Real estate investors achieve excessive returns on their money by taking advantage of the security of the underlying asset to finance their deals with other people’s money (OPM). The capital stack is comprised of debt and equity, and each has a few varietals. Hotel loans are widely accessible across different lender types. Consequently, leverage is bountiful and allows hotel investors to reap great rewards from using OPM.
Hotel loans follow the same basic structure as Big Four CRE debt, but lenders tend to be more cautious and exercise greater diligence. Further, they take a holistic view that considers the deal sponsor, location, and asset quality, among other factors when making a lending decision.
Hotel loans fit in the safe, lower end of the capital stack. A lien right secures the property upon default, and a variety of factors determine pricing. These include the lender’s position in the capital stack, personal guarantee provided by equity investors, and prevailing market interest rates.
Total capitalization is the amount of money required to execute the business plan. A single individual may supply this money, but in most cases, a multitude of individuals and institutions combine to fill the capital needs.
Each capital provider in the deal has a different set of rights and responsibilities, which determine their position in the capital stack. Low positions in the capital stack have the least risk, and risk increases as you move up the capital stack.
The deal sponsor has the riskiest position, but she also stands to realize the greatest upside.
Hotel loans take one of two positions – senior and mezzanine.
The senior position is the lowest tranche of the capital stack. It is both the safest position and has the lowest return. Senior loans typically comprise 50-65% of total capital.
Mezzanine debt sits just above the senior loan with similar lien rights, but their riskier position allows for greater return. Mezzanine debt is more flexible and resembles equity in some cases. The two play well together when a borrower is seeking higher leverage.
Senior lenders get comfortable with mezzanine debt by way of an intercreditor agreement. This document outlines the rights and responsibilities of the mezzanine lender in the event of default. Their ability to effectively asset manage the hotel is of critical importance in approving this position.
Debt pricing has three major components – interest rate, amortization, and maturity.
Interest rates are fixed or floating. A fixed interest rate remains the same for the life of the loan. Alternatively, a floating rate adjusts periodically based on an amount in excess of contractually-defined index rate – known as the spread over the index rate.
Fixed interest rates are beneficial for both lenders and borrowers for their surety. However, floating rate loans may often be more affordable depending on current and projected economic conditions.
Amortization is the reduction of debt over a given period. Monthly payments are comprised of combination of interest and principal. These amortization terms are quoted in years and usually in five year chunks. Twenty-, 25-, or 30-year amortization are typical terms.
Hotel loans used for major projects, like intensive property improvement plans (PIPs), often forego amortization, thus monthly payments contain interest only. This has the benefit of reducing monthly debt service, but the loan balance does not change from origination to maturity.
The PIP should increase asset value relative to the loan size when taking an interest only loan. This has the benefit of reducing leverage and, subsequently, risk for a later recapitalization.
Finally, maturity is the date when the last payment on the hotel loan and the total outstanding balance is due to the lender. Note, amortization and maturity terms do not always align in a commercial real estate loan the way they do in home loans.
“10-year money,” refers to the maturity date 10 years from today. The loan will come due in a certain amount of time and a balance will remain. Equity investors must pay this balloon payment in full or replace the loan with a new one.
Deal specifics, property value, and cash flow determine the amount a lender will finance.
Judgement on deal specifics accounts for equal parts subjective and objective measurements. The deal sponsor’s experience, composition of equity investors, and market-related risks are major factors here. They determine a lender’s comfort level in going higher in the capital stack.
Property value is a more objective measure of risk, though it also has plenty of areas for subjective judgement. Preliminary underwriting determines the value initially, and deeper analysis and appraisal confirms or refutes that value during due diligence.
Considerations, like sales of comparable hotels in the area, sales of same-branded hotels in the region, and replacement cost determine the value of a hotel on the open market. Historical and projected cash flow also have a major influence in these values. However, the intrinsic value of the underlying real estate forms the basis for a conservative approach.
Property value is related to deal specifics in the relative weight of cost to value. Every hotel requires additional costs beyond the purchase price. Therefore, lenders quote many hotel loans as a share of cost – loan-to-cost – as opposed to value – loan-to-value.
Value has an important place in benchmarking the lender’s total exposure.
Cash flow makes up the final loan sizing consideration. This comes in the form of debt yield (DY) and debt service coverage ratio (DSCR). These credit metrics represent the spread between operating cash flow and debt payments.
Lenders will flex the size of the loan to ensure the equity investors have enough excess free cash flow to justify the investment’s long-term sustainability.
Lenders look for a stabilized debt yield with a healthy spread relative to market capitalization rates. This provides comfort that they will cover their balance sheet requirements regardless of the loan’s resolution.
Today’s generation of lenders is much more diverse and sophisticated than ever. Data abundance, specialization, and hyper-connectivity paved the way to a debt landscape that is both very competitive and globally-oriented.
