CMBS isn’t coming back, the FDIC is putting the squeeze on regional banks, and valuation has gone out the window. What better time for a heated discussion on the state of lending?
Editor’s note: This article was originally posted on 30 March 2010. The article was chosen as part of Hotel News Now’s look back at 10 years of the hotel industry.
ATLANTA—Borrowers would be wise to buckle their seatbelts: They’re in for one hell of a bumpy ride.
This according to Joel Ross of Citadel Reality Advisors during a heated breakout session at the recent Hunter Hotel Investment Conference.
“The reality is that (the commercial mortgage-backed securities) market is a long, long way from coming back,” he said. “… (Merrill Lynch, Lehman Brothers, Bear Sterns)—these are all people who were dumping money in the market like crazy. … All these are the places where a lot of this CMBS money was coming from … All those people are gone permanently. They’re not coming back. … The availability of capital to the market just isn’t going to be there for many years to come.
“Don’t expect a whole lot of money to come back like in ’07, because it’s not going to happen in your lifetime, I can tell you that,” Ross added.
To make things worse, approximately 150 banks are out of business, and another 700 banks are in serious trouble.
“The regulators are all over the rest of the banks that you guys normally use,” Ross said. “They can’t make you loans, and they’re not going to be able to make you loans for quite a while.”
Lending will eventually come back in three to four years, but when it does, it will be extremely conservative: 60 percent to 65 percent loan-to-value ratio, 1.5 coverage on historical cash flows, priced at 300 basis points spread over 10 years with 20 percent to 25 percent amortization, according to Ross.
But conservative terms are not necessarily a bad thing, argued Jim Merkel, president of Columbus, Ohio-based Rockbridge Capital. Before the lending markets spiraled out of control, hotels historically were underwritten at 65 percent LTV with 150 to 200 basis points spread over long-term debt pricing.
The void of debt financing likely will be filled with equity, he added.
“Free markets tend to find a way to make money,” Merkel said. “If there’s a lot of capital and there’s opportunity and we’re growing cash flow, money will find its way into our industry.”
Extend and pretend—stupid or smart?
Ross said extending and pretending is just plain stupid from the owner’s perspective. For example, if an owner bought a hotel in ’06 for US$10 million, and the lender says he’ll extend for two years if the owner puts in another US$1 million, the owner is simply pouring in good money after bad on an asset that’s worth less than the loan. In two years, the capital markets won’t be accommodating, and the owner will have to pay down more equity on an asset that realistically won’t recoup its original value.
The owner would be better suited to pay down US$1 million only if the lender writes down the loan to something more realistic.
But for some owners, extending is the only option, said David Mumford, senior principal of Newport News, Virginia-based brokerage Mumford Company. Such borrowers might have all their eggs in one basket, so they don’t have a choice but to gimp along and hope to play another day.
“I just want you all to understand: All you’re doing is trying to hang on to what you’ve got; you’re not making any money,” Ross countered.
Merkel, speaking from the lender’s perspective, said every situation is different.
“Under (Ross’ proposed scenario), if you can predict the future and you don’t believe in your asset or that you can (improve) your (net operating income), sure, then it would be dumb to put more money into it,” he said. “But that’s not what we’ve experienced in the 18 years that we’ve been actually investing dollars into real deals that have had some volatility to them and need some cash flow modifications in times like these.”
When a lender is invested in the right product with the right management team, then extending the loan can yield dividends when the market rights itself, Merkel said.
Throwing the hammer down
During the discussion on extend and pretend, a panel attendee mentioned that some banks will go after personal guarantees, so an owner has no choice but to extend.
“Bologna,” said Ross. “They’re not going to chase your guarantee.”
When lenders brought borrowers to court to seek those same guarantees during the down cycle between 1989 and 1993, most judges simply threw the cases out, he said.
“Personal guarantees are only there to do what they’re doing to you, which is to threaten you,” Ross said, pointing to the audience member who voiced his concern. “They’re never going to do it. It’s only a hammer guys. That’s all it is.”
Values: ‘A little bit of denial’
Values are down. Correction: Values are way down, said Mumford.
While that’s a big enough challenge in and of itself, an even bigger roadblock to recovery in the transactions market is the unrealistic expectations of sellers, said Tim Dick, senior VP of TriMont Real Estate Advisors, based in Atlanta.
“We still have a lot of borrowers and some of our clients … that are in a little bit of denial on some of these values,” he said. “There’s going to be a big resetting of values as soon as people begin to accept reality.”
And they better start accepting it soon, Ross said. The return of “good ol’ fashioned” conservative lending will require more equity, which means the value has to be less because of the higher cost of capital.
Valuation processes are moot given the lack of activity in the market, the panelists agreed. Until there’s some level of transparency, the bid-ask gap will remain too far to traverse.
“People are going to have face reality and accept that values are where they are,” Dick said. “When you go out and have a transparent process … and let people examine what it is you have, and they make offers ... and know the limitations just as well as you do after they’ve examined it, that’s market value.”