Strategies in the Lodging Industry
|By Anwar R. Elgonemy,
Jones Lang LaSalle Hotels
Since 1990 the financing and ownership of lodging real estate have undergone substantial transformations. Specifically, the owner’s equity (security), required for hotel real-estate deals has fundamentally changed the way lodging assets and companies are financed. Hotel buyers, developers, owners, and managers need to understand the different alternatives to securing debt, as well as the viability of numerous financing strategies - an intimidating task in increasingly volatile markets.
One of the issues in lodging finance is the ratio of debt to equity. Debt can be beneficial, of course, but only up to a point - beyond which the costs of potential financial distress begin to outweigh the benefits of leverage. That is an important issue for investors because debt-to-invested capital affects a hotel’s cost of capital and, therefore, the overall value of the property.
The lodging industry has earned a reputation as a high-risk business for lenders and mortgage investors. Obtaining financing for a lodging property calls for creativity, tenacity, and flexibility. Today, hotel developers and operators find themselves not only aggressively competing for a constantly changing pool of funds (both equity and debt), but also having to deal with increasingly complex terms and conditions for the efficient use of those funds.
Before pursuing debt-financing alternatives hotel investors need first
to consider four basic elements, namely (1) business risk, (2) the need
for financial flexibility, (3) the degree of management’s risk aversion,
and (4) tax considerations (Exhibit 1).
Real-estate Capital-flow Trends
The level of capital flows to real estate between 1983 and 2001 highlights
the importance of private debt in the marketplace (Exhibit 2), which is
expected to continue to play a significant role in future capital funding.
Capital flows are anticipated to return to a temperate level in 2002, as
lenders and investors re-enter the market. In fact, total capital flows
to real estate in 2002 are predicted to increase by 12.5 percent over 2001
(although at 14.2 percent below 2000 levels), driven primarily by the private
|Between 1983 and 2001 lodging-industry senior-mortgage commitments
fluctuated considerably, slumping in 1991 at only $160 million and peaking
in 1986 at approximately $1.8 billion. In general, when the prime lending
rate declines, senior-mortgage commitments tend to increase in an inverse
correlation (Exhibit 3).
According to the American Council of Life Insurers (ACLI), in 2001 a cumulative total of approximately $7.4 billion in commercial mortgages held by insurance companies was secured by hotel and motel properties, compared to $6.3 billion in 2000, indicating the continuing reliance on debt in the lodging industry. As a point of reference, in 2001 the lodging sector constituted 4.3 percent of total senior-mortgage commitments.
The hotel-debt capital markets are currently characterized by high volatility, although interest rates are low, including the prime lending rate (Exhibit 4). However, there is still interest in established properties operating in markets with high barriers to entry, such as New York, Chicago, and San Francisco. The spread between the London Interbank Offer Rate (LIBOR) and the prime lending rate is essentially the profit to the lender.
Sources: Federal National Mortgage Association (FNMA) and Federal Reserve Bank of St. Louis
Hotel Debt-financing Fundamentals
The cheapest additional capital to raise is debt capital, so debt should be the first source of new capital. Only when a hotel company has raised so much debt that its financial flexibility is becoming impaired, or its cost of debt becomes too high, should it consider raising more funds by selling shares of common stock or even lodging assets.
Although there are multiple reasons why the possibility of debt financing increases the value of hotel real estate, this does not imply that borrowing $65 million on a $100 million hotel automatically increases the value of the property. If it did, then all investors would acquire properties using leverage. So, there is more to leverage than meets the eye, especially due to operational issues. The potential benefits of debt are usually already factored into the market value of the property, so that the hotel’s value is usually independent of specific financing decisions. Naturally, a 7-percent long-term loan in a 9-percent market does add value, but that value is derived from below-market financing and not from the decision to acquire debt per se.
When a hotel owner uses debt, the interest payments are tax deductible. Furthermore, the use of debt increases the tax basis beyond the equity investment, thus enhancing the tax shelter generated from depreciation. Those two tax-related fundamentals allow the hotel owner who uses debt to reduce the IRS’s share of net operating income.
