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Debt Financing Alternatives & Debt Restructuring
Strategies in the Lodging Industry
By Anwar R. Elgonemy, Jones Lang LaSalle Hotels
September, 2002

Introduction

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). 
 
 

Exhibit 1
Fundamental Considerations Before
Seeking Debt Financing

Business risk:

Business risk is inherent in the property, and is related to the volatility of its sales and its degree of operating leverage. In most cases, hotels can compensate for a large amount of business risk by employing a relatively conservative capital structure (high equity and little debt).

The need for financial flexibility:

The fact that interest must be paid on debt (but dividends do not have to be paid on equity) has important implications for hotels that want as much financial flexibility as possible. The debt�equity ratio can be affected by the extent to which suppliers of debt capital fail to assess the risk of financial distress accurately.

The degree of ownership�s risk aversion:

Hotel owners have to be comfortable with the risk that they are taking. If management has a great aversion to taking risk, it will seek to use a conservative amount of debt. This is one that gives the property the maximum amount of financial flexibility and imposes the least amount of leverage. Aggressive owners, on the other hand, may be willing to incur risk inherent by employing a large amount of debt in the capital structure precisely because of the leverage it gives to the bottom line.

Tax considerations:

Tax considerations include the marginal tax rate of the ownership entity, and the way the tax law treats payments to various suppliers of investment capital. For example, the fact that interest on debt capital is tax deductible, while dividends paid to suppliers of preferred or common equity capital are not, can influence the targeted debt levels. Generally, the higher the marginal tax rate is, the greater the incentive to use more debt. 
 

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 market.
 


Sources: LaSalle Investment Management, the Federal Reserve, and the Roulac Capital Flows Database.


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.
 

Exhibit 5
The Pros and Cons of Debt Financing

At the Property Level

Advantages of Debt Financing

  • The use of leverage in hotel real-estate investing is a way to maximize the return on equity through a relatively small down payment (Exhibit 6). When building real estate, leverage helps one grow fast without extreme risk. The best scenario is when property values increase faster than the interest charged on borrowed funds.
  • A debt load is an incentive that forces a hotel�s management to maintain efficiency, since the financial leverage will work against earnings if management becomes lax and permits net operating income to decline.
  • Debt increases the interest tax shield, which increases the cash flow to equity, and should enhance the value of the property.
  • Leverage uses other entities� capital while allowing maximum control over the business.
  • Debt is an �enabling tool� that allows investors to tap into potential equity that would otherwise be unattainable.
  • With an increasing property value, the initial debt can significantly increase equity levels upon disposition.
Disadvantages of Debt Financing
  • High debt levels impose potential costs on a property in the form of the risk of default and the loss of financial flexibility.
  • Leveraging can, in some cases, �enslave� a hotel to the lender, and stifle management�s creativity and energy.
At the Portfolio Level

Advantages of Debt Financing

  • Non-recourse mortgage debt provides the borrower with a �put (sell) option.� That is, should the values of the properties fall beneath the loan balance, the investor may elect to hand back the hotels by tendering a deed for the properties to the lender in satisfaction of the indebtedness.
  • The use of mortgage debt increases the diversification possibilities within the real-estate portfolio.
  • In pension fund management, mortgage debt can be used for greater alignment between the �duration� of the investor�s assets and liabilities.  Duration is a concept designed to measure the sensitivity of assets and liabilities to a change in the level of interest rates.  One of the goals of pension fund management is to match the duration of the pension�s retirement liabilities with assets of identical duration.   In this way, the pension fund�s surplus is considered to be �immunized�, such that a change in the value of the pension fund�s liabilities caused by a change in interest rates is completely offset by a change in the value of the pension fund�s assets.  An investor can use mortgage financing to alter the duration of the leveraged real estate investment.  Essentially, the duration of fixed-rate mortgage debt offsets the asset�s duration. 
Disadvantages of Debt Financing
  • Financing real estate with debt is equivalent to �shorting� a portion of the investor�s fixed-income portfolio, and therefore alters the investor�s portfolio allocations.
  • An increased equity-yield fallacy is possible when investors focus on the leveraged yield rather than on the asset return in making their purchase decisions.
  • Long-term debt tends to lower the weighted average cost of capital (WACC, or discount rate) because of the tax-deductibility of interest. However, the introduction of large quantities of debt into a portfolio�s capital structure can result in higher levels of financial risk, which cause the WACC to rise.

