As everyone in the hospitality industry understands too well, the heavy real estate component Of the business requires large amounts of capital. The scarcity of well priced sources of such capital have played havoc with the ability of developers and purchasers of hotel properties to fill their appetite and to permit them to seize opportunities in the industry.

In the early to mid-eighties limited partnership vehicles, usually with tax deferral incentives, helped fill the gap left by financial institutions who were somewhat reluctant to provide debt financing. In the mid nineties "Real  Estate  Investment  Trusts" ("R.E.I.T.'s") became the financing vehicle of choice. Each time institutional lenders shied away from financing hotels and other similar related hospitality-businesses a new vehicle emerged to allow the Canadian industry to grow, led in each instance by the experience of the larger and more dynamic American marketplace. Toward the end of the last decade, once again led by the American example, (and indeed by American players, in many instances expanding into Canada), innovative vehicles were established to bring new sources of financing to this industry.

One such new financing technique has become commonly referred to as "conduit" financing. This debt financing results from "securitizing" an asset, which in our example, constitutes a mortgage and other traditional security (eg: a general security agreement on all of the tangible and intangible assets of the hotel, assignments of management, franchise and other major contracts respecting the operation of a hotel, etc.) given to a lender. The lender who acts as the "originator" of the mortgage, sells the mortgage to a single purpose-entity which, in turn, packages a number of commercial mortgages secured by different types of real estate assets. Together the "pool" of mortgages are sold as commercial mortgaged back securities ("CMBS" issues), not as individual mortgages. Each purchaser of a CMBS buys an undivided interest in the pool through either private placements or public offerings.

The pool has usually received a credit rating from a recognized credit rating agency such as "Dominion Bond Rating" or "Standard & Poor". This "pooling" and "rating" of the hotel mortgage significantly increases both the type and number of investors who could take advantage of investing in such mortgage security. In addition, because conduit financing can create mortgage pools containing mortgages which are backed only in part by hotel assets, the purchaser of  this security is not overexposed to any one property nor to any one sector of real estate. The pool has already done the "asset allocation".

While conduit lending has increased the availability of capital for the hotel industry, there are costs involved in going to this market. The requirements imposed by the rating agencies in achieving a sufficiently high rating for the security to make the vehicle efficient to the hotel industry combined with the uncertainty of the availability of purchasers for these CMBS securities at a particular  moment  in  the investment cycle means that the hotel owner / developer must be willing to meet new requirements and take on some of the risk in the financing process.

On the "risk" side, the lender's commitment may well be contingent upon, among other things, any material adverse change in capital market conditions which occur between the time of signing a commitment and the actual advance of funds. Similarly, the cost of funds (le. the interest rate) may be fixed only on or a few days prior to the date of the advance of funds although the commitment will contain a formula for determining the interest rate benchmarked, for example,  to Government of Canada bonds having a maturity date closest to the maturity of the mortgage.

On the "requirement" side, a number of additional factors must be considered by the hotel owner/developer:
 

In summary 'conduit" lending offers an exciting new source of capital which is in chronic short supply to the hospitality sector. Both American branch plants and Canadian owned mortgage lenders, including financial institutions, are now marketing this new vehicle. It will still take some time and much patience to determine its viability. 

This article was written by Norman I. Kahn, a partner in the Toronto law firm, Aird & Berlis, who practises in the area of Real Estate and has had extensive experience in the hotel acquisition and financing sector.