The most obvious use of debt financing is the reduction of the minimum investment necessary in any given hotel deal. Because investors generally have limited capital resources, a reduced minimum investment in one transaction allows them to spread their wealth over several investments. As diversification reduces portfolio risk, then lower risk should translate into higher value.
Combining financing possibilities with various forms of ownership, the decision maker can create new risk-return opportunities - meaning that new investments fit specific investor needs. As such, the flexibility to tailor the investment to suit the hotel owner is an additional benefit of using debt financing.
Advantages and Disadvantages of Debt Financing
The decision to use leverage should be made in the context of uncertain
asset returns and the portfolio implications of the leverage decision.
The great advantage of hotel debt financing at both the property and portfolio
level is maximizing the return on equity, while a chief disadvantage is
stifling management’s energy and creativity. Other advantages and disadvantages
are shown in Exhibit 5.
Leverage makes the volatility of investor returns greater than the volatility of the value of the underlying property. In other words, if the return on the hotel asset itself (before financing costs and taxes) exceeds the pre-tax cost of the mortgage debt used to finance the property, leverage is positive and the pre-tax return on the investor’s equity in the hotel will be greater than the pre-tax return on the asset itself. However, if the pre-tax return on the hotel asset is less than the cost of financing the investment, leverage is negative, and the return on the investor’s equity that is invested in the hotel will be less than the pre-tax return on the asset itself.
To demonstrate this basic principle, suppose that a full-service urban
hotel is acquired for $30,000,000 and the revenues and total expenses are
$10,000,000 and $7,000,000, respectively. Exhibit 6 shows the investor’s
return on equity if the hotel is purchased with no debt (unleveraged),
and if it is 70-percent financed with a 7.5-percent, 25-year amortization,
monthly payment conventional loan (ignoring the effect of depreciation
and income taxes).
The leverage is positive because the return on the hotel (10 percent) is greater than the cost of debt (7.5 percent), so that the leveraged return on equity (15.8 percent) is greater than the unleveraged return on the asset (10 percent). Although the return on equity increases with 70-percent leverage, this increase is accompanied by higher risk exposure to the investor’s equity position. Therefore, the resulting return on equity derived from the amount of debt used needs to be constantly measured against the investor’s required return on equity and tolerance level for risk exposure. The factor that is most important in producing leverage is the amount of debt used to finance the acquisition of the hotel, rather than the interest rate on that debt.
Different Sources of Debt Financing
In general there are four sources for third-party financing available via the debt-capital markets. These are: bank financing (domestic and overseas), insurance companies, conduit-loan securitization, and single-asset securitization (Exhibit 7). More specifically, Exhibit 8 focuses on typical loan terms and motivations by source of debt financing.
A number of variations of hotel debt financing and debt amortization exist (Exhibit 9), with each alternative best suited for a specific purpose or leverage strategy.
Mezzanine loans have filled the void in lodging-industry financing before, specifically in the early and mid 1990s when real-estate markets put some loan institutions in jeopardy through defaults. Banks, in turn, began to finance less of the construction costs with the first mortgage. The need for gap financing has recently re-emerged because public markets have been skeptical of the industry's expansion.
Mezzanine funding has become an attractive finance option for hotel owners being faced with a “credit squeeze.” The comparative advantages of mezzanine financing are demonstrated via a simplified numeric benchmark of the structure (Exhibit 10), while Exhibit 11 provides a snapshot of the advantages and disadvantages of mezzanine finance.
On the assumption that a hotel valued at $20 million was earning a net operating income of $2.4 million a year and achieved annual NOI growth of 3 percent, Exhibit 10 shows the difference in return for a hotel owner between a traditional and a mezzanine debt structure over a six-year period. Because of the leveraged nature of mezzanine finance, the internal rate of return would be sensitive to any changes in NOI.