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).
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Exhibit 6
Examples of An Investor�s Return on Equity
  Without Leverage With 70 Percent
Leverage
Equity contribution $30,000,000 $9,000,000
Total revenues $10,000,000 $10,000,000
Total operating expenses and fixed charges $7,000,000 $7,000,000
Interest expense (Year 1) $1,575,000
Net income to owner $3,000,000 $1,425,000
Return on equity (ROE) 10 percent 15.8 percent
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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.

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Exhibit 7

Characteristics of Different Sources of Debt Financing

Bank Financing
Insurance-Company Financing
Securitization -
Conduit Loan
Securitization �
Single Asset
A good source of traditional first-mortgage financing. Especially good source for low-leverage transactions with terms in excess of five years. The loans are structured on a conduit-program basis, and then pooled or securitized as commercial mortgage-backed securities (CMBS). Attractive option for large properties requiring more than $100 million in debt.
No pre-payment penalty. Lender fixes rate prior to closing. Lender takes on the underwriting risk with the rating agency. Competitive for low-leverage transactions.
Equipped to handle large transactions (more than $50 million). Less expensive than bank loans for a fixed-rate, long-term deal. Transaction can be completed more swiftly than for single-asset securitization. Can be structured with more flexibility than a conduit program.
Significant reporting requirements. More difficult to complete large transactions (more than $100-million deals). Generally attractive pricing for a single-asset owner, but with high up-front costs for small transactions. Lengthy underwriting process.
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Exhibit 8

Typical Loan Terms by Source of Debt Financing

Source of Debt
Property Type, Portfolio
Usual
Motivation of Loan
Type of loan
Typical Spread
Fixed or Floating
DSCR
Maximum Loan to Value
Term (years)
Fees
Bank Financing
Commercial Bank
FS
Acquisition
Non-recourse
LIBOR

+250 bp

Floating
1.35
50 percent
10
1.0 percent
Mortgage Banker
FS-Luxury
Refinancing
Non-recourse
Treasury

+350 bp

Fixed
1.50
65 percent
5
1.0 percent
Mortgage Banker
LS-Flagged
Forward on Construction Loan
50 percent recourse
Treasury

+200 bp

Fixed
1.50
65 percent
10
1.0 percent
Mortgage Banker
FS-Mid-tier/

Portfolio

Refinancing
Non-recourse
Treasury

+350 bp

Fixed
1.40
70 percent
15
1.0 percent
Investment Banker
FS-Mid-tier
Refinancing
Non-recourse
Treasury

+300 bp

Fixed
1.40
75 percent
5
1.5 percent
Insurance-Company financing
Insurance Company
LS-Flagged and un-flagged
Acquisition/

Renovation

Non-recourse
Treasury

+350 bp

Fixed
1.50
70 percent
10
1.5 percent
Insurance Company
FS-Convention Hotel
Acquisition
Non-recourse
Treasury

+350 bp

Fixed
1.50
50 percent
15
None
Securitizations
Securitized Lender
LS
Acquisition
Non-recourse
Treasury +350bp
Fixed
1.50
70 percent
20
2.0 percent
FS: Full-service
LS: Limited-service
bp: Basis points
Non-recourse: Loan without personal liability because the lender agrees it will seek no recourse against the borrower personally if the debt is unpaid.
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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. 
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Exhibit 9 

