debt-financing alternatives—refinancing and restructuring in the lodging industry

Debt-hancing Alternatives Refinancing and Restructuring

in the Lodging Industry

Debt is beneficial, but only up to a So, how much is too much?

BY ANWAR R. ELGONEMY

point, beyond which the disadvantages outweigh the benefits.

S ince 1990 the financing and ownership of lodging real estate have undergone substantial transformations. Spe- cifically, the owners’ equity (security) required for hotel

real-estate deals has fundamentally changed the way lodging assets and companies are financed. Hotel buyers, developers, owners, and managers need to understand the alternatives to securing debt, as well as the feasibility of numerous financing strategies-an intimidating task in increasingly volatile markets.

One of the issues in lodging finance is the ratio of debt to equity. Debt can be beneficial, of course, but only up to a point-beyond which the costs of potential financial distress begin to outweigh the benefits of leverage. That is an important issue for investors because debt-to-invested capital af- fects a hotel’s cost of capital and, therefore, the overall value of the property.

0 2002, CORNELL UNIVERSITY

The lodging industry has earned a reputation as a high- risk business for lenders and mortgage investors. Obtaining financing for a lodging property calls for creativity, tenacity, and flexibility. Today, hotel developers and operators find themselves not only aggressively competing for a constantly changing pool of funds (both equity and debt), but also hav- ing to deal with increasingly complex terms and conditions for the efficient use of those funds.

Before pursuing debt-financing alternatives hotel investors need first to consider four basic elements, namely (1) business risk, (2) the need for financial flexibility, (3) the degree of ownership’s risk aversion, and (4) tax considerations (see Exhibit 1, on the next page).’

‘Robert J. Stalla, Comprehensive Study Guide for the CFA Exam-Book 3, (Westlake, Ohio: Argentum, 2000), pp. 192-193.

JUNE 2002 Cornell Hotel and Restaurant Administration Quarterly 7

FINANCE I DEBT STRUCTURES

Fundamental considerations before seeking debt financing

(1) Business risk

Business risk is inherent in the property, and IS related to the volatrlity of its sales and its degree of operating leverage. In most cases, hotels can compensate for a large amount of business risk by employing a relatively conservative capital structure (high equity and little debt).

(2) The need for financial flexibility

The fact that interest must be paid on debt (but dividends do not have to be paid on equity) has important rmplicatrons for hotels that want as much financial flexibility as possrble. The debt-equity ratio can be affected by the extent to which suppliers of debt capital fail to assess the risk of financial distress accurately.

(3) The degree of ownership’s risk aversion

Hotel owners have to be comfortable with the risk that they are taking. If owners have a great aversion to taking risk, they will seek to use a conservative amount of debt. This IS one that gives the property the maximum amount of financial flexrbility and imposes the least amount of leverage. Aggressive owners, on the other hand, may be willing to incur the risk inherent in employing a large amount of debt in the capital structure precisely because of the leverage it gives to the bottom line.

(4) Tax considerations

Tax consrderatrons include the marginal tax rate of the ownership entity, and the way the tax law treats payments to various suppliers of investment capital. For example, the fact that Interest on debt capital is tax deductible, while dividends paid to suppliers of preferred or common equity capital are not, can influence the targeted debt levels. Generally, the higher the marginal tax rate IS, the greater the incentive to use more debt.

Real-estate Capital-flow X-ends The level of capital flows to real estate between

1983 and 2001 highlights the importance of pri-

vate debt in the marketplace (Exhibit 2), which

is expected to continue to play an important role

in future capital funding. Capital flows are an-

ticipated to return to a temperate level in 2002,

as lenders and investors re-enter the market. In

fact, total capital flows to real estate in 2002 are

predicted to increase by 12.5 percent over 2001

(although at 14.2 percent below 2000 levels),

driven primarily by the private market.

Between 1983 and 200 1 lodging-industry

senior-mortgage commitments fluctuated con-

siderably, slumping in 199 1 at only $160 mil-

lion and peaking in 1986 at approximately $1.8

billion. In general, when the prime lending rate

declines, senior-mortgage commitments tend to

increase in an inverse correlation (Exhibit 3).

