As we head into midyear, there’s a big disconnect between hospitality fundamentals, which are exceptionally strong for many assets, while the debt markets have been deteriorating meaningfully.
In the current environment, inflation and the Federal Reserve’s response have taken center stage, despite the strong fundamentals. The credit markets fear that aggressive monetary tightening by the Fed could tip the economy into a recession, which has resulted in higher credit spreads and all-in loan coupons. JLL, in its Hospitality Debt Market Overview, observed balance sheet lending spreads generally increasing by 25-75bps, and SASB CMBS whole loan spreads widening by 150bps+. Additionally, the floating rate index SOFR, which tracks the Federal Funds Rate, has increased almost 150bps since January, with the expectation that the index could increase another 200-250bps by the end of the year if Fed monetary tightening continues. As a result, all-in loan coupons are approximately 175bps to 300bps+ higher today, depending on lender type, compared to January, with the potential to be materially higher by year-end.
Loan pricing & leverage
While spreads and loan coupons are higher, liquidity for hospitality loans on existing assets still exists, with all major lender types—banks, debt funds, life insurance companies and fixed/floating rate CMBS lenders—continuing to quote hotel loans. Lenders are becoming more selective on the types of hotel loans they will originate, and some may begin to offer lower leverage:
- Banks are providing the lowest cost of capital but are focusing on the best deals and/or existing clients. They continue to be the most selective lender type and have adjusted spreads the least during this period of volatility. In fact, some banks have not increased spreads, while others have increased by approximately 25bps. Maximum leverage for banks generally remains at 65%, although we’re beginning to see downward pressure on leverage to 60%.
- The debt funds remain active, and are offering the highest leverage, but are generally the most expensive lender type. Debt fund spreads have increased 50-100bps this year; however, leverage has held steady at 65%-70%. We expect these leverage levels to decrease as a result of greater economic uncertainty. A significant challenge with debt fund execution today is that many funds are reliant on the CLO market for financing, and dislocation in the CLO market has created greater pricing and closing risk with some debt funds. Additionally, a number of funds rely on syndicating an A note to commercial banks, and with banks becoming more selective, many funds are finding it harder to syndicate the senior, which has caused some funds to pull back on hospitality originations.
- Life insurance companies have been selectively active in hospitality lending, offering pricing between bank and debt fund pricing, with leverage of up to 70%. Life insurance company debt pricing has widened by approximately 25-50bps over the course of the year.
- SASB CMBS, which has historically offered the highest leverage at the lowest pricing, has widened the most, with AAA CMBS bond spreads increasing by over 100bps since early this year and whole loans spreads by 150bps+ depending on leverage. The floating rate AAA spreads that are being observed represent post-COVID highs and are by far the widest levels that JLL has tracked going back to 2013. SASB CMBS leverage remains available down to 75%; however, as pricing has increased, borrowers have voluntarily reduced leverage to drive down whole loan pricing.
The construction lending markets continue to be selective and challenging, as high construction costs have put downward pressure on leverage. Banks and debt funds have been the most active lender types in construction with bank pricing generally gapping out by 25-50bps and debt fund pricing increasing by 150bps or more. Typically, the debt funds pull back on construction loans in choppy markets, so JLL expects construction loan liquidity to be challenging so long as the markets remain volatile.
JLL has not yet observed a material change in loan structures, but if the volatility continues, it anticipates lenders will get more aggressive in requesting debt service reserves and carry guarantees, particularly for assets that are recovering. Moreover, the price of SOFR caps has increased dramatically since earlier this year, but lenders have generally been willing to work with borrowers by offering higher caps, shorter duration caps or springing caps as a means of lowering cap costs.
Why we are here
A primary driver of the widening trend is a 40-year high in inflation and the Fed’s two-pronged response: 1) tightening monetary policy by raising short-term rates (the Fed Funds Rate) aggressively and 2) Quantitative Tightening (QT), which pressures longer-term rates.
The Fed has increased the Fed Funds Rate by 150bps since March and is expected to increase the rate by 75bps and 50bps, respectively, at its next two meetings in July and September. Thus, by the end of September, the SOFR index, which is the basis for floating-rate loans, and which tracks the Fed Funds rate, could be between 2.75%-3.00%, compared to 0.05% at the beginning of the year. Moreover, many economists expect the Fed to continue with aggressive rate increases, which could take the Fed Funds rate/SOFR index to 3.25%-3.75% by the end of the year. Comparatively, it took the Fed three years (between December of 2015-December 2018), to raise the Fed Funds rate by 200bps, a feat which it is on pace to achieve in four months in 2022.
The other major factor weighing on the markets is the Fed’s QT program, which will withdraw $95 billion of liquidity from the market annually, as the Fed allows its holdings of treasuries and mortgage debt to mature. For context, during the pandemic, the Fed increased its balance sheet from $4.2 trillion to $8.9 trillion, thereby injecting $4.7 trillion of liquidity into the system. In anticipation of the liquidity withdrawal, there has been upward pressure on medium- and long-term rates.
When taken together, these Fed actions have increased the risk of an economic slowdown, which has caused the credit markets to demand a higher risk premium due to uncertainty.
In the recent past, as the Fed increased the Fed Funds rate, JLL generally observed tightening credit spreads, which largely offset the impact of higher index rates. As such, all-in loan coupons did not increase significantly.
But those Fed Funds rate increases occurred in a benign inflationary environment that was sub-4% and the Fed was acting preemptively to get ahead of inflation. Lenders were generally confident that the Fed had inflation under control, and in the context of an otherwise strong economy, were willing to tighten credit spreads to win deals. This time it’s different: inflation has tested 40-year highs at 8.6% and the Fed is behind the curve on fighting inflation. Because it’s unclear how aggressively the Fed will have to raise rates to eliminate inflation, there’s far more concern today about an economic hard landing, which has put upward pressure on credit spreads. Additionally, inflation is bad for fixed income (loans) as it erodes the purchasing power of the future interest payments, causing lenders to demand a greater spread premium to compensate them for inflation risk.
When do things get better
Until these inflationary concerns abate, we believe that there will continue to be volatility in the debt markets. However, once the markets have greater clarity on inflation and better visibility of future economic performance, JLL anticipates a substantial tightening trend. Perhaps most importantly, the hospitality debt markets do remain open for business and the company is cactively placing debt on more than $4 billion on hotel loans.
