Ask United Kingdom hoteliers what they believe is the main barrier to development, and the likely answer is the availability of debt.
Debt finance had been readily available over the past decade and a half as interest rates barely rose above zero, but that landscape changed noticeably in 2022. For the past year and a half, interest rates have increased by 50 or so basis points a month in the U.K. as the country’s central bank has sought to slow down or reverse inflation.
The shift has led to fears among hotel owners that they would not be able to sensibly refinance properties with debt set to mature, as the costs of debt increase along with lenders’ increased reticence to risk.
Some economists believe hoteliers and other borrowers need to realize that higher interest rates are here to stay and a cost of business.
There is not a shortage of available debt, but what debt there is comes at additional expense.
On a webinar hosted by business advisory HVS London, Chris Sheppardson, managing director of magazine EP Business in Hospitality, said debt in the U.K. has become both a political and economic concern.
“Debt now … is becoming a global issue. It [globally] totals $42.9 trillion, about twice what it was last year. The world has a major debt challenge, and companies will need to face this challenge. The biggest barrier is the availability of debt finance,” he said.
Hoteliers suggest they don't expect the debt crunch to ease until the second half of 2024, Sheppardson said.
According to the U.S. Committee for a Responsible Federal Budget, U.S. debt will also total $42.9 trillion by 2032, or 116% of U.S. gross domestic product.
Tim Barbrook, head of debt advisory at HVS Hodges Ward Elliott, said economic stimulus will be the way out, but it is not a surprise that every decade or so the real estate landscape experiences a correction, either a shock such as COVID-19 or a macroeconomic event.
The increase in interest rates this time around comes hard on the back of the pandemic, but Barbrook said the two things are connected.
“There has been huge government intervention. In the U.K., the stimulus package equaled £6,000 ($7,741) per person. Printing money causes inflation, and the Bank of England used the only real lever it has, raising interest rates 13 times to the current 5% level,” he said.
Sheppardson cited estimates that £43 billion of hotel debt in the U.K. is set to mature.
“Bankers are actively offloading their commercial real estate exposure, thinking it is better to sell at a loss than to keep bad debts on their books,” Barbrook said.
James Salford, partner in real estate and hotel finance at legal firm Bird & Bird, said the interest-rate scenario has four major ramifications for the hotel industry:
- The fall in asset values will result in challenges to loan-to-value ratios.
- Interest cover ratios will be challenged and breached.
- Many existing deals are now outside of lending mandates.
- Kicking the can down the road, any “extend and pretend” strategy, is not a long-term option.
Salford said credit and investment committees have genuine concerns as to whether interest rates have peaked, with some economists predicting the peak might be 6%, one percent higher than it is now.
Salford said uncertainties around bricks-and-mortar pricing are further complicating the situation.
“The bid-ask gap has led to a lack of transactions and uncertainties over true values,” he said.
Gaps created by this uncertainty have paved the way for a significant number of alternative lenders who are very keen on lending, he said.
Worry Lines
In the U.K., June is the traditional month in which hotel covenants are stress-tested, Salford said. The result is likely to be a wave of breached loan agreements, he added.
“Starting now, more will seep through. ... Those with hedged interest rates will not see this now, but increasingly for them it will come through, too,” he said.
Sheppardson added that “sophisticated borrows are saying to their lenders, we will breach covenant, not because of hotel performance, which is excellent, but due to interest-rate increases.”
Salford said borrowers looking to refinance might be faced with a reduced debt quantity requiring additional equity, mezzanine debt or asset disposals.
“Deals that are over-leveraged, hotels in non-prime locations or assets with challenges — ground rents, under-investment, asylum hotels, new build — will be difficult to finance. Balancing the lender’s need for amortization with the owner’s need for a return on capital will be challenging,” he said.
Barbrook said he doesn’t believe mezzanine financing will provide a solution as many senior lenders do not like it.
“Even at lower levels, senior debt will consume a greater proportion of earnings before interest, taxes, depreciation and amortization, and increased interest rates will see its cost rise,” Salford said.
“Preferable equity deals may become more common, but borrowers face a difficult decision on interest-rate hedging.”
Barbrook said another headache is that capital will remain more expensive in British pounds than it is in euros, making continental assets more favorable than British ones.
Sheppardson said he expects lenders to insist upon debt reduction or the sale of assets, but even if there is some distress, it will be “soft enforcement, rather than formal insolvency.”
He said there will be growth in preferred equity transactions to help better structure deals and reduce risk.
“The position on development finance is complex. There are concerns around [furniture, fixtures and equipment] and [capital expenditures] spend being maintained. Ultimately, higher interest rates are here to stay,” he added.
All of which is leading to there being more exit risk.
Sheppardson said economics will result in a drop in hotel values.
“The maths suggest downward pressure will have to materialize,” Barbrook added.
“We are now in a different world. Interest rates at 0.5%? We are never going back to that world, not in our lifetime,” Salford said.