Hospitality Lending Part 4: Eight Best Practices in Hotel Underwriting and Risk Management
By Jeff Nolan
The US Hotel Market is currently experiencing the longest period of sustained growth in memory with occupancy and ADR at historic highs. In most New England markets, hotel performance has paralleled the overall US market. This has led to great opportunities during the past several years for lenders to finance both new and existing hotels.
Cobblestone has put together these 8 “best practices” in hospitality lending underwriting and servicing:
- Establish specific hospitality loan underwriting guidelines and credit policy. No additional comments necessary.
- Have a clear understating of FF&E reserves: Requires the escrow of FF&E reserves of 4.0 percent of Total Revenues for limited and select service hotels and 5.0 percent for full service hotels; (the exception to this would be if a major property renovation has recently been completed).
- Perform DSCR calculations: When establishing minimum DSCR covenants (pre- and post-distributions) and when calculating DSCR in credit approval memos and annual reviews, two distinct DSCR calculations should be performed: (1) calculation in which the numerator consists of the NOI of the property (before reserves and capital expenditures) and (2) calculation in which the numerator consists of Net Cash Flow (defined as NOI less the loan’s actual contractual reserves or the above mentioned industry standard reserve estimates if there are no contractual reserves required). This will enhance the bank’s ability to access whether the operating performance of a specific hotel is adequately supporting not only payment of debt service, but also the estimated capital investment required by the assets to maintain the brand standards and competitive positioning of the hotel.
- Underwriting projections: Hotel operating cash flow should reflect cash flow and DSCR analysis based not exclusively on present revenue levels. They should include a sensitivity analysis that includes occupancy and rate inputs from prior years and especially the periods of downturn.
- It is necessary to receive an annual business plan: A historical capital expenditure history should be requested from the borrower that shows the level of capital investment in the hotel. Experienced hotel managers/operators typically create an annual business plan for each hotel in which they explain the competitive environment of the hotel and their strategy for meeting business goals for the upcoming year.
- Require ongoing and comparison Financial Reporting: Require enhanced financial reporting criteria for hotel loans, including submission of management prepared detailed operating statements (including reporting of occupancy and average rate) within 90 days of year end. In addition, for franchised hotel properties, the borrower should provide their monthly Smith Travel Research reports on a semiannual basis. For OAEM or substandard loans operating statements should be required on a quarterly basis (in addition, statements should include the prior year comparable period for comparison purposes).
- Anticipate and fully understand the anticipated costs: Underwriting of franchised hotels should include, to the extent possible, an analysis of the franchise agreement and the anticipated cost of the next Product Improvement Plan (PIP) with discussion and monitoring of the borrower’s strategy to fund the PIP.
- Before renovations get review the full plan: For a renovation/repositioning/turnaround, borrower should provide a business plan with detailed semi-annual projections and assumptions supporting the post-renovation projections of the hotel.
If you have questions or concerns about hospitality loans we would love to chat with you more. Our credit underwriters are experts and can provide assistance and guidance through building or updating your hospitality lending guidelines.