August 1998 H&MM Column-Hotel Securitization
By Jeff Wilder
As the securitization of hotel loans grows ever more popular, it is of
more than passing interest how loans originated via this process are
priced to the borrower. In other words, what goes into how much interest
you'll be charged for a loan. I recently discussed this subject with
financing executive David Kidd of Finova Realty Capital. His company is a
major hotel loan originator. David provided valuable insight into the
banker/underwriter's thinking and I'd like to share it with you. His
comments follow.
Loan Pricing: Spread and Rate
The prospect of locking in long-term, fixed rate, non-recourse
financing at today's low interest rates has created record volume in
commercial real estate financing transactions around Wall Street.
Usually, each transaction is unique, every asset presents individual
strengths, and borrowers have very particular financing requirements.
Understanding how modifications to the "conduit lender's" basic loan
structure affect deal pricing will help to save you time and money.
The margin, or "spread", applied to a pre-arranged index rate (e.g. a 10
year Treasury) will determine the interest rate for the loan's
term. The numerous factors that go into determining that
spread vary from asset quality and organizational structure to
environmental matters and pre-payment provisions. Establishing
goals for the transaction, and creating a list of priorities early in the
process, will help ensure a successful financing transaction.<br>
Quality and Risk
Of foremost concern are the yield demands of investor in
the commercial mortgage backed securities (CMBS) market. CMBS loans
are priced based on the quality of the asset and risk associated with the
individual loan. Asset quality is based on the hotel's physical
condition, the market it serves, and its position in that market relative
to competition. Additional concerns include how the property is managed
and accounted for. Keeping well-organized records, and having the back up
documentation regarding special circumstances presented in the historical
financial statements, also reflect on the quality of the asset.
The economic risk of any loan is fundamentally measured by the degree of
leverage, as measured by both the loan-to-value (LTV) and the debt
service coverage (DSC) provided by the assets' net operating
income. Simply put, the lowest spreads are made available to high
quality assets in strong markets with low leverage requirements. As
LTV and DSC constraints are "tested", a spread premium is ordinarily
imposed to account for increased risk. The spread will increase
depending on the leverage required (i.e. 60% vs. 75% LTV). Constraints
vary, but in today's market we find an 80% LTV to be the maximum leverage
accepted. The same principle applies to to DSC; the higher the debt
coverage provided by cash flow, the lower the spread.<br>
Structure
Beyond quality and risk, loan structure plays a large part in
determining loan pricing. Due to CMBS investor demands for steady,
uninterrupted cash flows for defined periods, the market has established
standard structures that lenders will provide to optimize both the rate
spread to the borrower and the yield to the investor. For example,
the best pricing is now achievable with a 10-year term and a 20 to 30
year amortization schedule. Alternative maturity schedules are
available but, because they vary from the ideal with respect to the CMBS
bond structure, these ordinarily command a spread premium.
Typically, deviations from a basic 10 year term structure can add 10 to
30 basis points.
Similarly, customized pre-payment formulas that deviate from either yield
maintenance or defeasance formulas impact the interest rate. Although the
details of these methods are beyond the scope of this discussion, the
important point to remember is that there are other options.
However, expect that unique modifications will impact the spread
level. For example, a declining prepayment penalty structure might
add 30 to 50 basis points to the spread.
There are other concerns, beyond those already discussed, that also
impact pricing. For example, is the hotel full-service or limited
service, franchised or independent ?
The Ratings Agencies
The common denominator in the CMBS pricing equation is the
ratings agencies. Ultimately, all lenders need to present the
"pool" of loans being brought to market for ratings agency scrutiny. In
order for the pool to bring the most value to the lender, it needs to be
rated highly by agencies such as Moody's or S&P. If there are
issues of quality, risk or structure that vary from the ideal being
sought by investors, it causes the overall pool's bond rating to be less
favorable and thus affects the marketability of the entire package.
The key to a successful financing is establishing objectives, listing
priorities, and asking questions. Getting the information, early on, that
you need to properly structure a financing, be it an acquisition or a
refinance, will not only save time and money, but eliminate needless
headaches. Speaking from personal experience, having somebody like
David Kidd from FINOVA Realty Capital (dkidd@finova.com) in your corner
throughout the transaction is invaluable.
Copyright © 1998. All rights reserved.