According to the American Council of Life

Insurers (ACLI), in 2001 a cumulative total of

approximately $7.4 billion in commercial mort-

gages held by insurance companies was secured

by hotel and motel properties, compared to $6.3 billion in 2000, indicating the continuing reli-

ance on debt in the lodging industry. As a point

of reference, in 2001 the lodging sector con-

stituted 4.3 percent of total senior-mortgage

commitments.

The hotel-debt capital markets are currently

characterized by high volatility, although inter-

est rates are low, including the prime lending rate

(Exhibit 4, overleaf). However, there is still in-

terest in established properties operating in mar-

kets with high barriers to entry, such as New York,

Chicago, and San Francisco. The spread between the London Interbank Offer Rate (LIBOR) and

the prime lending rate is essentially the profit to

the lender.

Hotel Debt-financing Fundamentals The cheapest additional capital to raise is debt capital, so debt should be the first source of new

capital. Only when a hotel company has raised

so much debt that its financial flexibility is becoming impaired, or its cost of debt becomes too

high, should it consider raising more funds by selling shares of common stock or even lodging assets.

8 Cornell Hotel and Restaurant Administration Quarterlv JUNE 2002

DEBT STRUCTURES FINANCE

~ X H i B I T 2

Cap i t a l f l o w s to real e s t a t e

2 0 0

1 5 0 . c~ o

1 0 0 o

~ 5 0

._o - 0

r ~

-50

m I

1983 1985 1987 1989 1991 1993 1995

I Public-equity REITS I Private equity I Public-debt CMBS

Sources: LaSalle Investment Management, the Federal Reserve, and the Roulac Capital Flows Database.

1997 1999 2001

I Private debt

L o d g i n g - i n d u s t r y s e n i o r - m o r t g a g e c o m m i t m e n t s

.=

o -¢1 "6 C 0

=E

$2,000

1,800

1,600

1,400

1,200

1,000

800

600

400

20O

0

I Millions of dollars 20%

Prime lending rate 18

10 ~.

6 g 4

I II I 2 o

"83 '84 '85 "86 '87 '88 "89 '90 '91 "92 '93 '94 '95 '96 '97 '98 '99 '00 '01

Sources: American Council of Life Insurers (ACLI) and the Federal Reserve Bank of St. Louis

Note:The line represents the prime lending rate while the bars are the annual mortgage-commitment amounts.



EX"~BiT

Average annual LIBOR and prime lending rate, 1992 to May 8, 2002

10%

9

8

7

6

5

4

3

2

1

0

- , . . , . . . . . . __

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

- - Average annual LIBOR Prime lending rate

Source: Federal National Mortgage Association (FNMA) and Federal Reserve Bank of St. Louis.

Although there are multiple reasons why the possibility of debt financing increases the value of hotel real estate, this does not imply that bor- rowing $65 million on a $100 million hotel au- tomatically increases the value of the property. If it did, then all investors would acquire properties using leverage. So, there is more to leverage than meets the eye, especially when one consid- ers operational issues. The potential benefits of debt are usually already factored into the market value of the property, so that the hotel's value is usually independent of specific financing decisions. Naturally, a 7-percent long-term loan in a 9-percent market does add value, but that value is derived from below-market financing and not from the decision to acquire debt per se.

When a hotel owner uses debt, the interest payments are tax deductible. Furthermore, the use of debt increases the tax basis beyond the equity investment, thus enhancing the tax shelter gener- ated from depreciation. Those two tax-related fundamentals allow the hotel owner who uses debt to reduce the IRS's share of net operating income.

The most obvious use of debt financing is the reduction of the minimum investment necessary in any given hotel deal. Because investors generally have limited capital resources, a reduced minimum investment in one transaction allows them to spread their wealth over several investments. As diversification reduces portfolio risk, then lower risk should translate into higher value.

Combining financing possibilities with various forms of ownership, the decision maker can create new risk-return opportunities--meaning that new investments fit specific investor needs. As such, the flexibility to tailor the investment to suit the hotel owner is an additional benefit of using debt financing.

Advantages and Disadvantages of Debt Financing The decision to use leverage should be made in the context of uncertain asset returns and the portfolio implications of the leverage decision. The great advantage of hotel debt financing at both the property and portfolio level is maximiz- ing the return on equity, while a chief disadvan- tage is stifling management's energy and creativity. Other advantages and disadvantages are shown in Exhibit 5.

