Filling the Cap Stack Gap
January 20, 2014 7:08am
By William G Sipple
Even with great availability of low cost senior debt today, we still see a lot of projects suffering from a gap in their capital stack. Most of these deals are new construction projects, but there are plenty of acquisitions that have the same issue. Many of the owners are seeking some type of "passive" equity to get their projects off the ground. They are hoping to identify groups that will take a non-controlling interest in a project and settle for lighter equity returns. They often prefer to see these investors come in through the riskiest phases of the project and want to exit them from the deal at or prior to stabilization. While there are certain groups out there that will invest in deals on this basis, they are few and far between. Owners and developers would be better off seeking a structure that appeals to a wider range of the capital sources.
The options available to owners to fill the gap will vary based on a project's, size, quality level, geographic market, product type and sponsor experience. It is generally the case that good quality assets in strong markets with experienced sponsors will have a much higher probability of attracting capital. Potential sources of gap capital include:
Each of the first four areas above could fill a column on its own. They all require significant work to assemble, and often the timing requirements are so lengthy as to make them impractical. Putting together a hotel capital stack can be like assembling a puzzle with moving parts that must come together simultaneously. The latter three options, on the other hand, can be effective tools that are negotiated in a reasonable amount of time.
KEY MONEY: Key money from the brand or management company can be an excellent way to bring additional capital to a deal. It is often structured as a loan that burns off over the term of the agreement. The term can sometimes be negotiated down to a shorter period. There is generally no interest paid unless the “loan” goes into default.
Companies usually do not want to be the first capital into the deal, so they time the payment to occur once the property opens or is substantially complete. It is sometimes earmarked for specific project costs like FF&E, working capital, or project operating shortfalls.
The corresponding negative for the owner is that there is less flexibility in negotiating many of the management or franchise terms, including fee structure, contract term, termination provisions, and performance outs. Just remember, key money is not “free” by any means.
SUBORDINATE DEBT: Subordinate debt, usually structured as Mezzanine Debt, can be an effective tool to get more leverage into the transaction. It is priced higher than senior debt, but below equity return rates, and is secured by an assignment of the ownership interest of the borrower.
Owners can often layer mezzanine debt on top of the 65% to 70% loan-to-value senior loan to get to an overall loan-to-value in the 80% to 85% range. The cost of this capital can be from the high single digits to high teens, depending upon the project specifics. It is generally co-terminus with the senior loan and may be interest- only at a lower rate to allow for the property’s cash flow to cover the debt service payments. In this case, payments are then trued-up to the lender upon a sale or refinancing of the hotel. Mezzanine lenders are very concerned with seeing a viable exit for their position. They also consider what their basis in the asset will be if the borrower defaults. They adjust their cost of capital to reflect the perceived risk associated with the loan.
Potential negatives are the increased risk associated with higher overall leverage, the difficulties in negotiating an inter-creditor agreement, and the potential tax liability in the event of a default where there is forgiveness of debt.
PREFERRED EQUITY: A third option for some projects is preferred equity. Owners should be realistic about how this capital will be structured and need to be prepared to share the project returns. Preferred equity may be structured as a direct ownership interest in the hotel with a stated return that may or may not include a “kicker” in the event of a capital event like a sale or refinancing.
Alternatively, the deal may also be structured with a Promote position with Cash Waterfall feature. In this instance, the owner/developer has a “promote” position in its participation in the hotel’s cash flow. The preferred equity may have a “pay rate” during the term of the arrangement, with a true-up rate upon a future capital event. For instance, the preferred equity will capture the first cash flow produced by the hotel until a base level of return is achieved. Cash flow over that amount would be split according to a negotiated formula, or “cash waterfall.” There may be multiple thresholds above the base level. Upon a sale or refinancing of the asset, the preferred equity would typically receive the first cash flow taking it to a higher return, say 20 percent. The negotiated cash waterfall formula would then dictate splits over the higher return to the preferred equity.
Advantages to preferred equity include lower overall leverage, which may result in better debt terms; no need for an inter- creditor agreement; no personal guarantees; and in the event the project returns are lower than expected, you usually won’t get wiped out if the cash flow doesn’t cover the preferred equity minimums.
The bottom line is there are numerous options for filling a capital gap, but owners should be realistic about structuring terms that are capital friendly and the compromises that will be needed. There is very limited availability of truly passive equity that is content with mediocre returns and narrow control provisions. Owners should focus on the structure that works best for all parties.
Previously published in www.LodgingMagazine.com
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Contact: Bill Sipple
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