Current lending market conditions afford good opportunities for hotel owners. The number of new lenders that have entered the real estate market since the end of the financial crisis continues to grow.
This includes traditional clearing banks, institutional lenders, new debt funds, challenger banks, local authorities and pension funds. The immediate impact of the increased competition is to exert downward pressure on prices. In addition, the diversity of the lenders allows for creative debt structures and highly tailored solutions for hospitality assets.
Adding to this is the extremely low interest rate environment, with five year swap rates currently at 0.75% – the lowest they have been in over two years. The chart below indicates the current interest rate market in the UK – not far from the level of the current floating rate. The levels of these markets in the past few months, in particular, have allowed many of our clients to hedge/fix financing costs and to pre-hedge future financing costs at all-time low market rates.
Ground Rents and Income Strips
One route to optimise your debt structure is to deploy a ground rent or income strip strategy. Indeed, there is no shortage of investors looking for long-term, inflation-linked secure income streams. A key benefit of a ground rent strategy is that it is aligned with the underlying characteristics of your asset. The ground rent or income strip tranche will rank senior to any other leverage, so it does not necessarily increase the total debt on the asset and can reduce the total cost of debt on a blended basis.
In the UK regional market, local authorities have also stepped in as participants in this asset class. The role that local authorities play may vary from project to project, but as a direct debt provider they can offer commercial loan terms at very low prudential borrowing rates. It is not an obvious route to consider, but the transactions completed by various councils, such as London Borough of Barking and Dagenham and Rochdale Borough Council, in the past 18 months illustrate their appetite to be involved in projects within their own jurisdictions, and to be flexible in the role they can play.
The broadening definition of the sector and its impact on lending
Another recent trend is the changing nature of the ‘hotel’ sector. As the sector evolves to meet the demands of changing clientele, types of accommodation available to both leisure and business travellers have. Serviced apartments, short tenancies in co-living locations and home share accommodation are all now widely available. We have experienced situations where lenders are not sure how to fit these providers into their credit models when trying to measure their overall sector exposures. When presenting a debt opportunity to potential lenders, the narrative around the drivers of demand is crucial, as is a clear representation of the operating income, sensitivity analysis and of course residual/alternative use of the asset.
FX risks and the cross-country interest rate differential
While many domestic hotel owners and investors don’t pay much attention to foreign exchange markets, they do have a big influence on the sector overall. Overseas investors accounted for around 75% of total investment into UK hotels last year. It would seem that the uncertainty created by Brexit was more than outweighed by the ‘UK on sale’ impact of a weak currency. There has been increased allocation from European institutional equity investors into alternative real estate, which is also partly currency related.
Those investors entering a GBP asset from a non-GBP capital source may want to consider the FX risk they face during the holding period of the asset, and ultimately at the point of exit. Unlike interest rate risk, it is difficult to hedge currency risk over long periods, so when hedging foreign currency assets, the ‘norm’ is to do so with a rolling strategy using FX forwards. Forwards allow the currency risk to be hedged, but they also create exposure to movement in interest rate differentials between the two currencies. Currently there is a ‘cost’ to hedging GBP assets from a EUR fund of approximately 1.3% per year due to the interest rate differential (i.e. the forward rate is ‘worse’ than the current spot rate). However, for USD funds hedging GBP risk, there is a ‘benefit’ of approximately 1.4% per year as US rates are currently comfortably above UK rates (so your hedged rate is better than the current spot rate).
JCRA has advised on all types of projects mentioned in this article. Do get in touch if you would like to explore your options for a refinancing, fund raise or to discuss hedging solutions. We offer impartial advice, so that you get the best solution for your unique circumstances at the best possible price.
By financial risk specialist Jackie Bowie, CEO of independent debt and hedging advisory JCRA