Every CRE deal sponsor starts with an idea about how to build a better mousetrap. It could include renovation, operational enhancements, or just different market positioning. Hotels offer as many and more levers for value creation as any Big Four CRE asset. Hotel investing requires the right team to effectively execute on a winning strategy. Appropriate equity partners are an essential piece of that puzzle.
Equity Structure and Positioning
Equity is the riskiest tranche of the capital stack. It sits above all other secured money, in a precarious place, and with little to no recourse if a deal sours.
An investor’s position within the capital stack has some influence on her ability to take control of the deal. Still, an absolute loan default could wipe out all investors regardless of their equity stake. Therefore, investors make an extra diligence effort to understand the sponsor’s experience, risk mitigation strategies, and overall hotel investing abilities before committing.
That said, astute investors secure their investment and enhance risk-adjusted returns by considering a variety of positions within the equity portion of the capital stack.
Hotel investments are accessible anywhere in the capital stack for the right investor. Still, the most abundant opportunities for equity investments lie in common equity.
Common equity sits at the top of the capital stack. It is the riskiest position, but it also has the greatest potential for outsized returns. This is the position that most people think of when they make an investment in stocks or real estate deals.
The operating agreement assigns shareholder rights according to their share class. However, separate agreements, or “side letters,” dictate special rights for those investors with the ability to negotiate a better deal.
A single investor may fill this portion of the capital stack, as in the case of a joint venture. Many investors in this tranche usually comes in the form of a private placement. Each approach has its nuances, attributes, and challenges so it’s best to review the options with a qualified attorney and/or financial intermediary.
The sponsor’s position is common equity. Sponsor co-investments receive the same rights and returns as all other investors in that same share class. A separate share class governs additional voting rights and the promoted interest (also known as the “promote”). The promote is the sponsor’s outsized profit share for exceeding prescribed performance hurdles.
The most secure position within the equity tranche is preferred equity. This looks and feels a lot like mezzanine debt, but it does not have the same lien rights to the property.
Equity positions are very flexible. Investors in this space do not report to regulators or have statutory investment mandates. A partnership agreement between the sponsor and investors governs these investments.
Preferred equity is a terrific option for increasing leverage because it acts like debt, but senior lenders treat it like equity. Payment frequency, convertibility, and payoff are the major considerations to include in a preferred equity agreement.
Many preferred equity positions require consistent dividend payments, regardless of the operation’s ability to pay. This could put an undue strain on your operations. Therefore, consider dividing the payment frequency into current pay with accrual options to allow more flexibility.
Convertibility allows the investor to take in the upside of an equity windfall or protect the downside in the case of default. Your senior lender will have a lot to say about this, but it’s also important to consider how a conversion would impact common equity.
How you eliminate this obligation is as much an important consideration as paying off your loan. Allow for flexibility to pay off preferred equity investors freely in the event you see more upside in replacing that money with other financing. A prepayment mechanism that provides some level of yield assurance should do the trick in your negotiation.
This is an intermediate to advanced technique for filling the capital stack, so approach it cautiously. Capital providers that operate in the preferred equity tranche are very astute and structure these deals regularly. A good attorney and financial intermediary should help guide negotiations to optimize your outcome.
Common and preferred equity are the most common forms of equity in hotel investing. That said, some skilled investors take a holistic approach to evaluating their position in the capital stack that may include participation in many or all tranches.
A structured equity approach is very popular in capital scarce markets. It provides the sponsor with all the capital to complete a project from a single source. Though, the blended cost of capital may be a little higher than if each tranche were independently sourced.
Just because this single source provides all the capital doesn’t mean it’s all their money. Players with this strategy align their risk and return expectations in the money market just like you would in real estate. The investor may syndicate each tranche in her capital stack, but you maintain a single point of contact for the life of the investment.
Relationships and Execution
Healthy equity investor relationships form in a long courting process. This is in stark contrast to lender relationships, which may come together in a speed-dating-like marketing process.
Equity positions are not secured investments. That is, they don’t have any collateral behind them in the case of default. They also come with more control over major decisions about the operations than debt. This requires a level of comfort and working dialogue that evolves over time.
Big corporate sponsors, REITs, and high net worth investors dominated ownership for most of the history of hotel investing. Private equity funds entered the industry in a big way in the early 2000s. This ushered in a classic private equity model that empowers skilled operators with ownership interests aligned with achievement.
A joint venture is an equity investment that assigns roles and responsibilities in line with each partner’s strengths. Money partners bring capital. Deal sponsors provide access to real estate investments, asset management, and an effective investment team.
Partnerships comprise one or a handful of investors. However, each partner must have a material impact on the investment. All shares convert from partnership interests to securities as soon as a single investor moves into a passive role. This opens the investment up regulation by the Securities and Exchange Commission (SEC).
