Mr. Clark

Finance & Investment

Debt & Equity Financing: What options are still available?

By Bryan J. Clark, President & CEO, Lion CFC Inc

There are several forms and sources of potential debt financing available to hotel owners in the marketplace today. Without getting technical and using a ton of industry "jargon," the three main types of debt financing available to hotel owners are conventional, unconventional, and hard/private money. Typically conventional financing requires an A to A minus credit rating and can be secured from banks, credit unions, thrifts, insurance companies, pension funds, conduits, and real estate investment trusts. Typically these loans are not held in a lender's portfolio, but rather sold on Wall Street in the form of mortgage backed securities. Although these sources of financing can and usually do offer the lowest rates (typically 100 to 250 basis points over the current treasury index), they are only suitable for loan amounts from $1M-$50M, require perfect guarantor credit, and a loan-to-value ratio of 70-80% though 60-70% is more realistic now in light of the "credit crisis" and so-called "residential mortgage meltdown." Typical conventional lenders offer terms from 10-20 years with a 5, 7, or 10 year balloon. Of course there are exceptions to every rule, but this is the norm.

Unconventional financing on the other hand allows for a credit rating of A minus down to D, a loan to value ratio of up to 90%, loan amounts from $1M to $100M or more, and can be obtained through certain banks, credit unions, and in some cases, insurance companies. Various commercial mortgage banks and real estate investment trusts also offer this type of financing. Rates for unconventional financing tend to be a bit higher, typically anywhere from 250 to 700 basis points over the current treasury index. Terms for unconventional loans vary from lender to lender. However terms from 10 to 30 years are available with a balloon at 5, 10, or 15 years.

Hard/Private money is available for all types of credit. Loan-to-value ratios are available from 50-100% using the true definition of loan to value (loan amount in relation to market value as opposed to loan amount in relation to purchase price). Conventional and unconventional lenders will not lend 100% of the purchase price of a property regardless of the property's market value. However, a private money lender may (and usually will) understand when the purchase price is deeply discounted and therefore warrants a loan for 100% or more of the purchase price. Loan amounts for private/hard money loans have no limits as to their minimum or maximum. Since it is indeed private money, the loan parameters can be quite flexible and are usually determined on a case-by-case basis. Typical sources of hard/private money are private investors, some credit companies, and occasionally commercial mortgage banks. Rates for private money loans can be anywhere from 600 to 1600 basis points above the current treasury index although private money rates are typically quoted based over "prime." Total loan fees for hard/private money loans will run from 2 to 20 points which usually come out of the loan proceeds at closing.

Equity, as opposed to debt financing, is typically cash that is invested into a property or project on a joint venture or equity partner type basis as opposed to a traditional mortgage. Therefore the cost of such financing will be based on the potential "up-side" of the project and will utilize "internal rate of return" style underwriting. A real estate investment trust or real estate focused hedge fund can purchase a building or fund a project by use of equity instead of traditional debt financing, or more commonly a combination of both debt and equity. Typically the equity being used to fund such a project does not come from one private investor but rather a professionally managed pool of private investment capital/equity. Hotel owners and developers often form joint venture partnerships with real estate investment trusts, hedge funds, etc. in order to successfully fund a hotel project. Of course there are upsides and downsides to this potential finance structure. Clearly any sort of joint venture that is formed will require a portion of the profits or future profits to be shared in some manner with the trust or fund providing the capital. On the flip side, much of the financial risk of the project can be avoided by the hotel owner or developer when utilizing this type of joint venture partnership.

Although it was possible (and quite common) for a hotel owner to structure a deal with a 70%-80% first mortgage and 20%-30% equity at the height of the recent real estate boom, the capital "stack" available to hotel owners has changed significantly, and quite quickly. Despite the constant negative press debating the extent of the "credit and liquidity crisis," capital is still readily available for hotel deals if one knows where to look and are familiar with the various capital "stacks" and deal structures. For example, it is unlikely that a hotel owner will fund a new hotel deal with a 70%-80% first mortgage and the rest with equity due to increasingly more conservative underwriting by lenders and the increasing cost of equity. However, it does remain possible to structure a hotel financing transaction using a 60%-70% first mortgage, 10%-30% mezzanine financing by adding both a first and second mezzanine component ("b tranche" and "c tranche"). The "b" and "c" notes may allow up to 95% leverage while the remaining 5% could be filled with "gap" equity, owner equity, etc. although equity financing or partnering will almost always require an ownership interest in the property or venture.

