HOSPITALITY LENDING

If there is one lending sector that has outperformed all others, it is hospitality lending. After 9/11, many independent bank hotel loans rose to a 7% delinquency rate and credit dried up. Since that time, hospitality delinquencies have dropped to a mere 75bp. Pricing, while compressed since 2004, has remained fairly robust and now averages Libor + 3.28%. While returns are more volatile than almost every other CRE sector, this volatility has been falling in 2006. Our short-term projection for hospitality lending is currently "stable," with an expectation for slight improvement. Corporate spending on travel should increase next year and vacation travel is expected to remain steady. Going into 2007, we make one recommendation based on this hospitality loan performance data. Banks should reduce their holdings of the economy-line hotel sub-sector, as it is slated to deteriorate past 2008. When it comes to hotels, we monitor some 32 metro markets and in almost each one, luxury and ultra-luxury room rates have become more sensitive to demand and supply. This rate stability has served to make earnings more predictable, which is a positive characteristic. Part of this rate sensitivity is a result of better analytics being employed by many hotel firms, part is greater reliance on the internet for bookings and part is higher demand by consolidators. These factors have resulted in many hotel properties being more accurate in their supply conditions and more reactive to changes to those conditions. As a result, we have seen higher occupancy and higher revenue per available room. This has allowed loans to higher-tiered brands to increase their DSC despite rising interest rates. On the other hand, properties such as Holiday Inn, Comfort Inn and Best Western have produced lower DSC in the past 12 months. We would normally recommend increasing exposure to this sub-sector at this stage of the economic cycle (since lower-priced brands normally increase occupancy in a down cycle relative to luxury properties). However, increased room rate sensitivity has changed hotel lending risk. Greater sensitivity means upscale hotels are more likely to cut their rates, stealing market share from economy chains. During the first week in April in Seattle, Hyatt was below plan and cut their rate from $360 per night to $195. As a result, occupancy increased and rates are trending back up. Back in the 1990's, it would have taken the hotel chain 2 or 3 months to adjust pricing. Another input into our hotel model is the increased strength of luxury hotel operator balance sheets. Given superior performance over the past 2Y, hotel operators now have more cash and lower debt. Owners of properties with Westin, W, Ritz-Carlton and to some extent Marriot flags, usually also have lower projected default rates than other operators. For users of our Loan Pricing model, you can get up to the month projections on independent delinquency rates and recommended reserve levels. For other bank's not yet using our model, know that delinquencies should remain stable, with higher-end properties expected to outperform many other lending sectors for the next several years.