|By: Kirby D. Payne, CHA - July, 1997
Never having had enough capital to take advantage of all the various opportunities to grow that have presented themselves, I am very conscious of the cost of capital. The less you have, the costlier it is and the harder it is to get.
Capital for hotel ventures typically consists of two components, debt and equity. Their costs are the interest on the debt, the investors' expected return on equity and the cost of obtaining the capital itself. Some of the cost of raising capital can initially be folded back into the debt or equity but in the end it is paid for with additional interest or less profit distribution.
The cost of debt actually includes several different components. Among the possible components are mortgage origination fees, mortgage brokerage commissions, points, prepayment penalties (if one prepays later in order to obtain better terms from another source), legal fees (the borrower's and the lender's), appraisal fee, environmental study fee, and finally interest. The component with the most impact over time is interest.
Interest rates charged for commercial mortgages are impacted by a number of factors. These might include, but are not limited to, the term of the loan, whether the interest rate is variable or fixed, the basis on which the variable interest moves and the amount it can fluctuate in any one period, interest rates at the time the loan commitment is made, the actual source of the funds the lender will be using to make the mortgage loan and a lot of issues that are purely subjective..
These subjective items include the lender's perception of these items: the risk of the hotel project relative to the other loans that could be made; the ultimate value of the collateral; the financial stability of the borrowing entity and its principals; quality of management; and if the project "fits" in the lender's loan portfolio relative to the type of project it is. Where the lender stands relative to achieving their lending goals for the time period and the political strength of the particular person carrying the loan through the underwriting process are also major factors.
Aside from looking at debt coverage ratios and loan to value ratios the lender is going to consider all these other factors at some level. They will all ultimately affect the amount of the loan and the terms. Every aspect of the terms has a relative cost to the borrower.
For instance a lender may make the borrower escrow funds to complete certain required improvements in the hotel. Distribution of those funds will not be done until they receive all documentation that the improvements are completed, paid for and lien releases obtained. This means the borrower has to come up with the funds from other sources until the lender releases the funds. There is a cost to those additional funds, either additional interest or opportunity cost because they are not invested elsewhere.
If the escrow agreement is written so that the bank will pay for the improvements from the escrow fund as they are completed the borrower may not have to come up with as much extra money. The lender, however, is now assuming some risk that the projects will, in fact, be completed. For this to work efficiently for the lender, borrower and contractors, the escrow agreements and contracts for construction all have to be coordinated to all parties' satisfaction.
The cost of coordinating these items will show up as time, legal fees and probably higher prices from the contractor. The point here is that a hotel developer with sufficient capital does not have to do these things or bear these costs. This savings increases the return on the investment as compared to a developer with less capital.
If the lender perceives one borrower and his or her project to be less risky than another's they may grant more favorable terms in the loan in the form of slightly lower interest. On the surface the impact of this may not be significant but the reality is quite different. For instance on a $10,000,000 project with a $7,500,000 mortgage for 20 years the difference between an interest rate of 8.5% and 8.25% is $14,184 in principal and interest payments. If one disregards the tax implications of this and only evaluates the cash on cash return on equity the difference is just over a half a percentage point.
If the investors were going to receive an average cash on cash return on equity from operations of 19.65% with the 8.5% percent interest rate they will now receive one of 20.217%. Which developer will have the easier time raising equity capital? Among other things easier means less costly. And less costly also translates into even higher returns on equity.
While one doesn't usually think of equity as having a cost it does. In the simplest terms an individual investor has choices as to where s/he might invest. These alternatives all have different levels of expected return and risk. The higher the perceived risk the higher the expected return. If this investor could have invested in a government backed security and had a return of 6.0% without risk then their perceived cost is at least that amount. If they are going to take the risk of investing in something they know nothing about, have no control over and which has no liquidity they are going to have a much higher expectation for their investment return. The developer is probably going to have to forego some return until the investors' expectations are met. This is a cost of capital to the developer.
Another example might be when the developer is larger and decides to go to the public for the equity. Whether the approach is through a registered private placement memorandum or a small stock offering there will be significant legal, accounting and other fees associated with the fund raising project. Depending on the planned source of funds, the size of the fund raising has to be greater than a certain amount to justify these methods.
On the other hand a major publicly traded REIT (Real Estate Investment Trust) or C corporation has already gone to this expense. So much money, hundreds of millions or more, has been raised that the cost of the funds is relatively low relative to interest rates. Such a company will simply buy a hotel for cash from their cash reserves or credit lines in a very short process and if appropriate get a mortgage at their leisure on very favorable terms.
Because they were able to act quickly and pay all cash to the seller this buyer probably obtained much more favorable terms on the purchase. As a further point, because their cost of capital was so much lower their earnings expectations do not need to be as high as the smaller entity with the higher cost of capital. It is this relationship to the cost of capital that makes these companies appear to overpay for existing hotels as viewed from the smaller entities' perspective.
By driving up the price of existing hotels, these companies lower the achievable returns of the smaller companies when both are seeking the same types of hotels. This is one reason smaller companies seek out hotels to buy that the larger companies may not pursue for one reason or another.
The smaller company needs to deal with sellers who are patient and wait while the capital for the purchase is raised. The seller will wait because they have been unable to sell it to another buyer or because the price is higher. In either case the return will be lower or the risk is higher for the buyer. After all, why wouldn't anyone else buy the hotel?
In the end, the company with less capital cannot afford to make mistakes and has to maximize cash flow by being a very good hotel marketer and operator. The company with more capital and higher returns can, of course, afford to pay premium wages to its key executives and other staff.
The cost and availability of capital affects every aspect of competition in the hotel industry in very fundamental ways.
For additional information, contact:
Kirby D. Payne at the firm
American Hospitality Management Company
1500 South Highway 100, #375, Minneapolis, MN 55416
Phone: 763-591-7640 Fax: 763-591-1593
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