It is important to note that the type of transaction i.e. acquisition, development, refinance, value-added or repositioning, etc. will have an impact on the type of financing available. For example, "value added/opportunistic" deals can usually be structured in a variety of ways including the use of higher leverage first mortgages (sometimes up to 100% LTV when utilizing hard money), higher leverage mezzanine investments, or joint venture deals where 90%-100% of the required equity can be secured from an "opportunistic" real estate equity fund. Every "opportunistic" real estate equity fund has their own "flavor of the week" regarding the deal and property types they are willing to look at and invest in so it is important for hotel owners and developers remain aware of the debt and equity financing available for the deal type they are pursuing. It is common for debt and equity providers to change their deal preference and underwriting requirements fairly often so it is good to be aware of the underwriting requirements of the various lenders of both debt and equity prior to considering any "value-added/opportunistic" transaction.

Hotel financing is usually available for development, acquisition, and refinance transactions of approximately $1M-75M with "loan-to-value" (LTV) ratios up to 75% (up to 95% "stretched" using mezzanine financing), and with terms of usually 3-10 years. Both fixed and floating rate loans are available and pricing will almost always vary depending on the overall leverage and deal structure. Non-recourse financing with "standard carve-outs" should be expected. Mezzanine loans of approximately $1M-15M (per property/project) are readily available for acquisition, development, and refinance transactions up to 95% "LTV" with terms typically ranging from 1-3 years. Equity investments are also available for acquisition, development, and refinance transactions with individual equity investments usually ranging from $1M-20M per property/project and terms of up to 10 years.

Hard money is often overlooked and perceived as being "hard" on the bottom line although this is not always an accurate perception. In fact, hard money can often be a great source of financing for "opportunistic" and "value-added" transactions for a variety of reasons. One reason to consider hard money would be a land purchase (for development of a hotel or resort) or a hotel purchase where either the land or the hotel (or both) are being sold at a discount or significantly under "market" value. Hard money lenders will sometimes allow the Borrower to use the "market" value of the property when computing the "LTV" (loan-to-value) calculation. This means that if a piece of land or a hotel must be sold quickly, and therefore the owner is selling significantly under value (20-30% under market value), a Buyer can often use hard money to cover the entire purchase price of the property with hard money financing. Another point to consider is that a hard money acquisition transaction can usually be closed within two to three weeks, meaning a savvy hotel owner or investor can close on the purchase before anyone else even knows about the opportunity or before the local bank's "loan committee has even looked at the deal for another hotel owner/investor. Since there is typically no "loan committee" or other bureaucratic underwriting process when dealing with hard money lenders, hotel owners and developers should always be aware of and have access to a variety of competent hard money lenders so they are able take advantage of hotel opportunities very quickly before the opportunity is gone. Once a hard money acquisition transaction has been closed, conventional financing or interim financing should be secured as soon as possible to refinance the hard money loan and thereby reduce the cost of funds on the mortgage.

Another reason to consider hard money is for redevelopment or repositioning of a hotel property or other real property asset. Since hard money lenders will often use the "after completion" value of the property for "LTV" calculations when structuring a construction or redevelopment loan, it is usually possible to secure financing for 100% of the cost of redevelopment or repositioning of the hotel asset. Of course the cost of funds will typically be higher with hard money lenders than that of a construction lender or local bank, however, the "opportunity cost" is often not worth the risk of the local "loan committee" changing their mind at the eleventh hour and killing the deal. The "fickleness" of the loan committee should always be something to consider when making a decision whether or not to pursue conventional financing over hard money when structuring an opportunistic or value-added transaction, especially if there is an impending deadline or other need for a quick funding.

Bryan J. Clark is President and CEO of Lion Commercial Funding Consultants Inc. Lion CFC maintains relationships with real estate investment trusts, hedge funds, and a variety of private money pools. The firm is a leader in innovative alternative finance structures and solutions involving standby letters of credit, bank guarantees, medium term notes, bills of exchange, and "take or pay" contracts. Mr. Clark is a member of the Urban Land Institute and contributing writer to various monthly publications. Mr. Clark can be contacted at 858-602-8080 or info@lioncommercial.com Extended Bio...

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