Why the Top Hotel Investors and Lenders Are Conscious of Capital RiskThe Basics of Hotel Loans
Incessantly, sophisticated hotel investors and lenders seek out high risk-adjusted returns. That is, they seek for transactions where their risk exposure yields a higher return than comparable projects or loans. There are several factual and subjective risk factors. Having awareness of the evident objective hazards, however, allows sponsors to detect and minimize these risks prior to a deal's advanced stages. The risk tolerance of capital providers corresponds to their position in the capital stack. They may act as a lender, an investing partner, or in any other capacity.
A shrewd sponsor may maximize revenues by establishing a contract with the appropriate participants in each segment.
Capital Stack Elements
Diverse hotel investors and lenders contribute the necessary funds to finalize and capitalize a transaction. These partners provide capital from and to a certain total capitalization amount. Zero to sixty-five percent of total capital may be provided by a lender, while equity investors provide the remaining to close.
These distinct components of the total capitalization are referred to the capital providers as "tranches." Each tranche of capital has distinct risk, payment, and lien rights characteristics. Investors and lenders assess their exposure based on their "last dollar" in the transaction.
The largest forms of capital for hotel investors and lenders, respectively, are equity and debt. Different players combine within these categories to provide sponsors with a bewildering number of funding alternatives.
The structures of senior and mezzanine debt are distinct, yet they share a risk viewpoint. Similar to the link between common equity and preferred equity, but "higher up" in the capital stack.
No matter how the capital stack is assembled, one thing stays constant: the amount of all tranches must equal 100 percent of the overall capitalization. In addition, capital requirements should be evaluated at the time of closure and beyond to ensure that adequate funds are available to complete a PIP or ramp operations.
Rights, Risk, and Remuneration
Hotel investors and lenders have distinct business models. Their interests in property ownership and management could hardly be more divergent.
Lenders invest funds on behalf of bank depositors, investors, and syndicated trusts, among others. Although some lenders have the human capacity and processes to take control of a defaulted loan, most prefer to collect payments and hope the loan performs.
Equity investors are more tolerant of failure risk. They construct sophisticated asset management teams that keep a close check on the property's performance in order to react to any hint of trouble.
These organizational structures indicate their tolerance for risk.
Lien Rights
Everyone in the capital stack has a valuation at which bringing the asset into their balance sheet makes sense. Lenders evaluate this last dollar based on their capacity to dispose of the asset. Partners in a joint venture are more concerned with market value and upside possibilities.
The methods in which hotel investors and lenders handle lien rights are comparable yet vastly unlike. In the event that the asset's sponsor or business strategy fails, however, both parties attempt to seize possession.
Early in the engagement, investment partnerships do thorough due diligence to address sponsor default. They seek experience, methods, and business plan indicators that decrease the likelihood of failure. The partnership agreement permits substitution of the sponsor as the operator in the case of failure. However, their ownership of common equity remains unchanged.
Lenders are more merciless when seizing possession of the asset.
Nobody wishes for a company strategy to fail, yet it often does due to internal and external factors. The hotel lender has the power to seize the property if the borrower fails to comply on many metrics, nonpayment being the most obvious. This entirely destroys the capital investments of the sponsor and partners.
Risk Awareness
From the macroeconomy to the property level, hotel investors and lenders face a vast array of hazards. Several examples include:
- Market risk
- Credit danger
- Inflation risk
- Risk of concentration
- Most providers of capital are price takers.
Private markets are inefficient, but there is often sufficient competition to define the cost of each sort of capital. The benchmark for conservative lenders, such as commercial banks, is the risk-free rate on 10-year Treasuries.
All interest rates and periods are increased in comparison to these vanilla loans.
Greater risk incurs additional expense. Among others, this manifests as choices between the cost of capital, personal guarantees, and time of maturity.
This is evident in mortgages, auto loans, and credit cards that price risk based on credit history. The commercial real estate capital markets rely on transaction-specific information, such as the property, your experience, and your business strategy.
Timing of Money
Hotel investors and lenders differentiate themselves further by how and when they get payment.
Everyone is acquainted with loans that demand monthly payments of both principle and interest. This type of loan, known as an amortizing loan, is typical for vehicle loans and mortgages.
Loans for commercial real estate may be entirely or partially amortizing.
A loan with complete amortization repays the whole principle sum during the term of the loan. In contrast, a partially amortizing loan includes a maturity balloon payment in the middle of the loan's term. In this instance, the investors have returned a substantial portion of the loan through monthly instalments, with the remainder due at maturity.
Current payment is the necessity to pay each month regardless of financial flow, regardless of whether the loan payment includes principle or merely interest. Nevertheless, certain loans and the vast majority of equity investors let payments to accumulate (or accrue) if the property's cash flow does not permit current payment.
Accrued interest payments add to the unpaid principle sum. This increases the overall cost of capital since periodic interest on loans is calculated based on the current amount. Nevertheless, it offers a great deal of flexibility in circumstances when payments are unclear.
Current and accrual payments are instruments that enable for more imaginative contract structuring in business plans for new building and major renovations.
Loans and Equity That Perform Identically
The murky region between debt and equity further complicates matters.
Mezzanine debt and preferred equity behave similarly, but capital providers arrange them similarly to senior debt and common stock. This covers lien rights and the timing of payments. However, their risk profiles are very similar.
This portion of the capital stack gives the maximum flexibility for the sponsor to maximize low-cost profits. It is a piece of transitional capital that permits sponsors to acquire a transaction when they are nearing their maximum investment capacity.
Senior lenders account for around 65 percent of the overall capital. Mezzanine debt can be layered on top of this portion to increase an investor's return to at least 85 percent. However, the default rights for preferred equity are slightly different.
In case of default, a mezzanine lender maintains a lien on the property. In such a scenario, the preferred equity holding changes to common stock.
At a certain point, this is primarily a matter of semantics. Prior to investing in such a structure, hotel investors and lenders must establish strategic judgements on its significant legal implications.
High leverage poses several dangers for all parties involved. Common equity is not contractually obligated to make payments, unlike debt and preferred equity. Consequently, a larger portion is more adaptable when the going gets rough.
Additionally, common equity gets the most from the upside, thus your decision to construct a highly leveraged capital stack depends on your conviction in the transaction. In order to create the most effective capital structure for your company strategy, it is necessary to analyze each point of the capital stack.
