No doubt about it, the economic crisis has resulted in a significant change in the financial landscape. Many of the active lenders are no longer in existence, or are facing regulatory constraints limiting their ability to lend.
Here’s a macro-look at indoor waterpark investment performance to help explain some of the current investor indifference and offer some suggestions for indoor waterpark owners and developers.
In short, commercial real estate is experiencing a tough one-two punch of rising capitalization (cap) rates and declining net operating income. Most experts predict this will result in declines of 40 percent to 50 percent from peak to trough values.
To understand why, you must understand a concept called the cap rate. It is defined as the ratio between the net operating income produced by the property and the amount paid to purchase the property. The cap rate is a rough approximation of the cost of capital (debt and equity) and the perceived risk of an asset (that is, a higher perceived risk would result in a higher cost of capital and thus a higher cap rate).
In 2007, relatively cheap and abundant money resulted in cap rates of approximately 8.5 percent and allowed marginal projects to work — indoor waterparks and other commercial real estate. That led to overbuilding and the overcapacity that exists in all sectors of commercial real estate. For example, when vacancy rates for office buildings in the United States are near 20 percent, do we really need to build more before utilizing existing space? The answer is clearly “no.”
Furthermore, because the existing space can compete better on price, new projects would not make economic sense to a lender or investor. Today, risk aversion and higher risk premiums have resulted in capitalization rates near 12 percent. Based on analysis, most investors believe a 30 percent drop in property values has occurred just from the change in cap rates, though there have not been significant property sales to support this conclusion.
In terms of income and revenues, though the depth of the recession and its impact on waterpark resorts is still unknown, other hospitality projects have experienced a significant drop in net operating income. Nor has the performance of the indoor waterpark sector escaped completely unscathed. Today, the industry is divided into the large destination resorts, led by Great Wolf Resorts based in Madison, Wis., and the smaller hotels with “snap-on” waterparks.
Great Wolf Resorts, has reported a drop in revenue — albeit less than the hotel sector in general — making it clear that the indoor waterpark concept may not quite live up to the old belief that it is completely recession-proof.
Furthermore, many smaller properties are struggling. Some are unable to pay debt service and a number have been unable to even cover operating expenses. Their lenders are not getting paid and equity investors are not getting paid, creating an understandable “bad taste” for the industry.
Given the current picture, the question becomes, what next? How can waterpark resort operators and developers best prepare for the time when credit markets bounce back?
For starters, it is more important than ever to know your lender. A friend of mine received a loan from Prudential, and after congratulating him on his financing, I asked which group within Prudential provided the financing: CMBS group, pension fund, general account, or opportunity fund. His response was, “I am getting a ‘piece of the rock’ and that’s all that matters.” He has since discovered that, yes, it does matter where the money comes from because each group has different motivations, lending styles and, most importantly, the ability to be flexible. Therefore, seek to understand your lender’s business goals and objectives, and what you can do to help meet those goals and objectives. The more you can help your lender today, the more they will remember you when the market returns.
Understanding your lender means open and frequent communication. Anticipate the lender’s questions and provide answers before questions can be asked. The more information an indoor waterpark owner can provide to lenders and investors, the more comfortable they are with their investments.
Additionally, a high level of communication enhances the lender’s perception of you as a knowledgeable, capable borrower, the kind the lender will want when the market recovers.
Remember, one of the five “C’s” of lending is the character of the borrower, and how you handle yourself in these difficult times will help define your character. It can help eliminate risk. Because risk can be defined as uncertainty, when lenders cannot understand or explain what is going on with a property, their perception of risk may be greater than the actual level of risk. This is especially important when a property is not performing according to the original projections and providing the original anticipated returns to the lender or equity investor.
Reaching out to your community and building goodwill is another important strategy in these difficult times. Indoor waterparks are significant economic engines and have a lot to offer the communities where they are located. Partnering and sharing will endear you to customers and neighbors, and provides an opportunity to be a leader in your community.
Perhaps some of the best advice can be found in the poem “All I Really Need to Know I Learned in Kindergarten”: Share everything, play fair, and don’t hit people/ when you go out in the world, watch out for traffic, hold hands and stick together.
Ultimately, commercial real estate markets will recover when the economy is finished with the painful de-leveraging process that we’re in the midst of. For example, it’s hard to justify investment in a new indoor waterpark when I can buy one at a foreclosure sale at 50 percent of replacement cost.
Buying such an asset at 50 percent of replacement cost means an equity investor lost their investment and the lender has taken a loss on the original loan. This is the de-leveraging process in which we find ourselves today.
Until then, operators should not bury their heads in the sand. They should be forthright and realistic with their lenders, understanding their lenders’ and investors’ views of the asset in comparison with other commercial real estate assets.