10 Cornell Hotel and Restaurant Administration Quarterly JUNE 2002

DEBT STRUCTURES I FINANCE

Leverage makes the volatility of investor returns greater than the volatility of the value of the underlying property. In other words, if the return on the hotel asset itself (before financing costs and taxes) exceeds the pre-tax cost of the mortgage debt used to finance the property, leverage is positive and the pre-tax return on the investor’s equity in the hotel will be greater than the pre-tax return on the asset itself. However, if the pre-tax return on the hotel asset is less than the cost of financing the investment, leverage is negative, and the return on the investor’s equity that is invested in the hotel will be less than the pre-tax return on the asset itself.

To demonstrate this basic principle, suppose that a full-service urban hotel is acquired for $3O,OOO,OOO and the revenues and total expenses are $10,000,000 and $7,000,000, respectively. Exhibit 6 (overleaf) shows the investor’s return on equity if the hotel is purchased with no debt (unleveraged), and if it is 7O-percent financed with a 7.5-percent, 25-year amortization, monthly payment conventional loan (ignoring the effect of depreciation and income taxes).

The leverage is positive because the return on the hotel (10 percent) is greater than the cost of debt (7.5 percent), so that the leveraged return on equity (15.8 percent) is greater than the unleveraged return on the asset (10 percent). Al- though the return on equity increases with 7O- percent leverage, this increase is accompanied by higher risk exposure to the investor’s equity position. Therefore, the resulting return on equity derived from the amount of debt used needs to be constantly measured against the investor’s required return on equity and tolerance level for risk exposure. The factor that is most important in producing leverage is the amount of debt used to finance the acquisition of the hotel, rather than the interest rate on that debt.

Different Sources of Debt Financing In general there are four sources for third-party financing available via the debt-capital markets. These are: bank financing (domestic and over- seas), insurance companies, conduit-loan securitization, and single-asset securitization (Exhibit 7). More specifically, Exhibit 8 focuses on typical loan terms and motivations by source of debt financing (Exhibits 7 and 8 are on the next page spread).

Pros and cons of debt financing

At the property level

Advantages of Debt Financing The use of leverage In hotel real-estate investing is a way to maximize the return on equity through a relatrvely small down payment (Exhrbrt 6). When building real estate, leverage helps a firm to grow quickly without extreme risk. The best scenario is when property values increase faster than the Interest charged on borrowed funds.

A debt load IS an rncentrve that forces a hotel’s management to maintain efficiency, since the financial leverage will work against earnings if management becomes lax and permits net operating income to decline.

Debt increases the interest tax shield, which increases the cash flow to equity, and should enhance the value of the property.

Leverage uses other entities’ capital while allowing maximum control over the business.

Disadvantages of Debt Financing

l High debt levels Impose potential costs on a property in the form of the risk of default and the loss of financial flexibility.

l Leveraging can, in some cases, “enslave” a hotel to the lender, and stifle management’s creativity and energy.

At the portfolio level

Advantages of Debt Financing

Non-recourse mortgage debt provides the borrower with a “put (sell) optron.” That is, should the values of the properties fall beneath the loan balance, the investor may elect to hand back the hotels by tendering a deed for the properties to the lender in satisfaction of the indebtedness.

The use of mortgage debt Increases the diversification possibilities within the real-estate portfolio.

In pension-fund management, mortgage debt can be used for greater alignment between the “duration” of the investor’s assets and liabilities.’

Disadvantages of Debt Financing

l Financing real estate with debt IS equivalent to “shorting” a portion of the investor’s fixed-income portfolio, and therefore alters the investor’s portfolio allocations.

l An increased equity-yield fallacy IS possible when investors focus on the leveraged yield rather than on the asset return in making their purchase decisions,

l Long-term debt tends to lower the weighted average cost of capital (WACC, or discount rate) because of the tax-deductibrlrty of interest. However, the introduc- tion of large quantities of debt Into a portfolio’s capital structure can result in higher levels of financial risk, which cause the WACC to rise.

