's advisory team. Full- service hotels have required renova- tions by the larger brands and more volatility in net operating income, making it much more important to ef- fectively show the value proposition to lenders. HREB: Is hotel supply and demand in equilibrium across the Midwest, or do you see pockets of overbuilding? How challenging is it for borrowers to obtain a hotel construction loan? Nowaczyk: We're seeing solid equi- librium across the Midwest. Chicago has seen a lot of supply come on line, but most of the new product has hit the market already and has been suf- ficiently absorbed. There's been a lot of building in the Midwest, but we haven't seen a negative impact from it. Banilivy: Parts of the Midwest are experiencing an in- flux of supply, and those specific mar- kets are starting to feel the pressure of this new supply. For example, in Chicago the number of hotels currently under con- struction and set to open this year and next is a concern for lenders. However, parts of Chicago are still in need of new lodging accom- modations. We've seen many developers devi- ate from the hotel component or hold off on construction due to a lack of financing. In today's market, lend- ers are becoming more disciplined in construction lending. More than ever, lenders are taking into account spon- sorship experience, liquidity and the ability to complete the project. Many smaller Midwest markets are experiencing supply increases of greater than 10 percent in a one- or two-year period. With RevPAR pro- jected to grow 2 percent annually for the near term, it will take several years for these markets to absorb this sup- ply. We will definitely see RevPAR erosion until demand and rate growth catch up. Bolin: While underwriting is tight- ening, it is also true that the hotel in- vestment market is more liquid than ever compared with previous cycles. Cap rates, which were double digits 10 years ago, are now roughly equiva- lent to other investment-grade prop- erties in some submarkets. Today, strong sponsorship is one of the most important factors in being able to obtain a hotel construction loan. That said, as usual it is the project's lo- cation and its demand drivers that will determine the success of a project. Schick: All construction lending is receiving more scrutiny, and hotel lending is no exception. While eco- nomic indicators remain favorable, metrics also indicate that we are at the top of the market, and lenders are reluctant to risk getting caught with a partially constructed or stabilizing property at the advent of a downturn. Many lenders that have histori- cally favored hotels are pulling back. Nonetheless, construction financing is available. It may require more effort to find the right lender, and the borrower will need to be flexible to respond to more conservative lending terms. Shah: There's a solid equilibrium in hotel supply and demand in most markets across the Midwest. Lenders are increasingly supply-focused, mak- ing the hotel construction environ- ment challenging. Certain pockets of Chicago have an oversupply of hotel rooms, but healthy demand growth and modest supply growth will bring this back to equilibrium. HREB: Are there any markets in the Midwest where there is a notable un- dersupply of hotel rooms, where de- mand is outstripping supply? Banilivy: This is the multi-million dollar question. There were a lot of markets with these opportunities a few years ago, and that is why we are seeing massive supply increases in heavy concentration. The West Loop area of Chicago is a great example. This area on the Randolph Street Cor- ridor had no hotels two years ago. There are now over 1,800 hotel rooms in development or pre-development in this smaller corridor where a few major companies have announced headquarters in the area. In 2015, Google relocated 650 of its employees from River North, which gave the area instant cachet. Since then, many companies have decided to relocate and/or develop new head- quarters in the area. Most notably, McDonald's is currently construct- ing a new $250 million headquar- ters on Chicago's Near West Side. The 608,000-square-foot structure is expected to be complete within six months. Nowaczyk: Indianapolis has a real- ly solid outlook and hasn't seen much supply growth since the JW Marriott opened in 2011. The city has main- tained high occupancy since then, and projections for tourism growth remain strong. Shah: The Midwest remains an in- teresting market, as companies look at the Midwest for growing their distri- bution hubs and developing industri- al spaces. This leads to more business travel, which in turn leads to the con- sumption of more hotel rooms. Markets with favorable tax struc- tures remain attractive for hotel de- velopers. A few markets in particular with noteworthy opportunities in- clude Kansas City, Kansas; St. Louis, Missouri; Racine and Milwaukee, Wisconsin; and selected markets in Indiana. HREB: Is the expansionary phase of the hotel sector at or near the peak of the real estate cycle, or is it past the peak? What advice do you give devel- opers today? Shah: We are at an extended ex- pansion phase of the current real es- tate cycle. Due to some recent fiscal measures, we should have another 24 months of more growth left in the cycle, notwithstanding any shocks in monetary policy (such as interest rates hikes) from the Federal Reserve. My advice to the developers is to carefully evaluate project costs, as building costs have gone up and con- tinue to go up due to a labor shortage and wage growth along with peaking RevPAR. It's important to ensure con- servative underwriting and evaluate projects without speculating there will be a continued increase in RevPAR. Banilivy: We as an industry need to be mindful of the incredible run we've had since the Great Recession. Hav- ing said that, we believe that there are still legs in this cycle and pockets of opportunities. In addition, with the recent passage of tax reform, this should only help our industry moving forward. Developers still need to be pragmatic about how they are forecasting rever- sion values (i.e. sales prices) when their hotels are stabilized, and make sure that RevPAR growth needed to sup- port these exit valuations are realistic. Schick: New hotel supply is slow- ing overall, though in some markets it appears to remain robust. Occupancy, ADR and RevPAR remain strong and still appear to be growing year over year. If you are going to develop a new hotel property, it's important to look long term today. Supply factors are changing. The merger between Mar- riot International and Starwood Ho- tels & Resorts Worldwide has affected loyalty programs, brands and compe- tition. And the impact of shared lodg- ing such as Airbnb is not fully realized or measured. Nowaczyk: Though we may see spreads tighten this year, LIBOR's steady climb over the past 12 months and into the foreseeable future will equate to what is a rising interest rate environment, and that is something developers have to account for in their budgets. Their interest reserves will need to increase. In light of this, developers could consider alternative forms of capi- tal. There are a number of low-cost sources of capital out there, such as historical tax credits, tax-increment fi- nancing (TIF) and the EB-5 program. The Midwest is witnessing an urban revival, with many people returning Wells Fargo Bank NA provided construction financing for a dual-branded Hyatt Place and Hyatt House hotel in the Wholesale District of Indianapolis. HRI Properties is developing the project, which is slated for completion in the second quarter of 2019. Sean Banilivy Paramount Lodging Advisors

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