Are Floating-Rate Mortgages Best For Hotels?

Real Estate Issues, Fall 2004 by Corgel, John (Jack) B, Gibson, Scott

FOCUS ON HOTELS AND HOSPITALITY

Observations from the Recent Cyclical Peak-to-Trough

INTRODUCTION

DURING JANUARY OF 2004, WE ATTENDED the American Lodging Investment Summit (ALIS), a large hotel industry investment conference held each year in Los Angeles. We sat through several sessions about financing hotel companies and properties at the conference. During literally every one of these sessions, fairly lengthy, and sometimes active, discussions erupted about the effective use of fixedrate versus floating-rate debt for financing hotel investments. Our take away from the experience-floating-rate debt makes sense as a general proposition because hotels, unlike other commercial real estate, have pro-cyclical income streams unbridled by lease frictions that should resemble the time-series patterns of interest rates. However, we, like the panelists and other participants involved in these sessions, had views grounded in considerable ignorance because empirical work has never been done to confirm or refute the validity of financing strategies based on mixing fixed-rate and floating-rate mortgage debt.

As discussed below, one can quickly construct arguments that create reasonable doubt about the time-series relation between hotel revenues and debt-service obligations based on periodic movements of interest rates. Hence, certifying this relation is not obvious, but instead, should follow from a managed empirical exercise. During the past few months, we spent time assembling the necessary data to execute this empirical examination and help answer questions about how closely hotel RevPARs and interest rate series used in floating rate mortgage contracts behave over time.

This article reports on some of the findings from our larger study. Specifically, we carved out the past five years as an especially relevant period because hotel revenues rapidly went from their highest peak ever in 1999 and 2000 to a very deep trough in 2002 and 2003. These revenue declines imposed sizeable financial distress costs on hotel investors and lenders as evidenced by the large increase in hotel delinquencies experienced during this part of the cycle.

FINANCIAL DISTRESS COSTS

Under the assumption that debt markets are efficient, debt is fairly priced regardless of whether it carries a fixed rate or floating rate. Thus, in a world without market frictions, the fixed-rate versus floating-rate decision has neutral valuation implications. In the real world, however, market frictions exist. Of particular importance when considering the fixed-rate versus floating-rate decision are issues relevant to managing financial distress costs, such as those directly related to mortgage delinquency and default.

Given the potential for these costs to arise, fixed-rate versus floating-rate financing decisions take on significant valuation implications. To maximize value, the objective is to structure interest payments such that financial distress costs are minimized. This objective is accomplished by aligning interest payments, to the extent possible, with operating cash flows produced by financed assets. When 1hotel operating cash flows decline, as they did during 2001 through 2003 1H, it is desirous to have interest payment obligations coincidently decrease, thus mitigating financial distress.

SHOULD HOTEL REVENUES TRACK WITH INTEREST RATES?

Hotel properties represent a special category of commercial real estate because the users of spaces agree to shortterm (possibly daily) tenancy, as compared to long-term (possibly twenty-year) leases. The volatility of revenues is a defining characteristic of hotels, a feature often cited by investors as the primary reason why hotel properties are viewed as riskier investments than other types of real estate. Yet for hotels and other property types, long-term, fixed-rate mortgages with constant debt service payments are the common means of financing.

Evaluations of the financial performance of hotel markets often begin with presumptions about the close relationships between macroeconomic fluctuations (i.e., the business cycle) and the sales of hotel room nights. The procyclical nature of the hotel business has substantial support from historical data. It is not shocking therefore to posit a connection between interest rates and hotel revenues even though connections between the real and financial sectors of the economy are seldom direct. As economic downturns and recoveries occur, the pattern of interest rate changes and the pattern of hotel purchases may not be synchronized because different sets of consumption behaviors affect travel decisions and decisions about borrowing and lending. The connection is further clouded by the fact that the determinants of average daily rates and occupancies come from the supply side of the market, which is governed by investment considerations, as well as the demand side. Thus, the underlying processes that drive the interest rate/RevPAR relation consists of a complicated set of consumption and investment influences.