Borrowers and lenders both enjoyed a fruitful 2017 and US Hotel Advisors predicts that 2018 will be more of the same.
Looking Back at 2017
Most experts predicted that 2017 would be a rough year for commercial real estate lenders and borrowers alike. The “Wall of Maturities” was supposed to come crashing down. The newly-instituted risk-retention regulations were expected to curtail lending capacity and damage liquidity. Both the 10-year Treasury rate and loan spreads were projected to rise. All of this sounds dreadful, unless of course it never happened. US Hotel Advisors took the contrarian view and got it right.
The “Wall of Maturities” turned out to be a non-event. According to Trepp, 5.18% of CMBS loans were 30+ days delinquent at the beginning of 2017, increasing to a peak of 5.75% in the summer, but dropping down to 4.89% by December. As predicted, borrowers faced with funding shortfalls, tapped the robust mezzanine loan market to bridge the equity gap as the percentage of CMBS loans originated with subordinate debt increased by more than 50% compared to the end of 2016.
Risk-retention regulations ultimately proved to be positive. The bond market applauded the idea of lenders having “skin in the game” and lenders were rewarded with a massive rally in credit spreads and a seemingly endless appetite. 10-year AAA CMBS bond spreads began the year at 103 basis points over the 10-year Swap rate and ended the year 25 basis points lower at S+78 basis points. 10-year BBB- spreads began the year at S+546 and ended at S+345, an improvement of more than 200 basis points. As we predicted, this translated to spread contraction, although admittedly, we did not foresee spreads dropping 50 basis points - a welcome surprise. CMBS volume finished the year at approximately $95 billion, much higher than most analysts predicted and higher than 2016 volume by approximately 27%.
The 10-year Treasury rate finished the year at 2.41%, lower than where it started the year (2.45%) but within our predicted range of 2.36-2.79%, the top end of the range representing the WSJ Economic Survey rate.
Looking Forward to 2018
Hotel Construction Loan Availability
According to Lodging Econometrics, there were approximately 99,881 new hotel rooms delivered in 2016 and a projected 112,016 rooms delivered in 2017, representing supply growth of 2.0% and 2.2%, respectively. The firm projects an additional 2.5% annual supply growth in both 2018 and 2019. As of 3Q17, there were 149,055 rooms in the “early planning” stages of development, with 251,259 rooms scheduled to start construction in the “next 12 months” and 208,523 rooms “currently under construction.”
US Hotel Advisors believes that a significant number of the projects within the stages of “early planning” and “next 12 months” will not break ground according to plan, with some being put on hold indefinitely. Sky-rocketing labor and materials costs will render some projects unfeasible; however, most mothballing will be attributable to the unavailability of traditional bank construction financing.
Projects with good projected profit margins will resort to non-recourse construction financing, which is more expensive than traditional recourse bank lending, but offers the benefit of higher leverage without the need for a personal guarantee.
Permanent and Bridge Loan Availability
CMBS, Life Insurance Companies, Debt Funds and REITs will have no problem meeting borrower demand in 2018. Even Life Insurance Companies, funded with the help of outside investors, are ramping up bridge loan programs. Recourse banks will continue to lose market share as more borrowers transition their growing portfolios to non-recourse financing to help minimize contingent liability risk. A large percentage of loans originated this year will be refinances of 5-year loans closed in 2013 and value-add or construction loans originated in 2015-2017, which should be positive for credit quality. Overall, lending volume will be down from last year, but it will be a function of the last recession (very few 10-year loans were originated in 2008) and not a new recession.
Given how far credit spreads declined in 2017, there will inevitably be a slowdown in spread contraction this year. The natural decline in demand-related volume mentioned above combined with fierce lender competition for high quality, low leverage loans will make 2018 a “borrower’s market” and be the main driver of spreads. Spreads will bounce around in a tight range and finish the year slightly lower than where they began.
The 10-year Treasury rate is approximately 150 basis points lower today than it was in April 2010, when it peaked at 4.01%, even though we are now in the 9th year of the business cycle. The Federal Reserve guides short term rates through use of the Fed Funds rate. This rate currently stands at 1.25-1.50%, up from 0.00-0.25% when the Fed began raising the rate at the end of 2015. The market, not the Fed, determines long-term rates (quantitative easing aside), which do not always move in the same direction as short-term rates. In fact, the 10-year Treasury rate is essentially flat year-over-year and yet the Fed Funds rate is up 75 basis points. Given the recent resurgence in wage growth, which had been largely non-existent throughout this cycle, we expect the Federal Reserve will follow through with its prediction of three rate hikes this year. Consequently, the Fed Funds rate is expected to be 2.00-2.25% by year end. Nonetheless, US Hotel Advisors once again believes that the 10-year Treasury rate will come in above the current rate but well below the WSJ Economic Survey rate of 2.93%.
The big winners in 2018 will be developers who opened up new hotels in 2016 and 2017 that will be ready for permanent financing now that they have at least 12 months of operating history. Lenders will be very aggressive on these take-out loans given that most of these hotels will outperform older properties in their respective competitive sets and borrowers will lock in long-term, fixed-rate financing at very attractive interest rates.