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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22 • February 2018 • Heartland Real Estate Business www.REBusinessOnline.com to the city. The underutilized historic buildings that define much of that ur- ban landscape are part of why people are moving back, and the revitaliza- tion of these assets presents great op- portunities to take advantage of these incentives. I would also advise developers to consider differentiating their product. Is there an opportunity to do some- thing mixed-use or adopt dual brand- ing, which diversifies risk? This could help secure more favorable financing, attract a better operator, and improve the asset's performance. HREB: To what extent has under- writing changed over the past few years for new hotel construction in the Midwest and what are the driving factors? Schick: In the last few years, lenders that have remained in the hotel construc- tion market have generally provided a lower loan-to-cost ratio and charged a higher interest rate. They have also been somewhat more re- strictive with the pro forma assumptions for underwriting. For example, while the market oc- cupancy may be greater than 70 per- cent, the lender will underwrite to a 65 percent stabilized occupancy. So, a lender's required debt-coverage ratio hasn't necessarily changed, but the as- sumptions for the cash flow are more conservative than the current market. Nowaczyk: Costs are certainly up — hard costs, construction costs, labor costs — partially due to rising interest rates. Leverage is down as well. Ear- lier in the cycle, banks were topping out at 65 percent loan-to-cost, but now it's probably closer to 55 percent. Shah: Underwriting is becoming increasingly sponsor-focused. Good sponsors with quality management companies get attention from the lending markets. Senior lenders are maxing out leverage at 60 to 65 per- cent loan-to-cost for construction deals. Lenders are starting to become slightly more conservative in the face of increasing supply concerns. Mez- zanine capital and tax credit financing continue to be available for selective new construction or adaptive reuse projects. HREB: How much weight does the hotel brand carry with lenders? Bolin: Considerable weight is given to the hotel brand (flag). Unbranded projects must have a very strong un- derlying rationale to gain underwrit- ing acceptance. The major franchisers have been consolidating, which has given them even more strength with the lenders who see, with some justi- fication, that the presence of a flag is a type of "warranty" of performance that unbranded projects simply do not have. Shah: Brand remains very impor- tant for the lender's underwriting decisions, unless the hotel is truly a boutique hotel run professionally. In the event a brand is absent from a ho- tel, lenders underwrite 14 percent of revenue for a proposed franchise fee, marketing and management fee. Brands provide a backstop for lend- ers' risk. Lenders focus on a brand's contribution to the top line of a hotel to ensure continued revenue genera- tion even during recessionary periods. Nowaczyk: In general, lenders pre- fer branded hotels. But how much a brand impacts financing depends on where it's located. The brand is less important for a hotel in places like downtown Chicago, Indianapolis or Kansas City, where all major brands are represented and being unbranded or soft branded may be advantageous. For a property in a smaller market, brand becomes more important as the hotel needs the benefit of familiarity to drive business to the property. Banilivy: Lenders are very selective on the types of brands they are willing to lend on. Typically, lenders like to see brands affiliated with Hilton, Mar- riott, IHG and Hyatt, but that is not to say they won't lend on other brands. The right story needs to be there to garner interest from lenders. Smaller lenders are sometimes also emotionally beholden to their ex- perience with a certain brand. Even though a brand may have a great track record, if a lender has had a bad expe- rience with a brand on a deal then the credit committee usually is averse to new loan originations with the exist- ing brand. HREB: Are hotel cap rates falling, rising or holding steady across the Midwest? What advice do you give prospective buyers and sellers? Schick: Over the last year, cap rates have been holding steady following several years of decline. (Some reports show small increases, while others show small decreases.) When acquiring a hotel, the consid- erations have not changed, but with lower cap rates there is less room for error. Thorough due diligence regard- ing CapEx, maintenance and oper- ating expenses are important, as is building in a margin for error. Also, many hotels have been built with TIF financing or tax abatements that benefit cash flow today, but will burn off over time. It is important to value those time-limited benefits cor- rectly and separately when purchas- ing a hotel. Sellers should be making strategic portfolio decisions today. With low cap rates and a good economy, selling can be appealing. Now is a good time