Hotel-debt Refinancing Fundamentals
In today’s jittery capital markets, and apart from private equity and entrepreneurial sources, there is still financing available for strong properties with strong sponsorship. For the most part, lenders are not usually concerned about the spreads and lower interest rates. Rather, what sparks the deal-making process is basically whether the deal shapes up as a strong one or not. Nonetheless, with the current low interest rates, there should be some straight refinancings occurring, provided that the underlying assets can support the deal.
While lenders are still hesitant to fund hotel loans, some are beginning to evaluate their current stance, especially as the lodging sector's worst is behind it. Whereas hotel fundamentals are not yet where they were before September 11, they are well on their way towards improvement. Therefore, a lender underwriting a loan using a property's existing financials would have a solid mortgage a few months hence, when the market improves even further.
An example of a high-profile refinancing deal involves the Chicago Marriott Downtown. The owners of the Marriott Downtown, a 1,192-room hotel, have recently begun shopping for $120 million of refinancing for the upscale asset. The Carlyle Group and LaSalle Hotel Properties (the real estate investment trust) bought the property in early 2000 for $175 million, or nearly $150,000 per key, from a venture between John Buck Company and the Morgan Stanley Real Estate Fund. The acquisition was financed with a $120 million floating-rate mortgage that was provided by GE Capital and the Bank of Montreal. The search for a new mortgage is being prompted by the fact that the existing mortgage comes due in about eight months. It is not known, however, whether that mortgage can be extended, and if it can, to what level its interest rate would climb. The loan carries a rate pegged to LIBOR plus 275 basis points, which translated to 4.9 percent at the end of 2001.
Hotel-debt Restructuring Fundamentals
During the period 2001–2002 quite a few hotel owners have not been able to meet their debt payments. This has caused a number of companies and properties to consider restructuring their debts. Some of those hotels may be able to resolve their situation with their creditors, in what is known as a “workout,” without resorting to court proceedings. Other hotels may be forced to file Chapter 11 petitions.
Compared to Chapter-11 filings, however, workouts can often cost less money in attorney’s fees, accountant’s fees, and lost time due to extensive court hearings. Moreover, debt restructurings can enable a company to survive if key components are kept in focus. For example, the debtor must realize that timing is paramount. If a hotel company waits until it cannot cover payroll, it is probably too late for anyone else to provide assistance, implying that reorganization efforts need to commence as soon as possible. In addition, a company must address any balance-sheet issues fairly quickly. These normally include long-term debt (mortgages); short-term debt (lines of credit); trade debt (debt owed to food vendors); and employee claims (insurance). Balance-sheet issues can be addressed by projecting the amount of cash that will be available to repay creditors, and by constructing a repayment plan that will fit those projections. However, if the projections bring to light that the company is better off liquidating than continuing operations, then the company may have a legal obligation to cease operating and liquidate for the benefit of its creditors.
Debt restructuring really means creative financing. Becoming creative tends to become necessary when a hotel is unable to produce the cash flow required to cover an owner’s debt service. Quite often, creative financing is also applied to assist owners in accepting substantial equity losses at the point of sale and to move on. In either event, the lender-owner takes a hit on his or her capital or suffers lower-than-market-rate yields as a result of the debt restructuring.
Restructuring primarily involves selling businesses, renegotiating loans, and raising additional capital. Warren Buffet’s mid-2001 bailout of troubled commercial real-estate lender Finova involved the reorganization of more than $10 billion of debt, the majority of which were bad loans.
The term “hotel debt restructuring” refers to general reformation cases, as well as to troubled-debt restructuring. General-debt restructuring simply refers to debt reformation whereby the lender has incurred no losses from the restructuring of debt. That is, where creditors have granted concessions by reducing the interest rate (i) to reflect changes in market fundamentals; (ii) to maintain the relationship with the debtor; (iii) by extending the repayment period, or (iv) granting a grace period. During the grace period the debtor continues to pay interest only at the original contractual interest rate where the creditors’ analyses have shown that the debtor is able to repay the full amount of the loan (principal and interest) as agreed in the original loan contract.
