August, 2013 Featured this month: Update on the Interest Rate Outlook------------- Page 1 Year-over-Year U.S. Occupancy and ADR Performance --------------------- Page 4 Hotel Credit Market Conditions --------------------------------------------------------- Page 5 Submit Your Loan Scenario ----------------------------------------------------------------Page 6 OUTLOOK FOR PRIME RATE AND LIBOR The last few months have been eventful in the interest rate markets, so now is a good time to review the outlook for the next couple of years. In this article we will look at the two rate bases used for most floating rate hotel loans, the Prime rate and LIBOR. The most likely places you will encounter a floating-rate loan proposal would be on an SBA 7(a) loan or on a conventional bank loan. The Wall Street Journal Prime rate is the most common index, but some lenders will also use LIBOR (also known as the London Interbank Offered Rate). The primary driver of short-term interest rates in the U.S. is the Federal Reserve. As a tool to reach its goals of low, stable inflation and solid employment, the Federal Reserve has the ability to create (and eliminate) money within the U.S. economy. Since the start of the Great Recession, the Fed has been creating huge quantities of money (known as Quantitative Easing) in an effort to stimulate growth in employment. The main way they do this is by using their newly-created money to buy bonds (mostly Treasury bonds, but recently some other types as well) in the open market, which has the effect of driving down interest rates on those bonds. In recent months the Fed has been buying $85 billion every month, and has succeeded in keeping short and long-term interest rates at unprecedented low levels. Their hope is that their activities will translate into lower loan rates, which will in turn stimulate real economic growth. In the case of the hotel industry, they want this lower financing cost to get you interested in building, renovating, buying, and refinancing hotels, which will directly and indirectly create jobs. As we have discussed in prior newsletters, interest on your loan is probably one of the largest expense categories in your hotel. At current levels, the interest cost on a typical August, 2013 Page 1 2013 Windward Financial, LLC
floating-rate hotel loan is around one-half of what it would have been in 2001. This makes a major difference in the economics of owning a hotel. Looking specifically at SBA 7(a) loans, hotel lenders in that market currently offer only variable rates. The SBA's regulations control how lenders set interest rates on their loans. Nearly all 7(a) hotel loans are set to adjust quarterly based on a margin added to the Wall Street Journal Prime Rate. The maximum margin that the SBA allows is 2.75% over the WSJ Prime rate. The WSJ Prime Rate is currently 3.25% giving a maximum starting rate of 6% for your hotel loan. So, if your loan is priced at Prime + 2.5% your rate today would be 5.75%. If the WSJ Prime rate adjusts upward to 3.75% a few years from now, your loan rate would adjust upward to 6.25% in that quarter (and your monthly payment would adjust accordingly). In theory each bank sets its own Prime Rate, which is the rate they charge on high-quality floating rate loans. The WSJ Prime Rate is a survey of several large banks' Prime Rate. But, in reality the WSJ Prime Rate is indirectly controlled by the actions of the Federal Reserve. The Prime Rate has historically moved in lockstep with another rate that the Fed sets by policy and controls through its monetary activities. That is the Federal Funds Rate, which is the rate at which U.S. banks lend money to each other. Since December, 2008, the Federal Reserve has been injecting sufficient newly-created money into the Fed Funds market to keep this interest rate essentially at zero (i.e. below.25%). Banks have historically automatically set their Prime rate at 3% over the Fed Funds rate, so that is why the WSJ Prime Rate has been at 3.25% (they round it off to even.25% increments) since December, 2008. So, if you want to predict where the Prime rate will move in the future, you have to predict what the Fed will be doing with the Fed Funds rate (also known as the "policy rate"). LIBOR is the British equivalent of the Fed Funds rate. Unlike the Fed Reserve, the Bank of England doesn't publicize a target LIBOR policy rate, so it is based on a survey of British banks based on their actual borrowing rates available in the open market. There was a