Traditional lenders still originate most commercial real estate loans, but competition is closing in quickly. Regulation and abundant capital created a perfect storm for the emergence of unique, niche capital providers, which is a benefit for hotel borrowers.
Balance Sheet vs. Marketplace
Loan holding strategy forms the basis for broadly categorizing lenders.
Lenders that hold a loan on their own books until maturity are known as balance sheet lenders. Those that sell the loan after origination are known as marketplace lenders. This differentiation impacts the credit decision and types of hotel loans pursued.
Commercial banks and insurance companies are the biggest balance sheet lenders. Commercial real estate gets a portfolio allocation based on prevailing and forecasted risk-return profile and opportunity cost for other loan types.
Marketplace lenders are non-bank institutions that originate loans with the objective to sell them on the open market. Commercial mortgage-backed security (CMBS) loans are the most visible of this type. Still, many other non-bank lenders are emerging because technology and regulation allows for efficient marketing, underwriting, and private capital formation.
Hotels comprise less than three percent of total CRE square footage, but hotel loans get upwards of 20-25% of total CRE allocation (for those that lend on hotels). This is partially because hotel values are often higher per square foot than Big Four CRE assets. However, they also have an attractive risk profile relative to other operating companies in the broader balance sheet allocation.
Traditional lenders are bound by an assortment of state and federal regulations. Bank and insurance regulators are interested in two things: deposit protection and efficient capital markets.
Commercial banks and insurance companies make most of their money on the difference (spread) between the cost of deposits – savings accounts, certificates of deposit, insurance premiums and claims (float), etc. – and the interest rate and fees charged to borrowers. These lenders must have enough capital to meet depositor demands so this becomes a delicate balance.
Regulation for CMBS originators falls under a completely separate set of government entities. These regulations are more concerned with the structure of the bonds and aligning interests between origination, servicing, and bond holders.
Private equity emerged as a major debt player in the early-2000s as a hybrid between balance sheet and marketplace lending.
New regulations coming out of the Great Recession restrained banks, insurance companies, and CMBS originators to focus on more conservative loans. Private equity debt funds proliferated to fill the void in the post-crash era.
Bankers displaced by the credit crisis found or built new companies that took the good parts of traditional lenders without the regulation and depository tightrope. They operate within a time-boxed fund that deploys capital over three years, holds for a short period, and harvests profits for investors in an eight-year timeframe.
Balance sheet lenders still have a major role to play in this brave new world. They operate on the back-end, where the debt fund lays off a portion of the loan on a warehouse line of credit with a commercial bank or insurance company.
Debt funds operate outside the purview of traditional lending regulators. Securities laws prohibit investments by non-accredited investors, but fund investment mandate is the primary restraint. This provides tremendous flexibility in making hotel loans that fit a defined investment criteria.
The market for hotel loans is vast and complex. It involves many different players engaged in as many strategies. A short article couldn’t possibly capture all this nuance.
Loan Closing Costs
Purchase price is never the only cost of acquisition. Additional expenses fall into two categories – closing costs and balance sheet items.
Closing costs are the expenses required for pursuit, negotiation, due diligence, and other services to get a deal closed. These include everything from title costs and service fees and to appraisal and survey costs.
Balance sheet items are those closing expenses that sit on your balance sheet as pre-paid expenses. Lenders protect their interest in the asset by ensuring the physical and legal integrity of the property. Therefore, pre-paid property taxes and insurance, among other expenses, are customary expenses at loan closing.
Closing costs materially impact the cash you need to bring to the closing table.
A high-quality financing intermediary can help you estimate these costs with the help of your attorney and title company. Hotel loans include a few additional closing costs that don’t show up in Big Four CRE loans, so be sure to align with the right team.
The federal government uses financing as a tool to accomplish a variety of objectives. Small business proliferation, rural development, and clean energy are the most prevalent for hotel loans.
The Small Business Administration (SBA) provides support to qualified hotel operators primarily through two loan guarantee programs – 7(a) and 504. Real estate investment is not the specific target for these programs, but the operational nature of hotels allows them to fit nicely together.
US Department of Agriculture (USDA) Business and Industry Guaranteed (B&I) loans provide a substantial loan guarantee that reduces the cost of capital for businesses that support rural community development. Real estate is a terrific use for this type of loan, particularly when an operating business, like a hotel, ties integrally into the real estate.
Property Assessed Clean Energy (PACE) financing is a unique financial product aimed at reducing the environmental impact and improving disaster resiliency of a property. PACE loans incorporate payments into the property tax bill, and public or private organizations may originate the loan. This is a terrific option for financing building envelope and energy-efficiency improvements in a brand-mandated PIP.
Each of these specialty hotel loans has nuances and complexities that require a qualified professional to handle. Survey your network for lender reviews and the best intermediaries before jumping head first into a specialty loan.