Mr. Davis

Finance & Investment

Cheap Hotel Debt Capital and the Current Interest Rate Environment

By Gavin Davis, Director, Neptune Hospitality Advisors, Inc.

The U.S. appears poised to be coming out of one of the best interest rate environments of our lifetime, where we saw the Federal Reserve cut the Federal Funds Rate by 500 basis points from 6.00% to 1.00% in a total of 13 rate cuts over 30 months between January 2000 and June 2003. This was done in an effort to stimulate an economy weakened from the dot.com crash, 9/11 and an economic recession (11 of these cuts accounted for 450 basis points of the move in approximately 11 months time), the continued improvement of overall hotel industry and secondary hotel mortgage market fundamentals are fueling high levels of capital into the market. In turn, interest rate spread levels are continuing to compress, which bodes well for borrowers.

Short-term Interest Rates Continuing To Rise

Against a back-drop of relatively benign inflation data (excluding energy and housing), positive signs of economic stability and growth have spurned the Federal Reserve to increase the Federal Funds Rate 175 basis points in the past year from 1.00% to 2.75%. Wall Street economists are predicting further rate increases in the foreseeable future and one of our most utilized interest rate predictors, the forward US Treasury yield curve, supports this generalization, having priced in interest rate increases over the next several quarters. Short-term Treasury and LIBOR rates in the open market have exhibited similar levels of increase as the Fed-controlled Federal Funds Rate. For example, 3-month LIBOR has increased from 1.11% twelve months ago to over 3.12% at press time.

Long-term Interest Rates Give-back on Heels of Rising Oil Prices

While longer-term yields, such as the 10-year Tbill have increased in the past several months, these rates have recently pulled-back as oil prices have reached all-time highs. A consensus of rising rates pervades the capital markets, but the pace and magnitude of such movements remain in question. Some economists have warned that such a rise in oil will prompt the Federal Reserve Board to take a more accommodative stance and perhaps stall interest rate increases by several months if overall inflation remains at bay. While the Fed will never comment as to the definitive length of such a "pause", it could last several months cite some economists. As long as some resumption of a Fed tightening at some point in the future remains on the agenda, which the interest rate markets still indicate, this is a medium- to long-term bullish economic indicator and harbinger of potential rate increases to come.

Precisely Predicting Interest Rate Movements is Futile

While accurately predicting future interest rate movements, especially short-term instruments (durations of less than one year), has proven a rather futile task for economists and market participants over the years, hotel owners as both capital users and "risk takers" cannot help but to measure the current cost (price) of capital against future expectations, partially by virtue of their predilections as buyers-can I buy this product for less tomorrow?

Today's Cost of Capital is Inexpensive

Since 1968 and up to 2001, the 10-year T-bill has only sat below 5.0% once, during the Russian Ruble crisis in the summer of 1998 and punctuated by the blow up of the multi-billion international bond fund, Long Term Capital Management (yield curves were inverted in this period).

The Federal Funds Rate that sits at 2.75% at press time, as an example, has not been below 3.00% since the early 1990s and excluding the period between April 1992 to May 1994 (and then for a period of only a few months) has not been below 4.00% since the U.S. abandoned the gold standard and began to use the Fed Funds Rate as a monetary policy mechanism to control interest rates in 1971. We can not envision the Fed Funds Rate will stay below 4.00% for any continued length of time. However, as with the past year, Fed Funds Rate increases will be consistent and measured in a march towards a more historic level consistent with Fed policy and a steady-state environment.

Today's debt capital prices, withstanding all other costs of financing, are historically compelling for both fixed rate and floating rate debt in our opinion. While our proxies for floating and fixed rate debt, 3-month LIBOR and the 10-year US Treasury bill, respectively have increased over the past six months, spread levels over these indices have continued to tighten.

Indeed, spreads for fixed-rate financing on full-service, quality hotel assets have declined to 125 to 150 basis points over corresponding 5- and 10-year Tbills. Limited-service hotel spreads are priced only slightly above this level. In addition, permanent lenders have become more comfortable with higher loan-to-values (75% full-service, 70% limited-service) in part because of improved macro trends in the hotel industry and in secondary hotel loan performance. Mezzanine loans for the highest quality deals can be secured for as low as 450 to 600 basis points over LIBOR, though generally, this spread level is 800 to 1000 basis points over at leverage levels up to 85%.

How Can I Benefit from Borrowing at those Low Interest Rate Levels?

These low levels of debt beg the question for hotel owners: how can I take advantage of such a compelling interest rate environment? The answer, of course, depends on a myriad of related variables closely linked to the hotel's existing debt, the hotel owner's investment objectives, desired holding period and the current and projected operating performance of the hotel in light of existing and predicted interest rate levels.

We recently have successfully helped hotel owners with seemingly cumbersome existing debt due to large defeasance or yield maintenance costs be effectively restructured in this current environment to take advantage of today's historically low rates. Such restructurings have allowed owners to take equity off the table, lock-in sub-6% fixed-rate financing, lower interest rate payments, eliminate recourse and allow for flexible prepayment. Prudent owners should be viewing today's interest rate levels as an opportunity and analyzing every hotel loan in light of this.

Gavin Davis is Director of Neptune Hospitality Advisors, Inc. He oversees soliciting and prospecting capital sources, the preparation of investment memorandums and proposals, facilitating the due diligence process, financial modeling and evaluation of all potential transactions. He started with CIBC World Markets as a financial analyst. He held positions with Prudential Real Estate Investors and REIT Legg Mason Wood Walker. Mr. Davis holds a BS from Cornell University’s School of Hotel Administration. Mr. Davis can be contacted at 858-964-5675 or gavin@neptuneha.com Extended Bio...

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