Debt Funds Lead Hotel Construction Lending

Debt funds are the most active lenders in hotel construction financing. Los Angeles currently has the highest level of new hotel construction in the country, and with a higher tolerance for risk, debt funds are well positioned to take advantage of the activity.

“Debt funds have and continue to be more aggressive than their banking counterparts. Debt funds are generally comfortable with higher leverage and have an elevated risk appetite relative to traditional construction lenders,” Malcolm Davies, principal and managing director at George Smith Partners, tells GlobeSt.com. “Typically these debt funds have promised their investors a higher yield and as a result are forced to lend on higher yielding deals—these deals are, more times than not, higher leverage hotel construction deals.”

However, traditional lenders are still active in the hotel construction space. “If the deal can support a lower leverage loan, Banks and lower risk private debt funds are extremely active,” says Davies. “Banks do not get as high in the capital stack, usually capping out around 60% and can include recourse. The limiting factor is the developer’s financial wherewithal and if they able to support the rigid constraints required by the lender.”

Overall, hotel deals are higher risk than more traditional asset classes. Multifamily and industrial deals continue to get more attention from lenders. “Generally lenders are less comfortable underwriting/lending on hotel construction for a number of reasons. First, operating a hotel is a complex and detail oriented business and hiring the correct operator is 50% of developing a successful hotel,” says Davies. “At its core, operating a hotel is daily business that can change, for better or worse, in a matter of weeks.

In addition, hotels are more susceptible to economic changes, making them higher risk than other asset classes. “Foot traffic into hotels is largely dependent on the greater macro economy,” says Davies. “If there is a recession or a health crisis, there is a high likelihood that there will be less occupied rooms in the near term.”

To hedge against the downside, lenders typically offer lower leverage on hotel deals and often have more constraints, like recourse and lock boxes, according to Davies, compared to other asset classes.