The increasing difficulty of construction lending
 
The increasing difficulty of construction lending
26 SEPTEMBER 2016 8:50 AM

Hotel lenders said it’s becoming increasingly difficult for borrowers looking to build new hotels, but sometimes it still makes more sense than buying existing properties.

PHOENIX—There are fewer lenders active in construction financing for hotels, sources said at the recent Hotel News Now Lender Roundtable.

Matt Mitchell, VP of Hall Structured Finance, said his company primarily works in the construction lending space and he’s noticed a shift in the amount of interested lenders this year. He said this can make it difficult to fill out the capital stack for a project.

“Some are finding mezzanine pieces to fill gaps,” he said.

Mitchell said it also allows his company to be a little more selective about what it puts on its plate.

“We’re looking at a few key items,” he said. “Deals put at the front have a good team in place … developers with good track records, good management companies, good architects. If that’s all in place, it goes a long way toward getting a deal done. If some of those factors are lacking or they’re having a difficult time putting together their cap stack, that’s where deals fall through.”

Identifying difficulties
Michael Maguire, managing director of Aileron Capital Management, said part of the difficulty of construction lending is properly gauging risk.

“For us, one of the craziest things I’ve yet to have a clear answer for is underwriting contractors’ balance sheets,” Maguire said. “Everyone wants a guaranteed-best-price contract, but you have no idea what their guarantees are worth. You could have someone build 200 Best Westerns, but his balance sheet looks terrible. It’s a very unique world.”

He said the promises of construction lending are often not met.

“The biggest obstacle of construction lending is that everyone is shovel-ready when they sign the term sheet, (then things fall behind schedule) and all of a sudden it’s $500,000 over budget,” Maguire said.
Neil Freeman, chairman and CEO of Aries Capital, said there are issues facing the construction landscape beyond financing availability.

“There are issues that come in that are governmental,” he said. “There are a lot of municipalities that make you run around from a zoning standpoint. Then you throw in things like affordable housing, and greenroofs, things that are driving up construction costs based on governmental needs.”

Does it still make sense to build?
Mike Muir, EVP of hotel lending at Live Oak Bank, said his company is still bullish on hotel construction.

“We can make arguments all day long that it’s cheaper to build than buy,” Muir said. “That makes for a healthy construction environment, unless you can find assets with good bones, maybe something coming of CMBS or a seven-year run and needs a $15,000- to $20,000-per-key renovation.”

But Michael Watson, director and head of U.S. lending for BMO Harris Bank’s Hotel Finance Group, said it isn’t always that cut and dried.

“The counterargument to building is the uncertainty of cash flow,” Watson said. “It all begins with underwriting.”

Pipeline might be overstated
The lenders at the table agreed that only a fraction of the hotels in the U.S. pipeline—HNN’s parent company STR had that pegged at 529,665 rooms in 4,322 projects under contract as of July—would be completed in large part because of financing obstacles.

Watson said he is particularly pessimistic about how many of those projects will be completed in the next two years.

“I would estimate 20% (get done),” Watson said. “That’s based on the packages and requests I see. … Part of that is I believe sponsors recognize a lot of obstacles to securing financing.”

He said he was still receiving packages in August that promised to be in the ground by June, which he said is an indicator of how long some projects have been languishing without funding.

“I like to see a lot of packages because it gives you insight into just how many flawed projects are out there,” Watson said.

Rick Rogovin, VP of Wells Fargo Bank’s Hospitality Finance Group, said there are a lot of factors that could influence how many projects actually get done, but there is one important factor.

“It all comes down to the cost of build versus buy and if cap rates go up,” he said.

He said the economics need to clearly favor new construction because the relative simplicity of transactions makes them more desirable for lenders.

“It’s easier for us to do transactions,” Rogovin said. “To do a construction deal takes a lot of time. It takes months and months, and in that period of time your money is just standing.”

He said his company is selective on construction deals because of the somewhat limited upside.

“If it’s a really good deal, you get paid off early, and if it’s a bad deal, you have it forever,” Rogovin said.

He said lenders will need to continue monitoring market conditions to see if construction lending makes sense.

“If the EB-5 pipeline dries up, a lot of big projects will go away,” he said. “And if cap rates inch up, people will put their money into buying existing projects or into (property improvement plans).”

But Muir said he doesn’t have any worries about the amount of new supply coming online because it remains below or near the long-run average after a sustained period of mild growth.

“The 2% number is something that doesn’t cause me any concern whatsoever,” he said.

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