Sophisticated hotel investors and lenders are on a perpetual hunt for high risk-adjusted returns. That is, they target deals where their risk exposure gets a better return than that of a comparable project or loan. Risk has many factors – objective and subjective. However, a knowledge of the clear objective risks helps sponsors identify and mitigate those prior to going very far into a deal.
Capital providers align their risk tolerance with their position in the capital stack. They may play as a lender, investment partner, or anywhere in between. An astute sponsor can optimize returns by bringing the right players to each segment in capitalizing a deal.
Capital Stack Basics
A variety of hotel investors and lenders combine to fill in the required money to close and capitalize a deal. These participants supply capital from and to a stated amount in the total capitalization. A lender may fill in from zero to 65% of total capital and equity investors make up the remainder to close.
Capital providers refer to these different portions of the total capitalization as “tranches.” Each tranche of capital has different characteristics of risk, payment priority, and lien rights. Investors and lenders look at their “last dollar” in the deal to determine exposure.
Equity and debt make up the two broadest categories of capital for hotel investors and lenders, respectively. Different players combine within these categories to offer a dizzying array of capital options for sponsors.
Senior and mezzanine debt have different structures, but they share a common risk perspective. Preferred and common equity have a similar relationship but “higher up” in the capital stack.
One thing remains universally true no matter how the capital stack comes together – all tranches added together must equal 100% of total capitalization. Further, capital needs should be considered at the point of closing and beyond to ensure sufficient funds to complete a PIP or ramp operations.
Rights, Risk, and Payment
Hotel investors and lenders have different operating structures. Their interest in owning and operating properties couldn’t be farther apart.
Lenders are in the business of putting money to work on behalf of bank depositors, investors, or a syndicated trust, among others. Most prefer to collect payments and hope the loan performs even though some lenders have the human capital and systems to take control of a defaulted loan.
Equity investors are more open to the risk of failure. They build sophisticated asset management teams that keep a watchful eye on performance at the property to pivot with any sign of distress.
These business structures define their risk tolerance.
Everyone in the capital stack has a value where it makes sense for them to bring the asset onto their balance sheet. Lenders look at this last dollar from the perspective of their ability to dispose of the asset. Joint venture partners are more interested in market value and upside potential.
Hotel investors and lenders approach lien rights in similar but very different ways. Nevertheless, both look for ways to get control of the asset when the sponsor or business plan fails.
Investment partnerships deal with sponsor default early in the relationship with exhaustive diligence. They look for experience, systems, and business plan signals that reduce the probability of failure. In the event of failure, the partnership agreement allows replacement of the sponsor as an operator. Yet, their common equity ownership remains intact.
Lenders are more ruthless in their taking control of the asset.
Nobody wants a business plan to fail, but they do for various internal and external reasons. Hotel lenders have the right to take control of the property when the borrower fails to perform on numerous measures, where non-payment is the most glaring. This completely wipes out the sponsor and partners’ capital investments.
A wide variety of risks bear down on hotel investors and lenders from the macroeconomy down to the property level. A few of these include:
- Market risk
- Credit risk
- Inflation risk
- Concentration risk
Most capital providers are price takers.
Private markets are inefficient, but enough competition usually exists to firmly establish the cost of each type of capital. Conservative lenders, like commercial banks, set the baseline around the risk-free rate – 10-year Treasuries.
All interest rates and terms adjust as a premium to those plain vanilla loans.
Additional risk comes with additional cost. This shows up as tradeoffs between cost of capital, personal guarantees, and maturity timing, among others.
This plays out efficiently in residential mortgages, auto loans, and credit cards, which price risk based on your credit history. Commercial real estate capital markets rely on deal specific data, like the property, your experience, and business plan.
Hotel investors and lenders further differentiate themselves by when and how they receive payment.
Everyone is familiar with loans that require monthly payments with a combination of interest and principal. This is known as an amortizing loan, which is common for auto loans and home mortgages.
Commercial real estate loans can be fully or partially amortizing.
A fully amortizing loan pays back the entire principal balance over the life of the loan. Alternatively, a partially amortizing loan has a maturity balloon payment in the middle of the loan. In this case, the investors repaid much of the loan through monthly payments, and the balance comes due at maturity.
The requirement to pay every month regardless of cash flow is known as current payment, whether the loan payment includes principal or only interest. However, some loans and most equity investors allow payments to build up (or accrue) if the property’s cash flow does not allow for current payment.
Payment accruals add to the unpaid principal balance. This increases the total cost of capital because loans calculate periodic interest based on current balance. That said, it provides tremendous flexibility in situations where payments are uncertain.
Current and accrual payments are tools that allow for more creative deal structuring for new construction and heavy renovation business plans.
Loans and Equity That Act Alike
The gray area between debt and equity complicates things further.
Mezzanine debt and preferred equity act alike, but capital providers structure them more like their senior debt and common equity siblings. This includes lien rights and payment timing. However, they have strikingly similar risk profiles.
This part of the capital stack provides the ultimate flexibility in maximizing low-cost proceeds for the sponsor. It is a transitional piece of capital that allows sponsors to get a deal when they’re on the edge of their maximum investment capability.
Senior lenders top out around 65% of total capital. Mezzanine debt can layer on top of that piece to get an investor up to 85% or better. Preferred equity can do the same, but the default rights are slightly different.
A mezzanine lender holds a lien on the property in the event of default. The preferred equity stake converts to common equity in such a situation.
At a certain point, this is more about semantics than anything. Still, it has important legal ramifications that hotel investors and lenders form strategic opinions on prior to engaging in such a structure.
High leverage has many risks for everyone involved. Common equity does not have contractual payment obligations, like debt and preferred equity. Therefore, a bigger slice is more flexible when the going gets tough.
Common equity also benefits the most from the upside, so your decision to build a highly leveraged capital stack relies on your confidence in the deal. This is true in analyzing every point in the capital stack to build the most efficient capital structure for your business plan.