New York Hotel boom helps drive debt surge
New York is experiencing an explosion in hotel construction.
While this is welcome news for visitors to Manhattan who should benefit from increased competition and lower prices, among bond investors and analysts the view is considerably less sanguine.
What's concerning is that as the issuance of bonds backed by a single hotel property quadrupled to $5.6bn this year and the total mix of hotel debt in all mortgage bonds has more than doubled to $9.9bn, according to data from Commercial Mortgage Alert, the size of the loss cushions that act as safeguards on the bonds have declined.
In addition, ratings firms that grade the securities, including Moody's Investors Service, Fitch Ratings, and Kroll Bond Rating Agency, disagree over the valuations of the debt, leaving investors to calculate the risks on their own.
"We will be very, very, very selective," said Anup Agarwal, head of structured products at Western Asset Management, which has more than $454bn in assets, about $65bn in the form of securitized debt.
Agarwal has scaled back his pace of buying of new hotel debt this year by at least 60pc, he said.
In the first quarter, a measure of the loss cushions on hotel mortgage debt declined on certain top-rated bonds by 11 basis points on average. Credit protection on single-A rated bonds fell the most, from 13.4pc last year to 12.7pc, Wells Fargo data sent to clients March 30 show.
Eroding loss cushions may be a concern as hotel debt floods the market if the risk isn't adequately accounted for in loss forecasts.
Conversely, if too much risk is priced into the bonds in a way that makes them too expensive, investors could also be deterred from putting capital into those assets.
Investing in hotel loans and securities that pool the debt is inherently riskier than other types of real estate because operational costs are higher, events that influence travel and tourism are not always predictable and competition is steep.
Steven Schwartz, chief executive officer of Torchlight Investors in New York, said he's become increasingly picky, but would consider taking on more risk for more yield.
"There is a point where too much hotel exposure is a concern," Schwartz said in a phone interview. "One possible fix is to adjust yields so they are more reflective of risk."
Bond rating firms, which compete for business grading the debt, are at odds over how much protection is needed for high grades on these bonds. Moody's, for example, has warned that this kind of security in general requires a higher credit cushion to receive a triple-A rating than its competitors demand, and it has warned it may raise its bar even higher.
"Performance in the hotel sector is peaking and the current levels are not sustainable," said EJ Park, a Moody's senior credit officer.
When banks hired a different ratings firm, including Kroll Bond Rating Agency, credit protection fell 67 basis points on single-A rated bond pieces, Chris van Heerden, an analyst at Wells Fargo said in a March 30 report. In addition, hotel property valuations from Kroll are 22pc more optimistic than valuations from Moody's, according to Barclays.
"Moody's penalizes these deals more," Barclays analyst Jasraj Vaidya said in an interview.
Kroll said in a statement that Barclays' assessment was an oversimplification of its ratings process and that its valuations are only one part of a methodology that the bank didn't fully analyze.
"The derivation of cash-flow and asset values is only one component of our overall analysis, which also includes multiple layers of stress testing," Eric Thompson, Kroll's head of commercial-mortgage securities, said in a statement.
Moody's and Fitch have seen declines in commercial mortgage bond ratings, according to Commercial Mortgage Alert data from April.
Fitch has only rated nine out of 20 such deals this year, data from the company show. Kroll has rated 14 such deals this year, according to Barclays.
By 2017, Manhattan will have around 10,000 new hotel rooms that will be available for bookings 365 nights a year, according to data provided by STR.
"Where are you getting all the demand from unless you have 3.65 million more tourists or business travellers per year?" Fitch analyst Jeffrey Watzke said.
"During the crisis, investors missed that deals did have credit enhancement, but the underlying properties were more leveraged," Agarwal said. "If the property was worth $250 million two years ago, now it is worth $300m to $350m. I'm not saying we are back in 2007-2008, but if you start with a more levered property, the level of protection isn't going to protect you." (Bloomberg)