With summer travel ended for the year, reduced in-person college events, “no-fan” professional sporting events, nonexistent corporate travel and other COVID-related issues, the fall and winter seasons look grim for the hotel industry.
In times such as these, hotel owners will need to explore all financing options in order to maintain liquidity. For the foreseeable future, there will not be a federal rescue plan or bailout for the lodging industry, and operators need to not just survive, but thrive.
The inability to stay current on debt service payments — not to mention potential operating losses — due to extreme revenue losses is creating a liquidity need for most hotel owners. Furthermore, loan maturities, frustration with CMBS servicers, and banks not extending forbearance could all add to the problem. There are many owners that, despite a discount to value due to COVID, still have significant equity in their hotels. These are the same owners that took a conservative approach to leverage prior to COVID, yet they could have the most to lose due to the pandemic.
Stephen Schwanz is president and CEO of CEO ZEL Capital Partners, based in Scottsdale, Arizona; Jeffery Cohen is senior vice president.
Traditionally, only two financing options existed in the hotel space: debt recapitalization and preferred/bridge equity:
Debt recapitalization: This method has limited options, but those do include SBA loans and bridge loans. Many banks and CMBS originators are not back in business today. Debt is coming from private debt funds looking to charge a premium spread on loans. We are hearing that the price of debt is in the L+500-1,000 range, and loan-to-value ratios are ranging from 50% to 60% (on “post-COVID values”).
Preferred equity: Because investors are providing venture capital to the company so that it can operate, they get preferential treatment. A preferred equity deal comes with various pros and cons for entrepreneurs and crowdfunding investors. For example, there is no dividend growth or income risk. The preferred equity investor can have veto power over major operational decisions. Upon default, the preferred equity investor can exercise the right to force a sale or become a managing member going forward. The costs to obtain preferred equity may be higher than mezzanine and senior debt. Most equity today is looking for minimum rates of return of 9% to 12% along with warrants or kickers. Ultimately, most equity providers are looking for returns in the mid-teens.
Sale-leasebacks
The sale-leaseback method is a new, alternative mechanism to consider when seeking financing.
Hotel sale-leasebacks have been popular in Europe and Australia for over 100 years. In the United States, real estate investment trusts (REITs) have conditioned the domestic lodging market that management must be relinquished and current ownership loses control of the business. Specialized lodging sale-leaseback REITs do exist in the U.S., but they tend to be more focused on unique subsets such as casinos, ski resorts and large entertainment or waterpark venues.
With a hotel sale-leaseback, the seller of a hotel becomes a lessee to a new owner, maintaining a brand flag and management agreement but avoiding certain economic risks and alleviating concerns about potential oversupply in top markets.
A hotel sale-leaseback offers an ideal alternative method to conventional financing by converting equity into cash and providing tax advantages. Once the investor purchases the property, the title is transferred and the franchise owner becomes the tenant. All deals are made under a lease or master lease that can be extended and expanded as needed.
Structure of a sale-leaseback
Every hotel and hotel investment opportunity is unique and has unique market demand generators that are critical to its revenues. Net lease investors have internal criteria needed for their internal rate-of-return models, and matching the investor’s need and the specific hotel asset goes through a process.
Hotels with high leverage to value usually are not strong candidates for sale-leasebacks, as minimal equity will remain after closing costs and escrows of PIP reserves or rental reserves (post-COVID). In most examples, sub-70% LTV will allow for a meaningful sum of equity to come out at closing.
Customary terms may include: a 20- to 40-year lease, renewal options, a repurchase option, no lock-out period for the repurchase option, capital off the table for deployment toward other sources and uses, and reserves for PIP and rent for a post-COVID recovery period. Buyback or continue to lease may also be an option.
Benefits of a sale-leaseback may include: IO operating expense, tax benefits, the ability to convert equity to liquidity, a possible source of DPO financing, the ability to take out construction loans and/or mortgages coming to term, the ability to maintain full control over hotel operations and management, reasonably quick due diligence and closing timeframes, the possibility of using the financing for acquisitions, higher leverage, and motivated specialized lenders.
Future of sale-leasebacks in hospitality
“In light of COVID, there has been a temporary loss in the value of almost all hotel assets. In addition, many hotel owners are not producing cash flow and as such are facing a liquidity crisis. The sale-leaseback repurchase option works really well for those owners who have equity in their assets, despite the impact from COVID. It allows that owner to retire their debt, cover their costs and generate liquidity today, yet it provides the owner a meaningful share of the upside in the future,” said Andrew Broad, Principal of Avison Young Hospitality.
Several factors and categories of players in the hotel and real estate sectors are driving the popularity of sale-leasebacks, which is why they are here to stay for the foreseeable future. Billions to trillions of dollars of investment funds currently sit on the sidelines seeking yield better than market. The sale-leaseback model allows for above-market returns and provides a financing vehicle for the seller-tenant when limited lenders are in the room at this time.
Additionally, very attractive to operators is the ability for value-add acquisition deals in certain markets and repositions under replacement costs. In some cases, through a sale-leaseback model, investors will come to the table with 82% financing or more. Operators that can find good purchase opportunities below market replacement cost can create substantial returns once the market has stabilized again.