In his recent book Finance and the Good Society, Professor Robert Shiller calls on the financial services industry to return to its role as steward of society’s assets. After a period of irrational exuberance across the entire hotel market, this sounds like a prescient message. But is it really happening?
Over the past few years, governments all over Europe have tried to stimulate bank funding by boosting the supply of money in a process it calls quantitative easing (QE). It’s a tried-and-tested trick of monetary policy, but this time round it has worked poorly. Growth across Europe is stagnant and banks, even with the help of QE, remain in the position that Shiller, a professor of finance at Yale, so rightly feared: unwilling or simply unable to serve the productive economy.
This is, for many reasons, a great shame. By most sensible metrics, the European hotel market is outperforming the rest of the economy. Many of Europe’s major capital gateway cities are performing unexpectedly well.
At the start of the crisis, hotel groups were forced to slash room rates in a desperate attempt to maintain consumer demand, but by 2011, figures showed that European revenues per available room (RevPAR) had grown at a much better rate than the wider economy.
The key to this success seems to lie in the way people relate to travel. Businesses may have tightened their belts, but they still perceive a need to travel, to meet their customers and familiarise themselves with foreign markets. And the same is true
for leisure travellers, if not for slightly different reasons. A recent study by PwC found that consumers are very keen to protect their holiday time and cut back elsewhere.
The mood hasn’t always been this optimistic. For a long time, many of the industry’s key players failed to appreciate just how cyclical the hotel market could be. In the decade before the crash, the industry resisted a number of political and macroeconomic events. But not this time round. Like most industries, the hotel sector has seen a clear dip in trading over the past four years, as well as a recovery that is not entirely uniform.
"When you look at the provincial sector, it still has some way to go," says Tim Helliwell, head of hotel finance at Barclays Bank. "If you adjust current performance to inflation, you can see that these businesses are in a far tougher place than gateway hotels."
As a domestic, GDP-led sector, it’s not hard to see why the provincial market is lagging behind. Problems in the eurozone, and a return to recession in the UK and other independent European markets can hardly help going forward. But long-term prospects still remain good for the hospitality sector and the major gateway cities continue to perform well.
With that assessment in mind, it seems unfortunate that credit markets are so tough. In recent years, debt finance has dried across the sector in a way that has seriously dragged down the wider investment market.
"UK and European banks remain cautious about lending to the hotel sector," PwC’s UK hospitality and leisure leader Robert Milburn states, "and, as a result, there is relatively little new lending. Most of their attention is on refinancing the loan portfolios they’ve already got."
Mark Wynne Smith, global CEO at Jones Lang LaSalle, agrees with that assessment. "It’s very tough securing bank finance for developments and existing hotels," he says. "I think most banks have an allocation for hotels that is a lot smaller than it used to be."
The root cause of the credit crunch is up for debate. For some, tight credit conditions are a natural function of a far broader crisis in bank liquidity. Potential lenders just don’t have enough cash to offer businesses if they want to meet the financial obligations they already have. But that’s not a story Helliwell finds particularly convincing.
"There is liquidity," he says. "There have been a number of large transactions this year and, indeed, at Barclays, we’re lending new money to new customers. It’s not that liquidity is absent, but that banks have become more selective about who they want to lend to."
There certainly seems some truth to this. You only have to look at the mint transaction in December, where over £300m of debt was raised, to find evidence of lending. But the issue of selectivity is certainly pertinent. Without the guarantee of future asset appreciation, traditional lenders are proving unwilling to lend money to unskilled and unknown parties. And that means either robust due diligence on new clients or choosing from a familiar set of large international players.
"It’s clear that the credit markets are favouring those companies and individuals that can demonstrate a very good track record over the past few years," says Wynne Smith. "That makes it harder for new entrances to secure financing, but I think banks would do well to really go back and focus on the fundamentals."
The benefits associated with financing proven brand families can’t be underestimated at a time where banks face such deep uncertainties. Concentrating on the fundamental qualities of brand, track record and location have always been the key to a sound property investment, and now more than ever.
