By: Jeff McKee
The hotel industry had a near-record year in 2014, and the future continues to look bright. This might be the ideal time to consider new hotel development, and while it’s not as easy as it once was, financing is available for many kinds of hotel construction projects.
What does it take to get funding from a hotel lender for a new development project? Experience, equity and the right kind of projects are the key criteria to secure a hotel development loan.
While it’s possible for well-capitalized developers with experience in other segments of commercial real estate to find money for first-time hotel projects, lenders are most likely to favor developers who have successfully developed and operated a number of hotels. It’s complicated to develop hotels, and it’s difficult to complete projects on time and within budget. There’s no substitution for experience, and that’s what is being rewarded by lenders.
Loans are available for a variety of hotel development projects, but the easiest projects to get done are limited-service hotels with total project costs of $10 million or less.
While most developers want to build properties in one of the top-tier hotel brand families, that’s not always possible due to impact issues. In many cases, it’s getting easier to finance hotels with flags from second- and third-tier brand families because there are limited opportunities to get the top-tier brands. If a market is deserving and requires a new hotel, then it might be time to look at alternative brand families.
If you’re looking for a hotel development loan, expect to put significant skin in the game. Lenders probably want 30% to 40% equity from the developer. That’s a lot of equity, but it’s much better than a few years ago when we were emerging from the dark days of the recession. At that time, if a developer could even find a construction loan, he needed at least 45% to 50% equity.
Lenders also want assurances projects will be completed—hopefully on time and on budget. As a result, recourse loans are pretty standard across the industry. The only way you can get around it is with completion bonds or perhaps cash-related collateral the lender can hold onto in case of a default.
Recourse can potentially roll off when the hotel is open and is a cash-flowing operating entity, but recourse remains an emotional guarantee for the lender that they won’t get stuck with a half-built hotel.
Another possible way to allay lenders’ fears is to obtain some sort of government-guaranteed loan, typically SBA financing. It would be from the SBA 7(a) program, so we’re talking about smaller projects, say $7 million and under. In that case, the SBA is providing an actual guarantee during the course of construction as well as a permanent piece of financing.
Today’s low interest rate environment is favorable for borrowers. Interest rates have remained pretty steady, and most construction loans carry floating rates that will be either prime-based or more likely 30-day LIBOR-based. Spreads are in the range of 250 to 350 basis points.
I’m not worried much about the Federal Reserve Bank raising interest rates, because net-net it would be a positive thing for the hotel industry and developers. Slightly higher interest rates would be a strong signal the economy is growing at a quicker pace, which means RevPARs are going to be going up at essentially the same trajectory as interest rates, if not a little bit higher.
Another key thing if you are a borrower: Be patient and be prepared. You must be ready to have professional and thorough pro formas with all assumptions in place. It helps to have someone who has been in the business to help organize that information. It’s important to know what lenders want and need and to have a concise loan package with all the details they will need to make informed decisions.
A lot of developers have shown interest in new hotel development, but the lending community has been constrained in offering financing. We’ve posed the question to our capital sources as to why they don’t get involved in new-construction lending now before the herd mentality takes over and everyone is throwing money at new construction and it becomes overheated.
We really haven’t really begun to tick up on the construction cycle so overbuilding is not a near-term worry. If I was a developer, however, I would keep my eye on the pipeline and if new development increases significantly I’d consider buying or selling hotels instead of new development.