Hotel development has become more challenging in recent years as a result of a number of factors, with securing development financing at the top of the list of hurdles as traditional banks retreat. As banks remain conservative, do alternative lenders hold the key to unlocking hotel development? What do stakeholders need to consider amid the changing financing landscape? And where does the alternative lender’s interest lie?
Callum Laithwaite, senior vice president at Starwood Capital notes that banks are very capital constrained at the moment, and with some of them trying to shrink their balance sheets and some having to deal with regulatory issues, development lending is being seen as the highest-risk form of lending.
“As such, if you’re a bank, you’re probably looking to tear down your development lending.”
However, he stresses it’s not all doom and gloom as a wide range of alternative lenders have come into the market in the past year.
The rise of alternative finance
“Since interest rates have been hiking and there's been a correction in asset prices, I’ve seen alternative lenders come into the market stronger and bids for development lending in particular have been taken up more heavily by alternative lenders,” he says.
Helena Murano, senior advisor at Arcano Partners says that although alternative lending isn’t as popular in Spain as it is elsewhere, it could be the answer for hotel investors, adding that although it’s more expensive, it’s a lot more flexible than bank financing. Her advice here for investors - particularly hotel owners or smaller medium companies - is to work out the opportunity costs.
“If you're taking on alternative lending which is more expensive than bank lending but is going to be a more flexible loan - is going to give you a higher LTV or a longer grace period - although the interest rates are going to be higher, work out the numbers because the opportunity cost of not doing the investment is going to be higher in most cases.”
Laithwaite agrees, noting “If you think of your opportunity cost on the deal or the relative cost of capital, having a debt profile that's drawn over 18, 24, 30 months isn't actually that costly if you're paying an extra point or two in the margin.”
He adds that in the last 12 months, pricing has converged somewhat as well. “Certainly from our side, on the more core types of loans on income producing assets, we are not very far off at all on the banking spaces as their cost of capital has increased or substantially doubled in some cases.”
What to expect
From an alternative lender’s perspective, Laithwaite says when assessing a hotel development project, underwriting can be very difficult.
“Since the second half of 2021, we’ve seen a lot of construction cost inflation. In addition to that, we’re having to use data that may be around three years old due to the impact of Covid so there’s a lot of triangulation of data. Having to base our calculations on this data requires a leap of faith.”
As a result, he says structures such as uncapped cost overrun guarantees are put into the deals. Milestone agreements can also be added in to ensure timely project completion.
“It's always a negotiation between us and the developer as to how much structure we can get away with. I think recently, we've gotten away with a bit more structure and that certainly been very positive for both parties.”
He adds that the use of key money in deals – trapping as much cash until they’ve completed the business plan – is really important.
On the topic of key money, Hyatt’s vice president development Europe and North Africa, Felicity Black-Roberts says it is playing an increasing role in development projects.
“Key money has become the norm. It went from being something very strategic to every project having key money in it. Also, pre-pandemic, there was never really a discussion about what it was deployed for. Now, it is much more allocated and can help bridge the gap in various aspects of a project, from strengthening tenant covenant to covering preopening costs," she explains.
Murano echoes Black-Robert’s point, affirming the impact of key money from a lender's perspective.
“Key money was a demonstration of the commitment the brand had with the project because we would see certain brands that were very interested in certain locations or certain assets and they would make a very big effort with the key money. And then we would see other projects that were a little bit more mediocre or not so special and they would have less or no key money.
So as a lender and as an analyst of the project, whether or not there was key money would make a difference in the structuring of the loan and then the amount of money that you could actually lend.”
Where they see opportunity
In terms of ongoing development deals and where the value lies, Laithwaite sees potential in lifestyle and luxury products.
“Since we’ve had the base rate hikes, we’ve seen investors wanting to drive net operating income (NOI). And where you can drive NOI in the hotel space is generally in differentiated products like lifestyle and the luxury product. We've seen the ability to drive net operating income in these areas.
We’re seeing people willing to pay up more for a really high-quality luxury product and we're willing to lend on that. We really like international gateway cities as these markets present consistent demand drivers and high barriers to entry,” he adds.
Black-Roberts and Murano also observe an increasing trend towards conversions as opposed to ground up development, especially in the leisure sector.
"Conversions are a lot more sustainable than ground up development. In Spain and France, you essentially can’t do a new development by the seaside. So you either do a conversion or go somewhere else. So it's more likely in my opinion that there will be more conversions than new developments,” Murano says.
Black-Roberts adds, “The deals we’re seeing are primarily conversions. From my perspective, as a brand, when we're looking to do management contracts and franchises, looking at where our pipeline is sitting in terms of what how we're sourcing deals, most of those deals are coming via conversions, not from ground up developments. I’ve seen ground up development dry up very much as a source for deals.”
She notes that where there are ground up developments, they’re often part of something bigger, such as a regeneration scheme which has the backing of a municipality or a local authority.
Looking ahead, Laithwaite forecasts a future where banks become, once again, more involved in development financing.
“We have seen banks come back strongly in the past and I think once this wave of correction and potential balance sheet shrinking has come through, we will definitely see banks come back again.”
For now, Murano says that alternative lending could also complement bank financing, explaining “If the bank can only give you for example, 50% LTV, they might accept a mezzanine or a subordinated loan from an alternative lender to complement the money that you need. So it's really worth looking at. And there are a lot of advisors that could help with this.”
All those quoted in the article appeared on stage at the International Hospitality Investment Forum held in Berlin between May 15 and 17, in a session called: Breaking the Development Deadlock.