Investors often think of hotels as a real estate investment. Those that make such investments quickly learn that a hotel is actually an operating business which resides on a piece of real estate. The investment is a balancing act between market dynamics, management and franchise agreements, F&B operating agreements and leases, union agreements, local ordinances, and loan agreements.
Contributed by Jonathan Falik, JF Capital Advisors, New York City
Often, hotel acquisitions or repositionings are financed using bridge debt. Bridge debt may be in the form of senior or mezzanine financing and is to “bridge” a hotel from its current operating and physical condition to a future more stabilized operating cash flow environment, suitable for permanent or traditional financing.
Bridge debt financing will command higher interest rates, have some onerous guaranties (especially for completion of CapEx projects), usually has a 1- to 3-year term (though there may be extension options), and generally has yield maintenance or a prepayment penalty. Many investors think of interest rates associated with bridge lending as exorbitant, yet it is almost always substantially cheaper than the required or implied return on an incremental equity investment.
We recently negotiated a bridge loan for a client which owns a full-service hotel in the Pacific Northwest with banquet and meeting space, leased out and self-operated restaurants, an expiring union agreement, and a sizable offsite parking operation. The owner was also desirous of repositioning the hotel which required a renovation and an affiliation with a major international soft brand while also needing to repay existing maturing debt.
Traditional balance sheet lenders had a difficult time underwriting the hotel given all of the uncertainty during the depths of the COVID-19 pandemic. In addition, the required conversion PIP CapEx was not fully priced out, timing for conversion was uncertain, and the ultimate renegotiation and resolution of the union agreement hadn’t been completed. The loan profile was a non-starter for the CMBS market as there were too many moving parts and some time before the in-place cash flow would support the debt service.
The bridge financing that was negotiated carried a high coupon rate but provided the flexibility and the ability to negotiate PIP terms, negotiate with the union, and have enough runway to reposition the hotel and take advantage of a recovering economy and a return to post-COVID normalcy. The interest rate was substantially lower than the cost of any equity capital investment and the term allowed enough time to execute the business plan and reposition the hotel, while also returning to a strong cashflow position (which will set up the future stabilized refinancing). The bridge loan required new equity investment by the borrower and PIP completion guarantees, but provided a CapEx reserve with flexibility on use, and a debt service reserve.
As the industry recovers from the disastrous impacts of COVID-19, an increasing number of borrowers will be looking to more expensive but flexible bridge loans as a solution and means of refinancing. This
will result from depressed cashflow, depleted FF&E reserves, brand mandated CapEx or PIP requirements, combined with maturing loans (in many cases with deferred interest expense).
Borrowers can best position themselves by getting organized, creating a well thought out strategic plan which includes an approach to CapEx needs or PIPs, pro formas showing recovery versus the market and competitive sets, and the ability to refinance the bridge loan in the future.