Hotel Finance: A new era for interest rates
Written By
James Salford
Partner
UK
I'm a partner in our London office, specialising in real estate and hotel finance, both in the UK and internationally. I have extensive experience of advising lenders and borrowers in relation to a broad range of real estate assets on senior debt, mezzanine debt and preferential equity transactions.
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For anyone who started their working life after 2008, the notion of base rates of 5% seems inconceivable, yet from 1694 when the Bank of England began publishing the base rate until 2008, interest rates averaged around 5% and have been as high as 17%.
The interest rate rises we have seen over the last 12 months both in the UK and in Europe were perhaps inevitable and the reality is that we are potentially returning to an era of interest rates more closely aligned to previous long-term norms. The rate rises have had a significant impact on transactional activity in 2023 and are likely to have a significant impact on the hotel market in 2024. As rates across Europe continue to move over the next 12 months it will create both challenges for existing hotel owners with debt finance but will also create opportunities for investors. Here we will look at the challenges facing hotel owners with debt finance and the likely opportunities for investors as we move into 2024.
The impact of the interest rate rises has impacted some hotel owners immediately, but many owners have financing arrangements which benefit from fixed rate arrangements or interest rate caps and so will only notice the impact when their existing deals expire. As most hotel facilities are for between 3-5 years, we are likely to see owners facing up to increased debt costs for the next few years as they come to refinance their existing arrangements. To give some sense of the challenge facing owners, a hotelier with a £20m debt facility in early 2022 would have been paying interest at a rate of around 5.5% with an annual interest cost of £1,100,000. That same facility today is likely to have an interest rate of 8.5% and an annual interest bill of £1,700,000. Apart from the obvious reduction in the economic returns existing owners will be getting on their investment, the additional interest costs are resulting in a substantial number of financial covenant breaches in financing arrangements as meeting interest cover covenants at the higher interest rates has proved challenging. This has resulted in some lenders asking owners to make capital repayments to bring loans back into line with interest cover covenants (in many cases even after the lenders have softened the covenant levels) and those owners looking to refinancing their existing facilities are likely to be offered a lower debt quantum than their existing facility, meaning that they will have to inject a significant amount of new equity in order to reduce their loan facilities. For those owners with a portfolio of hotels but no additional equity, it is likely to mean disposing of individual assets in order to raise the capital to sell down debt and so there may be opportunities for investors, although transaction values in 2023 would suggest that we will only start to see this on a significant level in 2024 and beyond.
The challenging interest rate environment has in some ways been mitigated by the fact that, unlike in 2008, lenders have for the most part provided very conservative levels of debt to the hotel industry and to date we haven’t seen a material collapse in hotel values (although there is a significant bid - ask gap for those deals that do come to market). Therefore, whilst the ability for Borrowers to service debt has become much more challenging, lenders have taken a very benign approach and have on the whole supported Borrowers through the rate rises. Having said that, as rates stabilise it will become apparent which Borrowers are able to survive in the higher interest rate environment and which deals have longer term structural problems and we anticipate that lenders will become more proactive in managing those Borrowers with issue to refinance or sell assets.
The other significant difference to 2008 is that the market now has a much wider range of alternative lenders willing to lend to the sector, many of whom are willing to lend at higher leverage levels which can bridge the gap on a refinancing. That will however come at a higher cost.
Finally, although the strong RevPAR performance across the hotel industry over the last 18 months has gone some way to covering the additional costs faced by Borrowers, there is also a much greater unknown for the hotel industry, which is how the rise in interest rates will impact on homeowners and their discretionary spend on travel and hotels. If EBITDA levels begin to fall away as a result of a wider economic downturn, then the market is likely to become much more challenging as a combination of reduced EBITDA and higher costs of debt will almost certainly see a fall in value.
It looks like the industry faces a challenging 2024 but is also likely to present opportunities for those willing to invest in the sector.
The impact of the interest rate rises has impacted some hotel owners immediately, but many owners have financing arrangements which benefit from fixed rate arrangements or interest rate caps and so will only notice the impact when their existing deals expire. As most hotel facilities are for between 3-5 years, we are likely to see owners facing up to increased debt costs for the next few years as they come to refinance their existing arrangements. To give some sense of the challenge facing owners, a hotelier with a £20m debt facility in early 2022 would have been paying interest at a rate of around 5.5% with an annual interest cost of £1,100,000. That same facility today is likely to have an interest rate of 8.5% and an annual interest bill of £1,700,000. Apart from the obvious reduction in the economic returns existing owners will be getting on their investment, the additional interest costs are resulting in a substantial number of financial covenant breaches in financing arrangements as meeting interest cover covenants at the higher interest rates has proved challenging. This has resulted in some lenders asking owners to make capital repayments to bring loans back into line with interest cover covenants (in many cases even after the lenders have softened the covenant levels) and those owners looking to refinancing their existing facilities are likely to be offered a lower debt quantum than their existing facility, meaning that they will have to inject a significant amount of new equity in order to reduce their loan facilities. For those owners with a portfolio of hotels but no additional equity, it is likely to mean disposing of individual assets in order to raise the capital to sell down debt and so there may be opportunities for investors, although transaction values in 2023 would suggest that we will only start to see this on a significant level in 2024 and beyond.
The challenging interest rate environment has in some ways been mitigated by the fact that, unlike in 2008, lenders have for the most part provided very conservative levels of debt to the hotel industry and to date we haven’t seen a material collapse in hotel values (although there is a significant bid - ask gap for those deals that do come to market). Therefore, whilst the ability for Borrowers to service debt has become much more challenging, lenders have taken a very benign approach and have on the whole supported Borrowers through the rate rises. Having said that, as rates stabilise it will become apparent which Borrowers are able to survive in the higher interest rate environment and which deals have longer term structural problems and we anticipate that lenders will become more proactive in managing those Borrowers with issue to refinance or sell assets.
The other significant difference to 2008 is that the market now has a much wider range of alternative lenders willing to lend to the sector, many of whom are willing to lend at higher leverage levels which can bridge the gap on a refinancing. That will however come at a higher cost.
Finally, although the strong RevPAR performance across the hotel industry over the last 18 months has gone some way to covering the additional costs faced by Borrowers, there is also a much greater unknown for the hotel industry, which is how the rise in interest rates will impact on homeowners and their discretionary spend on travel and hotels. If EBITDA levels begin to fall away as a result of a wider economic downturn, then the market is likely to become much more challenging as a combination of reduced EBITDA and higher costs of debt will almost certainly see a fall in value.
It looks like the industry faces a challenging 2024 but is also likely to present opportunities for those willing to invest in the sector.