On the other hand, troubled-debt restructuring refers to cases where financial institutions incur losses from the restructuring due to one or a combination of the following variables.
Debt restructuring should be carried out to maximize the creditor’s chances of getting repayment subject to the debtor’s ability to repay the loan, or in some other way improve on the conditions set out in the parties’ original contract. In particular, hotel-debt restructuring should be carried out to help debtors who have difficulties repaying a loan due to adverse market conditions or property-level mismanagement, but are expected to recover in the future. The lender will ensure that restructuring is not carried out with the objective of postponing or avoiding debt classification or provisioning requirements, or the avoidance of stopping interest accruals.
Distressed-debt investors who buy into restructuring processes have several advantages. Since they, along with their capital-markets advisor, are controlling the negotiations, they are protected to an extent from external-market conditions. They are also in control when restructured debt is returned to the market, which is when its full potential value will be realized. However, the challenge is to anticipate correctly the time and difficulty likely to be involved in a restructuring. The real test of a successful restructuring is the ability for the market to pick up on the residual package, whether it is debt or hybrid or equity, and trade it.
Financial institutions can contract an independent party such as a specialized group of experienced hotel-debt restructuring strategists. Hotel real-estate investment banks can establish a formal strategy for debt restructuring, whereby the highest level of management should participate directly in formulating this strategy.
The degree of creativity necessary to allow a hotel business to be financially independent often depends on fiscal pressures pressing down on either the debtor or creditor. For instance, a bank that has written down a hotel loan and taken back the property will be able to accept a market-level price for it, but may demand “concessions” to provide financing. On the other hand, a brittle seller owning a hotel that has not fulfilled the debt obligations to the lender may be in no position to negotiate. He or she may have to accept a soft note with minimal payments if the equity in the property is insecure. In both instances, a sale is contemplated.
Characteristically, the first two or three years after a sale or restructuring allow for a “breather” period and for conservative debt-service levels, often at below-market rates. Occasionally, the difference between the cash-payment debt schedule and a market interest rate is accrued and stapled on to the principal amount of the loan. The due date of the accrual, while negotiable, is normally deferred until the loan matures.
After the breather period, the creditor may expect an interest-rate incentive (kicker) in consideration of his or her earlier patience. For example, the creatively recast debt might bear an 8.5-percent base interest rate with additional interest equal to a percentage of gross room sales. Conceptually, that implies that when the business improves, the creditor is expected to share in the upside.
In addition to this bonus-payment plan, or instead of it, the creditor (or the advisor) may negotiate to receive a percentage of the hotel's future resale price. This often falls in the 25-percent range, and can be a helpful inducement to convince a creditor to be patient today. A clear definition of how this future bonus is paid and calculated is important to avoid future problems.
Since creative financing is usually done during times of financial stress,
participants go into a negotiation feeling that refinancing with fresh
outside capital is unlikely. Therefore, the need to weigh the different
options is prudent. The wide array of hotel-debt restructuring alternatives
is summarized in Exhibit 12.
More specifically, Exhibit 13 brings to light the potential sequence of options that are available to lenders and borrowers when a hotel loan could be drifting toward foreclosure.
Lodgian, Inc., struggling under a debt load of approximately $200 million, recently filed for Chapter 11 bankruptcy protection. Lodgian, a hotel owner that has a portfolio of 106 hotels throughout the United States, raised $25 million in debtor-in-possession financing from a group of lenders. Lodgian’s financing should allow it to continue normal operations while it restructures.
Lai Sun Development (LSD) announced in mid-2000 its restructuring plan to extend the put (sell) dates of its 5-percent exchangeable bonds due in 2004 and its 4-percent convertible bonds due in 2002 to December 31, 2002. The restructuring plan consisted of: (a) an organizational restructure proposal; (b) a debt-repayment schedule; (c) restructuring fees of 1.5 percent; and (d) a collateral portfolio.
