Make Sure Your Lender Gets Current Information

DEBT FINANCING TERMS ARE HAMPERING HOTEL TRANSACTIONS

by Jeff Wilder

for H&MM July 5, 1999 Issue

With the salad days of hotel deal-making in temporary repose, one important question is why. Is it that hotels are less profitable today than two years ago? Often, not. Certainly, we know about the REIT’s pulling back, but there are plenty of local and regional players to pick up the slack. So, what is one of the primary reasons for the transaction slowdown these days? The culprit may well be the inability to do junior financing to make deals work. Let me explain.

First mortgage financing, the mother’s milk of deals, is quite available. In our office, I get weekly faxes from lender after lender, promoting their recently closed hotel deals, and telling me about their current rates and programs for hotels. Yes, it is true that the "Wall Street mortgage market" has become somewhat more conservative and choosy in its underwriting and lending. However, the highly liquid and popular non-recourse CMBS (commercial mortgage backed securities) market is unquestionably open for business, as are the various SBA oriented lenders who mostly require personal guarantees on repayment (but whose lending limits have increased.)

Generally speaking, non-recourse CMBS debt is available in the 65% LTV (loan to value) range at 8 Ľ% to 9% interest with amortization schedules of 20 to 25 years and 10 year loan terms. That’s an historically advantageous loan profile, especially with property acquisition cap rates in the 11˝%-13% range. SBA guaranteed debt is more pricey, with rates running in the 9% to 10 Ľ % range; yet, the loans are often fully self-liquidating over 25 year terms and can be financed up to 80% of project cost--two nice bonuses. Both these markets are relatively liquid. But, the SBA loan’s personal guarantee provisions, juicier rates and limitation on loan size do limit their usefulness to smaller deals.

The deal-making disadvantage of the popular non-recourse CMBS loans lay primarily in their prohibitions related to junior financing. And, it’s a whopper of a problem that is doing more to slow down the pace of hotel deal-making today than almost any other factor. These loans almost always restrict the borrower from accepting secondary debt junior to the first mortgage position. The reason for this limitation is that it would eat into the cash flow available for debt repayment, thus impairing the first mortgagee’s loan position, by affecting the borrower’s ability to repay, and lowers the credit rating for the paper being created. This was okay to live with, at least in the short run, when borrowers could count on loans in the 80% LTV range. But when the debt level dropped to 65% +/- last year, deal-making difficulties became frustratingly obvious.

Here are two examples of how the problem of CMBS restrictions on junior financing adversely affects deal making. Let’s say that a hotel owner wishes to sell his property to a buyer with whom he had an agreement on price. Assume that the buyer has 20% cash equity and can only locate a 65% non-recourse LTV. More often than not, a reasonable seller would hold financing for the 15% "gap" in the form of a purchase money second mortgage (or for you West Coasters, a deed of trust.) The seller would have a second lien behind primary financing and, in the event of default on either the first mortgage or its own secondary position, he/she could go to court to enforce their rights. However, the CMBS lender does not see the secondary creditor as a backstop safety valve, someone who would step into the borrower’s position and continue paying on the first mortgage. Rather, he is seen as a drain on subordinated cash flow and, through the first mortgage instrument, is effectively restricted from either looking to the business cash flow for repayment or foreclosing. His position is basically unsecured and, therefore, it is unreasonable to think he would hold a loan for a portion of the purchase price. So, the deal dies though both sides had agreed on price.

Or, let’s say the seller and buyer agree on price for a property and that, in fact, there is debt and equity capital available to get the deal done without requiring the seller to hold a purchase money mortgage. However, the property needs upgrading to keep its franchise and the buyer sources out an F,F&E loan to complete the project financing and do the upgrading. The furniture/equipment lender will naturally want a first lien on what it is lending on, be it mattresses, air-conditioners, a new roof, or the like. However, the CMBS first mortgage lender has contract language in its debt instrument requiring that it must hold a first lien on everything in the hotel. Therefore, the equipment lender has no primary lien on the new stuff being bought and, as a result, will not, extend credit. So, there’s no way to finance the improvements other than with an additional equity injection. And, that may increase the cash needed to complete the deal to a level that makes it unappealing to the buyer. So, the deal dies on that score.

SBA loans generally allow for secured junior financing and equipment lending with UCC filings acceptable to the lender. This, even with first mortgage loan levels approaching 80% LTV. So, under those conditions, deals are able to get done. That’s why many of the deals I see closing today are smaller ones where buyers take advantage of SBA loans and their lack of prohibitions against junior financing.

Until the CMBS first mortgage financing market overcomes the restrictions on junior secured debt, I am afraid that this deal making problem will be with us and completing transactions will be hampered, as a result.