Wednesday, March 25, 2009

Hotel Development No Game of Monopoly

So you own Boardwalk and Park Place (or the best respective site for a hotel in your particular locale). And thanks to the credit crisis, interest rates are at rock bottom lows, the cost of materials used in construction have shrunk, architects can turn around designs more rapidly with fewer projects on their plate, and construction companies are bidding each other down for the same reason. All is good in the world of a hotel developer, right?

Um, not so fast. First there is an issue of scale. Regardless of product type, larger transactions are harder to finance these days. Many of the large market players that financed these transactions in the past are out of the game entirely. Most others are choking on their bad debts, and even the better capitalized sources continue to sit on the sidelines playing the waiting game...that is waiting for the economy to hit bottom. There is a universal aversion, both amongst most developers, and certainly among most sources of capital, of being the first one to gamble in terms of purchasing or developing in this market. Why risk buying now if prices will continue to slide? Why risk construction starts when bidding out the project in 6 months might yield cheaper options? And so we wait.

Yet, at least on the hotel development side, many major market players are finding that their smaller projects are actually getting financed, even in today's challenging environment. Projects that require between $10-20M are getting the green light. For example, Concord Hospitality Enterprises recently secured a $13.4 million loan to build a 124-room Courtyard by Marriott in Pittsburgh, a great flag in not the greatest market. So it is possible....

Unless of course you don;t have sufficient equity. Most lenders are looking at LTV's between 55-65% for ground up hotel construction, and that's assuming you have a stellar reputation, track record, project, strong financial statements, and of course high barriers to entry. If the sponsor needs to raise equity to meet these stringent requirements, they can more or less forget about their project for the time being, regardless of project size.

Sightings of private equity for ground up hotel development in the last few months (or foreseeable future for that matter) has been about as rare as a Loch Ness Monster sighting. Private equity firms simply aren't buying into the notion of ground up development when, despite a drop off in construction costs, you can still buy existing product for less than replacement cost. Returns would have to be approaching a ridiculous 50% for firms to start considering a change in this philosophy.

Who would have guessed buying Mediterranean and Baltic was your best bet after all.

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