FEATURE ARTICLE, FEBRUARY 2006

LENDING SPECIALTIES
Commercial real estate lending outside the primary sectors is a specialized ballgame.

Hospitality

This past year brought one of the best hotel markets in recent history and one of the most active years in the hotel lending community. Strong lodging fundamentals and a low cost of capital resulted in unparalleled investment activity, as a flood of equity and debt capital influenced the market. The majority of the activity occurred in the Northeast, Southeast, and in California, though this phenomenon was also seen in Midwest markets.

The relative change in the performance of midwestern hotels tracks closely to that of the United States, though hotels in the Midwest tend to experience less dramatic cyclical peaks and valleys due to the region's relatively consistent economic pattern. According to PKF Consulting's fourth-quarter 2005 Trends in the Hotel Industry research, which provides market forecasts, the average U.S. hotel achieved growth in rooms revenue per available room (RevPAR) of 11.2 percent more in 2005 than in 2004. Most analysts had forecast 2005 RevPAR growth to be 6 percent to 8 percent. By comparison, the average midwestern hotel experienced RevPAR growth of 8.2 percent. The region experienced growth below the national average, but most midwestern hoteliers still consider the performance trend to be very positive.

By and large, the midwestern lodging consumer is very brand conscious. While independent properties thrive in large urban locations, cities in the Midwest outside of Chicago are landscaped with nationally recognized brands including Marriott, Hilton and Starwood. This is primarily because the smaller Midwest markets do not achieve high enough demand to support independent hotels, which frequently cost more to build and tend to do better in high-barrier-to-entry markets. In general, today's hottest brands are Marriott's Courtyard and Residence Inn, and Hilton's Hampton Inn (and Hampton Inn & Suites), Hilton Garden Inn, and Homewood Suites. These select-service and extended-stay orientations have been extremely popular among guests, very profitable to owners and more appealing to lenders.

In response to consumer demand for a more lifestyle-centric hotel, recently introduced lifestyle brands such as Starwood's Aloft and Hyatt's Hyatt Place have received significant interest from developers. The market has recognized that the Generation X professional traveler and, likely, its successors, want lodging that fits their persona and style. Courtyard and Hampton Inn have already begun to stylize the brand by upgrading technology, providing quick on-the-go packaged food and beverages, and incorporating more modern design features.

The new brand concepts are well-timed as hotel debt investments remain desirable in the capital markets. Additionally, while debt indices (e.g., U.S. Treasuries and LIBOR) have increased materially in the past year, spreads have compressed to absorb much of the rise in the cost of capital. Hotel debt provides a higher yield than other real estate property types, and despite historically low spreads, lenders believe that there is still an adequate premium for this investment class. Additionally, the capital markets have become more sophisticated with diversification of risk by marrying traunched hotel debt positions with investors interested in the corresponding debt's risk/reward profile, and this should help to keep hotel debt markets efficient. Creative financing solutions remain available to hotel developers and include products such as mezzanine debt and stretched first mortgages. Faced with rising interest rates due to higher indices, investors are finding fixed-rate debt to be more attractive than floating debt, though with an active construction pipeline there should be significant demand for LIBOR debt this year.  

Development activity has increased significantly as existing asset prices have begun to exceed replacement cost.   But, while this wave of new construction is most likely the next phase in the cycle given that the hotel supply/demand relationship is better equilibrated than in the past few years, high construction costs might render many projects infeasible. The lack of new supply during the past few years has been a catalyst for stronger fundamentals, but if supply growth outpaces that of demand, lodging performance growth could slow. That being said, it is widely believed that there will be significant opportunities in 2006 as lodging fundamentals remain relatively strong.

— Adam Valente is a vice president of Columbus, Ohio-based RockBridge Capital LLC.

Healthcare/Senior Housing

Jeffrey Davis, Chairman and President, Cambridge Realty Capital Companies

The entities that most often receive the capital for these facilities also operate under unique requirements. “Whereas for most properties, your tenants are private companies or publicly traded companies, [for specialty senior properties] you are getting paid primarily by Medicaid and Medicare, which are two entitlement programs created by the United States government,” Davis explains. “Making it even more challenging is that each state has its own unique and distinct Medicaid program, which is run totally different than in any other state.” To be an effective direct lender, a company must be able to grasp the nuances, create an infrastructure and understand how the company is going to operate on a state-by-state basis.

Working with federal entitlement programs has its challenges; companies that work with the Medicaid and Medicare programs are scrutinized and heavily regulated. “There is very steady oversight, because you work for the federal and state governments. You are actually surveyed on an annual basis by the state,” Davis says. “If your survey doesn't come out in a certain fashion, until you resolve your deficiency, you can't take in any new revenue.” These regulations require efficient and careful work when originating loans.

The restrictions and guidelines inherent in lending for this product type make for arduous work. “I like to call it a micro-niche,” Davis says. “It's a very unique niche in the world of finance.”

When evaluating projects for potential transactions, the crucial factor in this sector is different from that of the typical product types. “In commercial real estate, everybody focuses on three magic words: location, location, location. In this business, the magic words are ‘owner/operator, owner/operator, owner/operator.' You are really underwriting a business, not the real estate,” Davis says. “That really addresses the crux of the difference between healthcare lending and investing and commercial real estate lending and investing.”

The Midwest senior housing/healthcare market has been performing strongly in recent years. The nursing home business is heavily correlated to the welfare and well being of the states. If the states are prosperous, there is more money to spend on their Medicaid programs. “Since 2000, states have substantially increased their tax revenue and are doing very well as business units,” Davis notes. “So, that has had a very significant impact nursing home markets throughout the country.” Assisted living facilities are performing well of late and the independent senior housing market has done well for a long time. “It is a very positive climate for all elements of the business,” he adds. “And there is new construction starting in a number of locations [in the Midwest.]”

The outlook for the senior housing/healthcare lending market is very good. The region is very healthy and exhibiting signs of strength as the new year takes hold. “The Midwest healthcare market is really a microcosm of the entire country,” Davis says. “The Midwest economy is doing very well.” Growth in this sector in the midwestern states should meet or exceed the level of growth seen in the other areas of the country, as should the amount of new construction.

— Kevin Jeselnik

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