’ Duration is a concept designed to measure the sensitivity of assets and Irabili- ties to a change In the level of interest rates. One of the goals of pension-fund management is to match the duration of the pension’s retirement liabilities with assets of identical duratron. (See, for example: Martin L. Leibowitz, “Total Port- folio Duration: A New Perspective on Pension Fund Asset Allocation, ” financial Analyst Journal, September-October 1986.) In this way the pension fund’s sur- plus is considered to be “immunized,” such that a change in the value of the fund’s liabilities caused by a change in interest rates is completely offset by a change in the value of the fund’s assets. An investor can use mortgage financing to alter the duration of the leveraged real-estate investment. Essentially, the duration of fixed-rate mortgage debt offsets the asset’s duration.



Examples of investors’ return on equity

Equity contribution

Total revenues

Without leverage

$30.000.000

$10.000.000

With 70% leverage

$9,000,000

$10.000.000

Total operating expenses and fixed charges $7,000,000 $7.000.000

Interest expense (Year I) - $1.575.000

Net income to owner $3,000,000 I $1,425,000

Return on equity (ROE)” 10% I

15.8%

*Net income to owner divided by equity contribution

Characteristics of different sources of debt financing

Bank financing

A good source of traditional first- mortgage financing

No pre-payment penalty

Equipped to handle large transactions (more than $50 million)

Significant reporting requirements

Insurance-company Securitization- financing conduit loan

Especially good source for low- leverage transactions with terms in excess of five years

Lender fixes rate prior to closing

Less expensive than bank loans for a fixed-rate, long- term deal

More difficult to complete large transactions (more than $100.million deals)

The loans are structured on a conduit-program basis, and then pooled or securitized as commercial mortgage-backed secunties (CMBS)

Lender takes on the underwritlng risk with the rating agency

Transaction can be completed more swiftly than for single-asset securitlzation

Generally attractive pricing for a single- asset owner, but with high up-front costs for small transactions

Securitization- single asset

Attractive option for large properties requiring more than $100 million in debt

Competitive for low-leverage transactions

Can be structured with more flexibility than a conduit program

Lengthy underwriting process

A number of variations of hotel debt financ-

ing and debt amortization exist (Exhibit 9), with

each alternative best suited for a specific purpose

or leverage strategy.

Focus on Mezzanine Financing Mezzanine loans have filled the void in lodging-

industry financing before, specifically in the early

and mid 1990s when real-estate markets put some loan institutions in jeopardy through defaults. Banks,

in turn, began to finance less of the construction

costs with the first mortgage. The need for gap fi-

nancing has re-emerged because public markets have

been skeptical of the industry’s expansion.

Mezzanine funding has become an attractive fi-

nance option for hotel owners being faced with a

“credit squeeze.” The comparative advantages of

mezzanine financing are demonstrated via a simpli-

fied numeric benchmark of the structure (Exhibit

lo), while Exhibit 11 provides a snapshot of the

advantages and disadvantages of mezzanine finance.*

(Exhibits 10 and 11 are on page 15.) On the assumption that a hotel valued at $20

million was earning a net operating income of $2.4

million a year and achieved annual NO1 growth of

3 percent, Exhibit 10 shows the difference in return

for a hotel owner between a traditional and a mezza-

nine debt structure over six years. Because of mezza-

nine financing’s leverage, the internal rate of return would be sensitive to any changes in NOI.

Refinancing Fundamentals In today’s jittery capital markets, and apart from

private equity and entrepreneurial sources, there

is still financing available for strong properties with

strong sponsorship. For the most part, lenders are

not usually concerned about the spreads and lower

interest rates. Rather, what sparks the deal-mak-

ing process is basically whether the deal shapes up as a strong one or not. Nonetheless, with the

current low interest rates, there should be some

straight refinancings occurring, provided that the underlying assets can support the deal.

While lenders are still hesitant to fund hotel loans, some are beginning to evaluate their cur-

rent stance, especially as the lodging sector’s worst

* Jones Lang LaSalle Hotels, “Finance Issues in Hotel Real Estate: Mezzanine Finance,” Hotel Topics, No. 1 (Septem- ber 1999), p. 5.


