A survey of community banker attitudes toward hotel feasibility studies

RMA Journal, The, April, 2004 by A.J. Singh, Raymond S. Schmidgall, Paul Beals

What is the value of information provided in currently available hotel feasibility studies? Not much, conclude 26 community bankers, who were surveyed while attending RMA's Risk Management Conference in October 2003. Bankers ranked existing feasibility reports by how they influence hotel loan decisions and the importance and reliability of various sections of the feasibility report. Lenders should be aware of the shortcomings of current reports and rally for better information.

With limited growth in the supply of rooms, as well as improving market conditions, the hotel industry appears to be in recovery. As occupancies and room rates increase, developers and other investors will consider "new builds" or acquisitions of existing hotels, and lenders will see new hotel loan requests come across their desks. Once again, consultants will be busy preparing a report critical for securing financing--the feasibility study.

Feasibility studies have received their fair share of criticism over the years for being ineffective in predicting future operating results of proposed hotel projects. As a result, many hotel and lodging owners who purchase and commission these studies view them only as "necessary evils" to secure financing.

As project financing has become institutionalized, it's not surprising that supporting documents are accepted in lieu of more time-intensive investigation. However, because they have a limited pool of capital, lenders want to originate loans with the highest expected return at a given level of risk.

The failure of a real estate project can be attributed primarily to the lack of an effective feasibility study, unsound or weak management, or poor market timing. (1) Therefore, from a lender perspective, there are three important reasons for seeking to influence the content, preparation, and analysis presented in feasibility studies.

1. Despite recommendations by scholars, industry professionals, and lenders for making hotel feasibility studies more effective, the essential form of the studies has remained unchanged for a long time. Some current research into feasibility studies concluded that little has changed since the industry upheaval of 1973-74: "Formal feasibility reports continue to be commissioned for hotel projects, but the essential methodology of the analysis and the format for the presentation of the results of the analysis have not changed." (2)

2. The hotel industry has gone through several periods of overbuilding, including the mid-1970s and the late 1980s. Most recently, the terrorist attacks in 2001 catastrophically affected demand and hotel performance. To a greater or lesser degree, during each of these periods, lenders were plagued with defaulted hotel loans: in many cases, they became the unintended owners of illiquid and management-intensive hotel real estate. Given the low margin (estimated at 2% return on assets) and high-volume nature of commercial bank loans, each $1 million of lost principal requires that banks originate $50 million in new loans to compensate for the loss ($1,000,000/2.0%= $5,0,000,000). (3) Lenders have a fiscal responsibility to their investors and depositors to reduce risk by exerting their influence on the preparation of feasibility studies.

3. As capital- and management-intensive projects, hotels are operating businesses "housed" in real estate. Hotels are a product more complex than the traditional commercial real estate classes--office, multi family, and industrial. They range from budget to full-service, short-term leases with higher exposure to market vicissitudes. They have complex operating structures that may include owners, management companies, and franchisers. And there may be only limited ability to "pre-lease" the hotel rooms. Such characteristics make hotel loans an inherently riskier asset class. Because loan to value (LTV) ranges between 55% and 70%, lenders have the largest proportion of capital at risk of all the parties involved in the project. And here we have the reason behind this survey: While restrictive lending terms may compensate for this exposure, a lender-specified feasibility study will strengthen overall underwriting quality and protect the lender's interest.

Survey Analysis of Results

Important factors influencing hotel loan decisions. While lending to hotel owners represents a business opportunity, it is also a credit risk. Successful lending institutions have well-defined, criteria-based credit standards to guide their lending decisions and reduce nonperforming loans. As noted in Table l, financial strength of the applicant, location of the hotel, and experience represent the most important criteria for community bankers when making hotel loans. This result substantiates the location-specific and management-intensive nature of the hotel business. The results also show that bankers' internal analysis conducted ranked higher than their reliance on feasibility studies, providing additional reasons to examine study methodology. It is ironic that bankers gave higher scores to individual factors, which are typically addressed in a feasibility study (location, economic climate, fit of project to the market) than to the projections made by the study itself. A logical conclusion is that, even though bankers value specific information contained in a feasibility study, the study itself has less predictive value when making loan decisions.