"It was undoubtedly the case that during the boom there was a lot of lending done against assets that were never and certainly never have been able to maintain a standard that could ensure value over the long term," Milburn declares. "It all comes back to the old adage that it’s about a good brand with a good operator in a good location."
Even with these three properties spoken for, lenders remain anxious to get the management and operation of hotels absolutely right. In some cases, being locked into a management contract or a franchise agreement can be bad news if it’s too long term. Most lenders, and indeed equity investors, want the freedom to switch brands and influence the performance of their asset. Often that means lending to a property whose contract is drawing to a close, but it’s also possible through the refinancing process.
"In refinancing, one of the things we’ve seen banks do is put their own management teams in place," Milburn says. "Very often these are people who have worked with other hotels in the past. But it gives the banks additional leverage to ensure that their agenda and objectives are pursued wherever appropriate and relevant."
It may seem perverse to attribute anything positive to a downturn as deep as this, but manufacturing greater creditor control through refinancing can’t be a bad thing for the banking industry.
For most banks, the question of refinancing is really an issue of liquidity. No one wants to sell a distressed asset at a price that creates loss, particularly when the need to maintain stronger capital ratios is being written into law. But sadly, for a lot of lenders that means a simple case of ‘extend and pretend’.
"It’s a case of rolling over the debt and pretending it’s all okay," Milburn says. "For assets in many of these portfolios, it’s hard to see values ever returning to levels at which they will be able to recoup their debt."
That picture of restructuring and refinancing is not entirely fair. Lots of deals made during the boom years, even those that require new loan terms, are likely to maintain their value. And nor is it all doom and gloom in the current investment market. Other avenues of finance do exist even with the capital markets so poor.
"To the extent that investment is going on, people need to look for new, more imaginative sources of finance," Milburn continues. "We’re certainly seeing a lot of funding coming in from international sources, China and India in particular, but also Egypt, Pakistan and Korea. It’s coming mainly from high-net-worth individuals, sovereign wealth funds and family offices. And they’re typically looking to do one of two things: either outright acquisition of individual properties or some kind of equity stake in a larger acquisition."
Those demographics aren’t surprising. These are capital-rich places, with investors who are perfectly willing to lock up their money for longer periods of time if the margins show for it. But they’re not the only source. Slightly closer to home, pension and insurance funds have started to enter the European hotel market. Their precise involvement in still slightly unclear, but some kind of influence is discernible.
"The insurance markets and pension funds are starting to look at real estate," says Wynne Smith. "But there is still a big funding gap in the office retail space, in which these entities have, in the past, tended to invest. I think it’s going to be some time before they reach the hotel space, but it will happen. The needs of the market are pretty great, but as they say, into every vacuum jumps an opportunist."
The way deals are being structured has also changed in the past few years. With debt funding limited, other forms of equity and mezzanine finance are needed to support deals. At the upper end of the market, most deals are being funded with cash, but as the market reaches the middle and budget sectors, that certainly changes.
"At the high end, if the owner is taking on debt finance, it’s likely to be post closing," asserts Wynne Smith. "But if you’re looking at the average term-sheet, you’ve got debt yields of eight times, no more than 50% of valuation and an average hotel spread of above 400."
"In many cases it’s about the deal-doers stitching together a portfolio of different investor types, each sitting at a particular level in the funding structure," Milburn adds. "A structure is being put together that gives an investor a vertical exposure to all those different types of funding."
It’s clear that the way lenders value a deal is also different. During the boom, a whole host of funders were comfortable being loan-to-value driven without necessarily understanding how a hotel is valued. But over the past two to three years, a new focus has emerged with lenders focusing on what multiple of cash they’re willing to lend to a hotel.
None of these changes – either to the mindset or the resources of the financial markets – should cloud the fact that hotels are still a fundamentally attractive asset. The exuberance of the past cycle may have dragged mid and low-performing hotels into a game they could never win, but sound investments do still exist. For the sake of prospective investors, as well as Shiller, it’s now down to finance to play its role, feeding the real economy and, in particular, the sector outrunning it.
This article was first published in our sister publication Hotel Management International.