LSD and Lai Sun Hotels International (LSH) streamlined their operations through reclassification of property and related investments to LSD and high-tech investments to LSH. By August 2000 LSD repaid 15 percent to each of the bondholders partly from the proceeds of disposing of several Furama Hotels for $236 million. By January 2001, LSD repaid another 15 percent each to the bondholders from the proceeds of disposing of 50 million shares in Sunday (an affiliated entity) worth $8.4 million. By December 31, 2002, LSD will repay the remaining 70 percent if bondholders exercise their put rights. In addition, LSD will pay restructuring fees of 1.5 percent on the remaining 85 percent after the initial 15-percent cash repayment. Lastly, LSD proposed to post a portfolio of collateral for the benefits of the bondholders, with an estimated value covering approximately 40 percent of the total outstanding of the exchangeable and convertible debt.
In 1989 a $100-million loan was taken out to build the Neveskij Palace Hotel in St. Petersburg, Russia. The 12-year, 7.5-percent loan was provided by Austria’s Creditanstalt-Bank to Germes, a company majority-owned by the City of St. Petersburg. In 1996, Creditanstalt demanded that the city pay up to $40 million toward the overdue loan, and began assessing late fees. Together with fines and interest payments, the bank was asking for $156 million. As the city was unable to meet its payments, a repayment schedule was worked out. The City of St. Petersburg asked the Vienna-based bank to drop half of its claim of $156 million, and to restructure the rest of the bill to be repaid between 1997 and 2017 at 4-percent interest. In return, the city put into a trust as collateral shares in Germes and various downtown St. Petersburg real estate.
Debt: Rocket Booster or Anchor?
A hotel investor will borrow because the interest tax shield is valuable. At relatively low debt levels, the probability of financial distress is low, and the benefit from debt outweighs the cost. At very high debt levels, however, the possibility of financial distress is a chronic, ongoing problem for a hotel, so the benefits from debt financing may be more than offset by the financial distress costs. In other words, the Achilles’ heel of real estate is too much debt, and a delicate balance between these extremes needs to be attained.
A large amount of debt forces hotel managers to be more careful with owners’ money, but even well-run properties could face default if some event beyond their control - such as a terrorist attack or a recession – suddenly occurs.
Jones Lang LaSalle (NYSE: JLL) is the world’s leading real estate services and investment management firm, operating across more than 100 key markets on five continents. Jones Lang LaSalle Hotels, the world’s leading hotel investment banking group, provides clients with value-added investment opportunities and advice. In 2001, its success story includes the sale of 7,972 hotel rooms to the value of US$1.3 billion in 39 cities and advisory expertise on 100,550 rooms to the value of US$26.3 billion across 255 cities. Jones Lang LaSalle Hotels’ services include transactions, mergers and acquisitions, financial advice and capital raising, valuation, asset management, strategic planning, operator assessment and selection and industry research.
Anwar Elgonemy is with Jones Lang LaSalle Hotels in Miami. Anwar draws on over nine years of advisory experience. Specifically, he conducts due diligence on hotel loan portfolios, strategic repositioning studies, in addition to site selection assistance and litigation support. Since joining Jones Lang LaSalle Hotels in April 2001, he has been involved in hotel transactions and asset management assignments. Anwar holds an MBA from Thunderbird, The American Graduate School of International Management, and a Bachelor of Science degree attained jointly from both the Conrad N. Hilton College at the University of Houston and The Glion School in Switzerland. He is a licensed real estate agent as well as a state certified commercial appraiser in California and Florida.
Anwar R. Elgonemy
Jones Lang LaSalle Hotels
2655 Le Jeune Road, Suite 1004
Coral Gables, Florida 33134
Tel: (305) 779-4958
Fax: (305) 779-3063
|Also See||Concrete to Cash: Real Estate Sale-Leasebacks in the Lodging Sector / Jones Lang LaSalle Hotels / March 2002|
|The Dynamics of a Hotel Deal in Mexico / Jones Lang LaSalle / July 2002|