by Ashish Amin
Driven by rising room rates, demand, and limited supply growth, hotel acquisition financing/refinancing looks to be back in full swing. Many lenders that were apprehensive in the past, have noticed this trend and are increasingly aggressive in this space. These lenders have become more sophisticated since the financial crisis and may now require additional navigating to make sense of the available options and nuances of financing.
The following identifies key items both lenders and borrowers consider for:
What are your priorities and what do you value the most in acquiring financing?
In most cases, financing is a major decision and can be very overwhelming. Many considerations have to be made including recourse, leverage, term, amortization, fixed rate or floating rate. These factors are vital in determining which lenders will suit your needs and should be established prior to starting the process.
How is your property performing and what is it bringing to the bottom line?
To underwrite any loan, the lender will initially require operating statements including past, present, and projected (proforma) income and expenses to get to net operating income (NOI). This process usually serves as a litmus test to get lenders comfortable with the property’s performance. Secondly, it will provide them with an indicator on valuation and loan sizing.
What is driving revenue?
Given the daily duration of leases for hotels, income is highly volatile and heavily depends on the state of the economy. The real estate market, supply, location, national/local economy, visibility, accessibility, and tourism all are integral contributors of revenue and need to be analyzed thoroughly by the lender to get comfortable. It is also particularly important for lenders to know if the hotel is flagged (franchised) or un-flagged (independent). Some lenders are very comfortable with independent hotels, while others require a brand affiliation.
How are you performing against your competition and what market share are you achieving?
The Smith Travel Research (STR) report is a treasure to any lender. It is unique to this asset type and tracks the three major metrics including occupancy, average daily rate (ADR), and revenue per available room (RevPAR). The report benchmarks a hotel’s performance against its competitive set and local market. This provides the lender the opportunity to see if they are performing above their market share or if there is room for improvement. It is also a good indicator of whether the property has been stabilized.
What are the terms of the franchise agreement and are you familiar with a comfort letter?
Most franchise agreements are termed for 10 years, unless they are new construction. From a lender perspective, this poses as a risk in sourcing permanent financing longer than the agreement. In most cases, the agreement is not transferable to hotel lenders and is not assumable by a foreclosure purchaser. The loss of a flag could substantially drop the value of a hotel. In the case of a foreclosure, the lender faces the risk of this loss or the additional terms imposed by the franchise that could include revised fees, property improvement plan (PIP) requirements, and additional brand specific requirements. To address this risk, a lender often requires a “comfort letter.” Simply put, a comfort letter is an additional agreement created by the franchisor to provide the lender rights to continue the franchise in case of a foreclosure.
What are your current and future PIP Requirements? Have you accounted for this?
All branded hotels require renovations and upgrades in the form of a property improvement plan (PIP). This is usually ongoing and will ultimately result in the termination of the franchise agreement if not completed during a certain timeframe. To minimize their risk, most lenders will either require the PIP to be current during the purchase/refinance of the property or escrow the funds into a reserve account. There are alternate options that can be negotiated including a hold back from loan proceeds, letter of credit, or even a completion guarantee. In addition, lenders will typically require a capital reserve equal to 4% of revenue. This accounts for future PIP renovations, unplanned projects, and the repair/replacement of furniture, fixtures, and equipment (FF&E). The lender will almost always underwrite the 4% for loan sizing, but can be flexible with the capital reserve requirement. A new build or detailed schedule of capital improvements can be used as grounds of decreasing the reserve requirements.
Have you looked into prepayment penalties and decided which way to go?
There are several options when it comes to lenders and a major differentiator is flexibility and prepayment penalties. A lot of the decision will be based on a company’s business plan and where they anticipate interest and cap rates going. A majority of financing recently has been offered by life insurance companies and banks. Life insurance loans tend to be balance sheet loans, while banks typically offer securitized loans, commonly referred to as conduits or commercial mortgage backed securities (CMBS). These loans are predominantly non-recourse and the tradeoff is prepayment penalties in the form of yield maintenance or defeasance.