With interest rates not expected to decline until mid- to late 2024, hoteliers are still navigating market conditions that are characterized by a higher debt-cost reality, fewer active lenders, and struggling debt coverage ratios. Further exacerbated by the recent U.S. bank collapse, which has made financing even harder to secure, deals are becoming more difficult to execute from a traditional lending standpoint.
Ultimately, the lending landscape looks very different than it did even six months ago. During the first three quarters of 2022, we saw that deals were much stronger. As interest rates rose in the fourth quarter, we started to see a slowdown that trickled into the first quarter of this year. For hoteliers looking to secure alternate funding sources, there are a few key factors that should be considered to ensure they’re choosing the best option.
Qualifying for a Loan
Before any type of funding can be secured, you must establish financial viability and ensure you’re in the best position to qualify. Aside from the basics of proving your hotel is a viable candidate and painting a picture of profitability, you should make sure you have a thorough grasp of the unique nuances associated with your project. Your business plan should capture a detailed understanding of your market, the competitive landscape, revenue per room available, branding, debt service coverage ratio, and loan-to-value ratio. Generally, the lender will always want to make sure you have a solid plan and can answer questions on profitability, revenue, and payback time frame. Depending on who you are borrowing from, the lender may have additional requirements. For example, a lender may request additional equity, more collateral, or a stress test of the cash flow and profitability of the property under extreme conditions.
In today’s landscape, lenders are far more selective and much more critical of pro formas. Although hotel occupancies have returned to pre-COVID levels, the only piece of the puzzle that is adjusting for the rising cost of inflation is room rates. Ultimately, lenders are taking a closer look at the historical performance of a property to determine whether it has been able to adjust for inflation to sustain itself. For hoteliers, this poses the question of how much they can charge per room before experiencing adverse effects.
Understanding Your Options
Before diving into the different options available, you should also be clear on what you’re looking for, whether it be access to experienced advisors who can guide you throughout your hotel lifecycle or fast access to capital. Knowing these distinctions will help you make the best choice for your individual situation.
For background, the most common route has traditionally been to go through a bank or SBA lender. This option is typically associated with long repayment terms, large loan amounts, and lower interest rates. To secure this type of loan, you’ll need to ensure you have a strong credit history and a track record of successful business in the industry. You may also be required to provide collateral to receive a loan. Both bank and SBA loans tend to be lengthier processes as opposed to an alternative lending route with an SBA loan typically limited to deals under $5 million.
Back in the 1980s, hotel owners experienced interest rates upwards of 18 percent. Although today’s rates are not as high, they can seem especially daunting when coupled with the new valuations of hotels that we’re seeing today. As is the case with any industry, we can expect to reach an equilibrium in the future, but hoteliers should expect rates to stay put through 2024. As you look to secure funding for a new or existing property, it will be crucial to be especially diligent and detailed in your underwriting and to consider alternate funding options.
Alternative Loans: Three Options to Consider
In the current lending climate, deals are harder to execute with conventional lending. Thus, hoteliers can consider alternative financing options such as mezzanine financing, construction loans, and bridge loans:
This type of business loan offers repayment terms that are retrofitted to your cash flow rather than being secured by the assets of your company. Because it ranks below secured debt in repayment priority in the event of default, this option carries more risk for the lender and is associated with higher interest rates.
This loan is generally treated as equity on the balance sheet, meaning it does not count as debt when calculating the debt-to-equity ratio—ultimately making it possible for the company to borrow using other methods.
This is a short-term financing option that is intended to fund a new construction project. With this option, the borrower does not receive the full amount upfront. Rather, the borrower works with the lender to create a draw schedule that outlines the project’s significant milestones and maps draws back to those moments in time. For example, the first installment may be used to develop the land and the next one might come through once the framing is complete. Taking into consideration the skyrocketing prices of development in this environment, this type of loan is becoming more difficult to secure.
This is a short-term financing tool that is generally in place anywhere from a couple of months to a few years. Compared to traditional, permanent financing, a bridge loan has a higher cost but is a much speedier option if you’re looking to secure funding quickly.
You can also use a bridge loan during an acquisition or a rehab, or to buy some time. For example, if you’re looking to buy a building that has a high vacancy, you likely won’t find the most favorable financing terms until that vacancy has been filled. In this case, the bridge loan serves as a tool to improve your property in the interim.