Debt Financing Alternatives

Alternative
When used by borrower?
Description
Blanket loan To consolidate properties for refinancing, and to "lock in" a property or other assets.  Covering more than one hotel asset.
Buy-down loan To lower the interest rate on the loan. Simply a fixed-rate, level-payment loan with an additional twist: A third party, typically the developer or seller, pays the lender (at loan origination) a fee to essentially "buy-down" the interest rate for the borrower for the first few years of the loan.
Convertible loan Borrower wants to obtain a below-market rate of interest over the loan term, resulting in improved cash flows and some appreciation at buy-out. The developer receives 100 percent of the project�s development cost, control of the property for a period of time (usually 10 years) and a loan at (or below) market rate. The lender receives a fixed-interest return, participation in 10 percent to 50 percent of the cash flow after debt service, and the right to convert the loan into 50 percent of the equity at an agreed date. 
Construction loan Tied to the ability of the developer to obtain permanent financing. Made on the security of a real-estate mortgage, the proceeds of which are disbursed gradually to pay the cost of construction and other improvements to the hotel as construction progresses. Usually short-term; used to finance the "creation of value."
Land sale-leaseback loan The borrower wants to apply the land lease expense as a tax deduction.  The developer usually sells the land to the lender at market value and then leases it back at a low rate (10 percent to 15 percent of the land value) for 40 to 50 years. The developer also must pay out a percentage of future cash flow and a share of the property�s appreciation. 
Mezzanine financing When borrower is in a "credit squeeze." Mezzanine financing is a cross between debt and equity instruments. It generates returns higher than typical bank interest, but is lower than the kinds of returns expected by equity investors. This credit structure offers more pre-payment and financing flexibility than equity, and any expected upside in terms of both performance and capital appreciation of the hotel is retained by the owner. (Described later in more detail).
Open-ended loan In connection with construction loans that are funded as the work progresses. Written to permit the lender to make additional advances in the future. This eliminates the need for a new loan if the advances are made.
Package loan Developer wants to negotiate only with a single lender and wants to pay only one set of closing costs. "Packages" are normally two separate loans (a construction loan and a permanent loan).
Purchase-money loan Borrower has insufficient funds beyond the loan. Taken by the seller from the buyer in lieu of purchase money (the seller helps finance the purchase).
Participation (club) loan Borrower should be hesitant to enter this type of debt structure. Lenders opt for this arrangement as a means of increasing their total yield on the loan. Made by several lenders, with each putting up a portion of the total loan.
Shared-appreciation loan Borrower has insufficient funds beyond the loan. The borrower receives assistance in the form of capital when buying the property in return for a portion of the property�s future appreciation in value.
Takeout loan After the construction loan.  The loan or other financial arrangement for a hotel construction or expansion project that follows the construction loan. Also called the "permanent loan" or the "end loan."
Wraparound loan If an investor has existing financing that cannot be assumed and a refinancing of the property is not possible due to market conditions or economic cost. Form of secondary financing tool in which the face amount of the second (wraparound) loan is equal to the balance of the first loan, plus the amount of the new financing. Because the interest rate on the wraparound loan is normally greater than on the original first loan, upside leverage is achieved on the new lender�s return.
Debt-amortization alternatives
Balloon  Price upon sale is projected to cover balloon payment at end of holding period. Maximizes cash flow to the borrower. Only partially amortized, and therefore requires a lump sum (balloon) payment at maturity.
Interest only  Low cash flow levels expected in initial years. Payments are for interest only with payment in full upon maturity. Since no principal is included in the payment, the loan balance remains the same.
Zero interest  Low cash flow levels expected in initial years. Structured with no interest charges whatsoever (the entire amount of each payment the borrower makes is directly credited to principal reduction). Borrower forgoes tax benefits of interest payments.

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Focus on Mezzanine Financing

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.