DEBT STRUCTURES I

FINANCE

Typical loan terms by source of debt financing Property Usual Maximum

Source of type. motivation Type of Typical Fixed or loan to Term debt portfolio of loan loan spread floating DCR value (years) Fees

Bank financing

Commercial FS Acqursrtion Non-recourse LIBOR Floatrng 1.35 50 percent 10 1 .O percent Bank +250 bp

Mortgage FS-Luxury Refinancing Non-recourse Treasury Fixed 1.50 65 percent 5 1 .O percent Banker +350 bp

Mortgage LS-Flagged Forward on 50.percent Treasury Fixed 1.50 65 percent 10 1 .O percent Banker construc- recourse +200 bp

tion loan __” -._ -. Mortgage FS-Mid-tier, Refinancing Non-recourse Treasury Fixed 1.40 70 percent 15 1 .O percent

Banker Portfolio +350 bp

Investment FS-Mid-tier Refinancing Non-recourse Treasury Fixed 1.40 75 percent 5 1.5 percent Banker acquisition, +300 bp

renovation

Insurance-company financing

Insurance LS-Flagged Acqulsitlon, Non-recourse Treasury Fixed 1.50 70 percent 10 1.5 percent Company and renovation +350 bp

un-flagged -“11- Insurance FS-Conven- Acqulsitlon Non-recourse Treasury Fixed 1.50 50 percent 15 None Company tion Hotel +350 bp

Securitizations

Securitrzed LS Acquisition Non-recourse Treasury Fixed 1.50 70 percent 20 2.0 percent Lender +350 bp

Notes: FS = Full service

LS = Limited service

bp = Basis points

DCR = Debt-coverage ratio (net operating income divided by debt service)

Non-recourse = Loan without personal Ilability because the lender agrees it will seek no recourse against the borrower personally if the debt is unpaid.

financial woes are apparently over. Whereas hotel fundamentals are not yet where they were before September 11, 200 1, they are well on their way toward improvement. Therefore, a lender underwriting a loan using a property’s existing financials would have a solid mortgage a few months hence, when the market improves even more.

An example of a high-profile refinancing deal involves the Chicago Marriott Downtown. The owners of the Marriott Downtown, a 1,192-room hotel, have recently begun shopping for $120-million of

refinancing for the upscale asset. The Carlyle Group and LaSalle Hotel Properties (a real-estate investment trust) bought the property in early 2000 for $175 million, or nearly $150,000 per key, from a venture between John Buck Company and the Morgan Stanley Real Estate Fund. The acquisition was financed with a $120-million floating-rate mortgage that was provided by GE Capital and the Bank of Montreal. The search for a new mortgage is being prompted by the fact that the existing mortgage comes due in about eight months. It



Debt-financing and -amortization alternatives

Alternative 1 When used by borrower? 1 Description I I

oraisal of Real Estate, eleventh edition (Chicago: Appraisal Institute, 1996), pp. 546-549). -.

Covering more than one hotel asset.

Debt-financing alternatil s (see: Appraisal Institute, The / 3pi

Blanket loan To consolidate properties for refinancing, and to “lock in” a property or other assets.

To lower the interest rate on the loan.

Borrower wants to obtain a below-market interest rate over the loan term, for improved cash flows and some appreciation at buy-out.

Tied to the ability of the developer to obtain permanent financing.

The borrower wants to apply the land lease expense as a tax deduction.

. . . -. .- . ..-.....- - .-. .-- -.-.... When borrower is in a “credit squeeze.”

In connection with construe- tlon loans that are funded as the work progresses.

Developer wants to negotla;; only with a single lender and wants to pay only one set of closing costs.

Borrower has insufficient funds beyond the loan. _ ___. _...-___ Borrower should be cautious. Lenders opt for this arrangement as a means of increasing their total yield on the loan. _ I ..-- -.. ..-. . -. Borrower has insufficient funds beyond rhe loan.

After the constructIon loan.

If an investor has financing that cannot be assumed and refl- nancing the property is not possible due to market conditions or economic cost.

Buy-down loan Simply a fixed-rate, level-payment loan with an additional twist: A third party, typi- cally the developer or seller, pays the lender (at loan origination) a fee to essentially “buv-down” the interest rate for the borrower for the first few vears of the loan.

Convertible loan The developer receives 100 percent of the project’s development cost, control of the property for a period of time (usually 10 years) and a loan at (or below) market rate. The lender receives a fixed-interest return, participation in 10 percent to 50 percent of the cash flow after debt service, and the right to convert the loan into 50 percent of the equity at an agreed date.