recent scandal involving the banks providing fraudulent responses to this survey to favor their own investments tied to LIBOR. Otherwise, LIBOR responds to some of the same forces that affect the Fed Funds and Prime rates, and you may occasionally have an opportunity to tie your loan rate to LIBOR. They key question for you as a hotel operator with a floating-rate loan is when the Prime rate might adjust, by how much, and under what economic conditions. As outlined above, the Prime rate will not increase until the Federal Reserve determines that a higher interest rate environment is necessary to control an unacceptably high level of inflation. Some now think the Fed will also be watching prices in financial markets that might be experiencing a "bubble", even in the absence of excessive real economic growth. While there is differing opinion on when this rate increase will come, here are some opinions worth listening to: August, 2013 Page 2 2013 Windward Financial, LLC
I will close by drawing again the important distinction between the Committee s decisions about adjusting the pace of asset purchases and its forward guidance regarding the target for the federal funds rate. As I mentioned, the current level of the federal funds rate target is likely to remain appropriate for a considerable period after asset purchases are concluded. - Ben Bernanke, Chairman of the Federal Reserve, June, 19, 2013. Chairman Bernanke was referring here to the time when the Fed might begin slowing its $85 billion in monthly bond purchases. If U.S. economic conditions continue to be favorable, the Fed might begin slowing (also known as "tapering") its bond purchases in the next few months. Chairman Bernanke is indicating that he believes the Fed Funds rate will stay as-is for a considerable period even after the bond purchases have come to a full stop. Even after "tapering" starts it will take a while for the purchases to come to a complete stop. Despite the above statement, the interest rate markets panicked at the thought that the Fed might be close to slowing its bond purchases. The outlook for the Prime rate didn't really change with this statement, but since then longer-term rates appear to have reversed a declining trend going back to the start of the financial crisis. The 10-year Treasury rate is up around.75% from early June. This affects fixed-rate hotel loans, which we will discuss in a future article. "Bernanke says follow policy rate & we agree. 2016 tightening @ earliest" - Bill Gross, cofounder of PIMCO, one of the world's large bond fund managers with $2 trillion under management, July 21, 2013. With this Mr. Gross is indicating that the Fed Funds rate will stay put for a good while longer (through at least 2016), even after the Fed starts slowing its money creation. The conclusion I draw from the above is that taking on a floating-rate hotel loan is still a reasonable risk in view of the stable outlook for the Prime rate over the next couple of years. One other consideration is that when the increase in the Prime rate comes, it will probably happen gradually. The scenario in which the Fed is forced to start raising the Fed Funds rate is likely to involve overly strong economic growth that is fueling inflation. Because of that, you will probably have strong revenue growth and value appreciation in your property to help offset the higher interest costs on your loan. August, 2013 Page 3 2013 Windward Financial, LLC
YEAR-OVER-YEAR U.S. HOTEL PERFORMANCE OCCUPANCY Occupancy rate for year-to-date 2013 is about level with 2012. See ADR on the next page. August, 2013 Page 4 2013 Windward Financial, LLC
AVERAGE DAILY RATE ADR growth continues to look very strong through year-to-date 2013. HOTEL CREDIT MARKET CONDITIONS Typical SBA 7(a) terms: 5.00% - 6.00% adjusting quarterly, 80% LTV, 25 yr. payback Typical SBA 504 terms: 5.75% -6.50% blended effective fixed rate, 80% - 90% LTV, 20-25 yr. payback. Typical Private Bridge Loan Terms: 9% - 14% interest rate, 3-5 points at closing, 55% - 60% LTV, approval and closing in around 3 weeks. Typical Life Company/Conduit terms: 5.00% - 5.25% fixed rate for $5.0 million+ loan amounts, non-recourse, 70% LTV. August, 2013 Page 5 2013 Windward Financial, LLC
LOAN SCENARIO SUBMISSION Would you like some quick feedback on a loan request you are considering? Click the following link to our on-line submission form at our web site: http://www.windwardfinancial.com/submityourscenario.html August, 2013 Page 6 2013 Windward Financial, LLC