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Exhibit 10
  Traditional Structure Mezzanine Structure
Funding    
Senior debt $12,000,000, 60 percent $12,000,000, 60 percent
Mezzanine debt $0, 0 percent $4,000,000, 20 percent
Equity $8,000,000, 40 percent $4,000,000, 20 percent
Total $20,000,000 $20,000,000
Pricing    
Base rate 4.5 percent 4.5 percent
Senior debt margin 3.5 percent 3.5 percent
Mezzanine debt margin 0 percent 17 percent
Leverage Ratios    
Senior debt LTV 60 percent 60 percent
Total debt LTV -- 80 percent
Sale proceeds (after 6 years at 12.5 percent terminal cap)    
Sales proceeds $21,800,000 $21,800,000
Less remaining debt $10,800,000 $14,800,000
Proceeds to equity $11,000,000 $7,000,000
Returns    
Leveraged internal rate of return (pre-tax) 21.5 percent 25.2 percent
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Exhibit 11
Mezzanine Financing
Advantages Disadvantages
Cheaper than equity Higher margins and fees
Capital efficiency Performance controls
Payment flexibility Documentation
Passive management Potential negative leverage
Increased leverage Senior debt negotiations
Retain upside Conflict between various lenders and borrowers
Cost savings Short-term finance
Funding diversification  
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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.

General Categories

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.

  1. Reduction of the principal or accrued interest.
  2. Loss from restructuring through acceptance of a transfer of assets in debt repayment where fair value of assets is lower than the credit written off.
  3. Concessions in the terms of loan repayment resulting in a fall in the present value of cash flows such that this value is lower than the sum of book value of the credits outstanding and the accrued interest.
  4. Loss from the debt-restructuring calculations based on the market value of the debtor�s business, the fair value of the collateral asset, or loss from other techniques in debt restructuring, such as from debt-to-equity swaps. 
Objectives

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.

Strategies

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. 

Alternatives

Since creative financing is usually done during times of financial stress, most 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. 
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Exhibit 12
Hotel-Debt Restructuring Alternatives
Extend loan term and defer principal payment Cross-collateral and cross-default provisions
Adjust interest rate Subordination of borrower profits for debt service
Re-amortization of the loan Additional borrower guarantees
Balloon arrearage Limit project scope (if for a new-build hotel, or expansion)
Repayment of arrearage from operating profits Lender agrees to forbear from assigning a receiver
Continued funding Automatic transfer of title if restructure is not successful
Additional funding Pre-foreclosure sale
Borrower sources other funds (i.e. corporate bonds) Deed in lieu of foreclosure
Debt-equity swaps Assumption of the debt by a new borrower
Use of additional collateral Lender takes an interest in the property via a third party
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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. 
 
Exhibit 13
Options Available Prior to Foreclosure
  1. The lender agrees to wait for the payment of the loan;
  2. The borrower brings the mortgage current for interest, but holds up on the principal portion of the payment;
  3. A partial payment of interest is made, the interest is accrued or added back to principal;
  4. A lump sum of interest and principal is made and the mortgage is adjusted to change the overall terms to provide relief for later payments;
  5. The borrower turns over all income, less operational expenses gained on the property, for application against the debt service;
  6. The lender agrees to refinance the loan to provide needed capital to bring the project back to its feet;
  7. The lender advances funds on a secondary loan to cover the debt service;
  8. The borrower adds additional security, the loan is extended into a blanket mortgage, and additional cash is added by the lender to cover the debt service;
  9. The borrower gives up partial ownership in favor of the lender for a reduction of the debt;
  10. A portion of the property is deeded over to the lender as a partial or full satisfaction of the debt;
  11. The lender allows time to try to sell the borrower�s interest in the property to another party;
  12. The borrower seeks secondary financing from another lender; or
  13. A deed in lieu of foreclosure (voluntary deed) is granted by the borrower to the lender and the debt is satisfied.

Examples

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. 


 
Contact:


Anwar R. Elgonemy
Associate
Jones Lang LaSalle Hotels
2655 Le Jeune Road, Suite 1004
Coral Gables, Florida  33134
Tel:  (305) 779-4958
Fax: (305) 779-3063
[email protected]
www.joneslanglasallehotels.com

 
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


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