The joint venture and operating agreements dictate rights and responsibilities of the partners. These documents explain how to handle major and minor decisions as well as partnership contributions and distributions.
Real estate syndications are as old as money. However, the JOBS Act of 2012 modernized regulatory mechanisms to raise private money for deals. Private placements and crowdfunding instantly became more popular and accessible, as a result.
A private placement is the sale of securities to investors that meet a variety of qualifying factors.
The operating agreement limits the rights and responsibilities of each investor to be very passive. Deal sponsors have full control over major and minor investment decisions, but major decisions around changes in offering documents require shareholder input.
Every investor and lender in the capital stack has an opinion about syndication. Generally, they like to see that the deal sponsor has something material to lose – “skin in the game.” They want to know that you will move heaven and earth to avoid default. A significant co-investment usually does the trick.
Seriously consider deal size when bringing small investments from multiple parties. Investors may have limited rights, but their influence is unquestionable. The smallest shareholder can be the most demanding with similar rights as all other common shareholders. Consequently, higher investment minimums and smaller investor pools makes this approach more manageable.
You’ll hear that real estate is a relationship business from everyone you meet in CRE. The reality is that relationships are the lifeblood of every business. Trust is the foundation of every good relationship, and this couldn’t be truer than in hotel investing.
Equity relationships form over time after reviewing multiple deals together. Between deals, you must present additional information that solidifies your place as a trusted partner. This could be anything from market reports to in-person visits. Anything to stay top-of-mind with your prospects.
The “Rule of 7” is an old marketing adage that a prospect needs to hear your pitch seven times before committing to buy the product or service. This may be a generalization, but the principle and magnitude are important.
Value is an essential component of a trusting relationship. Each interaction should bring your prospect to a better place than she was before you connected.
If that seems difficult, think about interactions with some of your favorite brands. Your emotional connection to that brand either increases or decreases based on the advertisement, marketing piece, or news that you just consumed. The needle doesn’t move far in most cases, but any positive movement drives you toward a sale.
Sales and marketing are part of the same conversation. The difference lies in approach and scalability.
Remember: people do business with others that they like and trust. First, build a friendship. Then, perform, and you’ll have a raving fan that generates more business than you could produce alone. It doesn’t take many.
A Word on Splits
Economics are the easiest points to make or break a deal.
Capital supply and demand dynamics are important, but partnership terms tend to be very sticky industrywide. That said, highly-qualified deal sponsors with an abundance of capital relationships have the most leverage to set favorable terms and stick to their guns.
People invest in hotels for a variety of reasons. Financial returns are often the leading factor, but it is important to understand the nuance in measuring those returns.
Investment return measurements are either absolute or relative to time.
An absolute return is one that doesn’t change based on when and how you distribute the cash. Profit and multiple on invested capital are the clearest examples.
Relative returns change based on how you adjust the measuring stick. Internal rate of return (IRR) and cash-on-cash return are the most popular of these metrics.
Both approaches have a place in a holistic deal evaluation. Nevertheless, each investor inevitably gives more weight to one over the other.
Institutional investors that earn a promote on IRR performance are inclined to optimize for that measurement. Alternatively, private investors that care more about generational wealth creation may prioritize absolute profitability.
A good understanding of what drives the hotel investing decisions of your target audience helps to build an offering to meet their needs.
Real estate investment partnerships rely on the expertise of the deal sponsor to source, close, and execute on a successful business plan. Financial partners recognize the time to become an expert and effort to produce exceptional results, which is why they aim to align with the best. This is equally true for high net worth individuals and institutional asset allocators.
Capital providers all along the capital stack come in with a minimum risk-adjusted return target. However, perspectives on risk change based on where someone sits. Lenders set up structures to protect against the downside, while investors look to win on the upside.
An investment waterfall accomplishes two functions for equity investors. First, it ensures that common equity gets their initial investment back plus a market-rate return. Second, it sets investment return targets (hurdles) to encourage deal sponsors to seek outsized returns. Profit shares adjust based on achieving these outsized returns.
The most basic waterfall requires that all invested capital, including the sponsor’s co-investment, first receives a preferred return. Following that preferred return, each investor gets their invested capital back. This ensures that the investment is meeting the basic needs and desires of all investors.
Profit splits diverge from the pro rata share after the preferred return and return of capital.
A deal sponsor earns a promote after achieving this basic hurdle. The simplest waterfalls adjust once at this point. However, more complex waterfalls set up a series of hurdles that get progressively more attractive for realizing higher returns. Look at your competitors’ offerings and discuss with your attorney for a benchmark on waterfall structure. Generally, it’s safe to assume that private investors prefer simple waterfalls, and institutional investors encourage more complexity.