Leaders discuss managing debt financing in Europe

Higher and harder. That’s the take-away phrase for those tuning in to the HVS Europe-led ‘Status of Hotel Debt Finance’ webinar on July 5, 2023.

The consensus opinion was that interest rates will remain high – more in line with 20th century averages – into 2024, 2025 and beyond. The hard reality, meanwhile, is that the passage of time puts lenders’ patience under increasing stress.

How will the issues be resolved, and when? There are many parts to the realistic answer, but little progress will be possible until market participants accept the ‘higher and harder’ outlook.

The online event, co-hosted by Bird & Bird, AlixPartners and EP Business in Hospitality, was attended by 425 delegates and led by Tim Barbrook, head of debt advisory at HVS Hodges Ward Elliott, and James Salford, partner at Bird & Bird. Moderated by Graeme Smith, partner and managing director of AlixPartners, panelists included Theo Hajoglou of Cheyne Capital; Paola Orneli Bock, vice president, Hotel Properties, Aareal Bank; Bob Silk, relationship director for Hospitality & Leisure at Barclays Bank; Kaman Stark, vice president at Goldman Sachs Asset; and Dan Williams, head of Hotel & Real Estate Finance at Virgin Money.

Deals need to get real

Resolution partly depends on deal activity. At present, by and large, buyers and sellers have starkly different ideas about value. Why? Because they have starkly different expectations about future interest rate trends and the strength of hotels’ operating performances. Buyers tend to fear the worst; sellers hope for better.

The rarity of deals makes it harder to be sure about asset value estimates across the board.  Where there’s doubt about value, the paths to resolution can be blocked simply because one of the key numbers in any refinancing plan has a huge question mark hanging over it.

Might things change? Yes, panelists suggested, if insolvencies, or lender-led soft-enforcement options encouraging borrowers to pay down debt with low-ball asset sales, become more commonplace.

European refinancings reach €43 billion

There is €43 billion-worth of European hotel debt which, the webinar heard, will fall due between now and 2025.

In that context, James Salford pointed to the stress on interest cover ratios (ICRs) - that is, agreements or “covenants” which set interest costs in the context of an asset’s operating earnings. He suggested that many covenants were likely to be challenged and, or, breached.

Added urgency regarding refinancing strategies comes because debt covenant certificates often fall due with end-June dates and are required for filing by the end of July, the panelists suggested.

Salford’s ICR example

Salford outlined an imagined example based on his recent real-life experience. He drew a scenario around a £50 million hotel with loan-to-value (LTV) funding of 50% - in other words, there is £25 million of debt. He assumed the asset value and earnings were unchanged but that the interest rate had risen to 8.75% from 5.75%.

The new normal is the same as the old, old normal. We are in a different world, and we are not going back.

Tim Barbrook

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The ICR? It would have crashed from a healthy 209% to a borderline-dangerous 137%. Falls in the value of assets would, of course, exacerbate the pressure on ICRs. Moreover, while hotel operating performances, in general, are reportedly fine, any deterioration would have a rapid detrimental impact on ICR early-warning signals.

“Many existing deals are already outside lending agreements,” Salford said. “Borrowers looking to refinance may be faced with a reduced debt quantum requiring additional equity, mezzanine debt or asset disposals. Deals that are over-leveraged, hotels in non-prime locations or assets with challenges… will be difficult to finance.”

“Balancing lenders’ need for amortization with the owners’ need for a return on capital will be challenging,” Salford added. “Achievable ICR covenants, until market activity increases and gives added certainty to asset valuations, will be challenging.”

Extend and pretend? Not this time

Salford said that lending practices known as “extend and pretend" were, contrary to the period after the banking crisis of 2009, unlikely to stick. Back then, ICRs could remain intact because interest costs were falling in tandem with operating earnings.

Lenders could extend the term of loans and hope – or pretend – that trading environments would eventually improve. Now, panelists said, it is often less painful for a bank to force a sale at a low valuation than hold a distressed asset on its balance sheet.

“Credit and investment committees’ concerns center around whether interest rates have peaked; the existing loan portfolio performance and cost of capital calculations; the impact of macro-economic issues on hotel performance; and uncertainties over hotel asset value.”

Development? That’s hard too

It will be harder to find money for new developments, panelists agreed. Bob Silk from Barclays said there was “a limited appetite for development funding” - though he also said that he was perennially cautious about the risks attached to new builds.

Theo Hajoglou of Cheyne Capital, which has a reputation for sponsoring development finance said, “It’s tricky to underwrite development at the moment but there are opportunities.” He cited projects converting offices into hotels as an example. Hajoglou also said his firm is undertaking larger volumes of work in the arena of refinancing to utilize capacity once dedicated to development.

Interest rates past, present and future

Salford drew attention to historic Bank of England interest rate data to illustrate the recent abnormality of ultra-low cost of borrowing.

Meanwhile, he showed that U.K. and Euro-area interest rates, as measured by five-year SONIA and Euribor swap prices, have doubled in the last two years, as data presented by Bird & Bird showed.

Rates are likely to climb further in the short term, the market data suggests, peaking in the spring of 2024. Moreover, while interest rates are likely to remain elevated, the cost of sterling-denominated debt will be noticeably and persistently higher in the U.K. than in the euro-area.

Longer term trends (see chart reproduced here with thanks) are that borrowing is likely to be more costly than in recent years, in both the UK and euro-area, towards 2030 and beyond.

Dan Williams of Virgin Money, the operational encompassing Yorkshire and Clydesdale  lending, said the industry would be “beholden to the economic environment” for all of the foreseeable future. Referring to data such as that in the graph above, albeit with a twinkle in his eye, he added, “Our obsession with swap rates will continue.”

People, place and product

That said, speakers agreed that the individual characteristics of a particular hotel venture were, and always will be, the key. “People, place and product,” to borrow Bob Silk’s phrase, will determine the outcome in virtually all circumstances.

Tim Barbrook of HVS Hodges Ward Elliott summed up the points made with the memorable assertion: “The new normal is the same as the old, old normal. We are in a different world, and we are not going back.”