BOUNCING BACK

Lenders are back in the hospitality game

BY MARK KAY, CFO CAPITAL

As the world approaches the one-year mark of when the hospitality market re-opened, it’s encouraging to see how quickly Canadian operating metrics have bounced back to 2019 levels.

Given the pace of recovery and overall strength of the industry, the good news is that a majority of lenders including Canadian, European and American banks, as well as Credit Unions, trust companies and Mortgage Investment Corporations (MICs) are now back in the market, offering much-needed liquidity. This is particularly helpful in facilitating new acquisitions, re-financing, and the long-overdue Property Improvement Plans (PIPs) that were postponed during the pandemic. Additionally, the demand for new construction is thriving and there is liquidity for that side of the sector provided that take-out financing, based on stabilized NOI assumptions, and the valuation is equal to or greater than the cost. There’s no question demand exists for new product in certain markets across the country, and as construction costs start to come down and valuations remain strong, we will see new product being built.

One of the key factors that drive credit decisions for lenders are valuations. Historically, the approach for valuations for hotels was a combination of an Income Approach analysis and a Direct Comparison approach based on recent trades. However, due to the lack of comparable trades over the last few years, the Direct Comparison approach can be more challenging to apply. Currently, with the improving performance of hotels, lenders are increasingly turning towards utilizing the Discounted Cash Flow (DCF) method, which considers the long-term performance of the property. Based on the current outlook for the industry, higher values per key are being seen today in some areas compared to 2019 given stronger ADRs and optimistic views on the continued recovery of demand.

Another important aspect for lenders is the debt service coverage ratio (DSCR). This ratio measures the hotel’s ability to cover its debt obligations, and lenders are focused on projections and ensuring that the DSCR meets their requirements, especially in this high-interest rate environment. In fact, interest rates between institutions can vary depending on their source of capital, and lenders are offering rates in the range of six to nine per cent for three to five-year fixed rates.

Capitalization rates, which have a co-relation with interest rates, are another aspect that lenders consider when valuing hotels. However, cap rates factor in other variables such as the geographic area, urban versus secondary/tertiary, quality of the asset, and whether the hotel performance. Despite the strong gains in performance, the challenge with focusing only on current “going in” cap rates is that current income levels being capitalized are still below what would be considered “stabilized” levels. Investment surveys typically quote rates applicable to stabilized levels, therefore cap rates should be applied to the “stabilization” year. It has been encouraging to see, given 2022 performance of hotels improved due to the strength of the market, that lenders can analyze the trailing 12 months and assess whether it is stabilized depending on the life cycle of the asset and other factors mentioned above.

Reported below are stabilized cap rate ranges by Colliers. Despite current financing costs, investor interest remains strong, which despite higher interest rates and softer economic outlook, has put competitive pressure on capitalization rates for quality assets that come to market. The hospitality sector is amongst the few sectors where inflation hedge returns are still available as ADR growth is above inflation.

While real-estate capital looks for yield, the accommodation sector in Canada provides a source for higher risk adjusted returns than other asset classes. That said, lenders recognize the volatility of the hospitality sector and therefore require a greater level of due diligence prior to issuing funding commitments.

In conclusion, lenders are now back in the game, providing much-needed liquidity to the hospitality industry. They are focusing on valuations, DSCR, STR reports, ADR rates, cap rates and interest rates to determine the best course of action. The industry is bouncing back, and with the right support from lenders and stakeholders, it has the potential to thrive once again. ◆