to review your portfolio to determine which properties contribute to your core strategy and which should be sold. Shah: Hotel cap rates are directly correlated to the amount of invest- ment activity. In 2017, transaction ac- tivity slowed com- pared with 2016. As a result, cap rates inched up slightly. In 2018, hotel cap rates will hold steady or experience slightly downward pressure because of the increasing cost of con- struction and economic expansion. My advice to buyers is to focus on replacement costs when evaluating hotel purchases, and not to overpay beyond that of replacement cost plus some premium. Also, buyers should not buy strictly based on projections. My advice to sellers is to evaluate re- financing and pulling cash out using a non-recourse loan before selling the hotel. There are very few alternatives available to deploy after-tax capital re- ceived from the sale. Bolin: We see that the best products, such as well-located projects in estab- lished markets, are exhibiting rates of return that are holding in the mid- single digits. Markets like Chicago still demand very aggressive cap rates in the urban core. That said, under- writing on new projects is indicative of tightening underwriting on exist- ing projects as well, which over time will affect cap rates. Banilivy: We expect capitalization rates to rise this year given the grow- ing supply and lower RevPAR growth projections. In 2017, we saw a lot of transactions fall apart because sellers' expectations on price were not in line with the new realities from buyers. In 2018, sellers will be more realistic on expectations, Paramount believes, and capitalization rates will increase. This is great for buyers, as we are ap- proaching equilibrium on pricing ex- pectations between buyers and sellers. We've seen many deals that were dead eight months ago come back to the market due to the buyer and seller expectations becoming more realistic. The best advice we can give our cli- ents is to be patient and wait for the right opportunity. HREB: Will passage of the Tax Cuts and Jobs Act have any impact on the borrowing climate for prospective ho- tel owners and developers in 2018? Banilivy: More than anything, this was a major psychological boost to corporations, individuals and any- body looking for a positive light to point to. Investors will become more encouraged to stay in the market, and they will be open to opportunities that they necessarily wouldn't have been open to 12 months ago. From a financial perspective, most hotels are held in entity structures that qualify for the new pass-through tax exemptions, so there will be some tax benefit to most hotel owners. Shah: We believe this will have a positive impact on the borrowing climate, making it lucrative for bor- rowers to utilize leverage to spend on CapEx and take advantage of the accelerated depreciation. Addition- ally, this will extend the current cycle by at least a couple of years, increas- ing business travel, increasing hotel RevPAR and putting slightly down- ward pressure on cap rates. This will lead to more refinanc- ing activity and investors increasing the supply of debt capital, both in the form of permanent capital avail- able through commercial mortgage- backed securities (CMBS) and bridge capital available through debt funds. Schick: We will spend much of 2018 trying to understand the implications of the Tax Cuts and Jobs Act and look for IRS guidance on interpretation. Nonetheless, I expect that the antici- pated lower corporate tax rate will sustain hotel prices and values in 2018 based upon the improved after-tax yield. Equity will become relatively less expensive since the lower busi- ness tax rate will lead to an increased after-tax income, while the tax benefit of loan interest deductibility will be lessened. Bolin: It remains to be seen what ef- fect the tax act will have. The percep- tions of the Federal Reserve increas- ing interest rates, and/or the hotel cycle hitting maturity probably have as much, or more, potential impact on borrowing than the tax act itself. Nowaczyk: The bill includes signifi- cant tax cuts for so called pass-through companies, which is how most real es- tate businesses are set up. But the ques- tion is what real es- tate investors will do with the savings. Theoretically, inves- tors will have more buying power and could pay more for an asset and still hit their return thresholds, but lower cap rates don't necessarily make for better credit metrics. Lower cap rates mean lower debt yields. Rather than focusing on acquisi- tions, some investors may put their money to work by reinvesting in their existing portfolios. The cycle is long in the tooth and so too are some assets, particularly those renovated at the beginning of the cycle. In addition to increasing NOI, the capital improve- ments could help soften the blow of any downturn in the economy, and leveraging that reinvestment through a refinancing could help achieve those same return thresholds. n Rushi Shah Aries Conlon Capital Michael Schick Q10 I Lutz Financial Services Matt Nowaczyk JLL

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