Construction loan Made on the security of a real-estate mortgage, the proceeds of which are disbursed gradually to pay the cost of construction and other improvements to the hotel as construction progresses. Usually short-term; used to finance the “creation of value.”

Land sale- leaseback loan

The developer usually sells the land to the lender at market value and then leases it back at a low rate (I 0 percent to 15 percent of the land value) for 40 to 50 years. The developer also must pay out a percentage of future cash flow and a share of the property’s appreciation.

Mezzanine financing Mezzanine financing is a cross between debt and equity instruments. It generates returns higher than typical bank Interest, but is lower than the kinds of returns expected by equity investors. This credit structure offers more pre-payment and financing flexiblllty than equity, and any expected upside in terms of both performance and capital appreciation of the hotel is retained by the owner.

Written to permit the lender to make additional advances In the future. This elimi- nates the need for a new loan if the advances are made.

&en-ended loan

Package loan “Packages” are normally two separate loans (a construction loan and a permanent loan).

1”1 111 _ _.... _ ._ __ __... ...” I ..__l_.l-_-. . -..--.._ _-___ __--__ Taken by the seller from the buyer In lieu of purchase money (the seller helps finance the purchase).

Made by several lenders, with each putting up a portion of the total loan.

Purchase-monev loan

Participation (club) loan

Shared-appreciation loan

The borrower receives assistance in the form of capital when buying the property in return for a portion of the property’s future appreciation in value.

The loan or other financial arrangement for a hotel construction or expansion project that follows the construction loan. Also called the “permanent loan” or the “end loan.” ._ _” _~__~~_~~~~_~~~_~~~~~~~~~~~~~~~~~~__~~~~~~~~_~~_~~~~~~~~~~~~~~~~~~~~~~~~~_~~~~ Form of secondary financing tool In which the face amount of the second (wraparound) loan is equal to the balance of the first loan, plus the amount of the new financing. Because the interest rate on the wraparound loan IS normally greater than on the original first loan, upslde leverage IS achieved on the new lender’s return.

Takeout loan

Wraparound loan

Debt-amortization alternatives (see: M.E. Miles and C.H. Wurtzebach, Modern RealEstate, fifth ed. (New York, John Wiley&Sons, 1994). pp. 45&452) __--.

Price upon sale IS projected to cover balloon payment at end of holding period. Maximizes cash flow to the borrower.

Only partially amortized, and therefore requires a lump sum (balloon) payment at maturity.

Interest only Low cash flow levels expected Payments are for Interest only with payment in full upon maturity. Since no principal in initial vears. is Included In the oavment. the loan balance remains the same.

Zero interest Low cash flow levels expected in initial years.

Structured with no Interest charges whatsoever (the entire amount of each payment the borrower makes is directly credited to principal reduction). Borrower forgoes tax benefits of Interest payments.


DEBT STRUCTURES I

FINANCE

is not known, however, whether that mortgage can be extended, and if it can, to what level its interest rate would climb. The loan carries a rate pegged to LIBOR plus 275 basis points, which translated to 4.9 percent at the end of 200 1.

Loan Delinquencies and Commercial Mortgage-backed Securities Data on delinquent hotel loans from 1991 to 2000 indicate that default rates decreased in the past 10 years, and the lodging industry was posi- tioned relatively conservatively in terms of debt. Demand for better loan information has risen considerably since 1998, when Russia’s default on government bonds sent tremors through the debt markets. The market for commercial mortgage-backed securities (CMBS) dried up quickly, and when it resumed, investors de- manded more lucid information on loans behind large CMBS issues. In addition, demand for more and better-quality information has prompted the rise of sophisticated techniques to monitor market conditions by real-estate investment banks, such as instant-feedback e-mail-driven investor- sentiment surveys.

Looking ahead, a change in hotel financing is expected to occur in 2004 and beyond, when the majority of loans reach an age that enables mortgage holders to refinance. Starting in 1994, the majority of hotel loans were made through conduit vehicles, which had restrictions on refrnanc- ing for 10 years. When 2004 arrives, many of those loans will probably be refinanced and leverage levels should increase. Even then, there is little reason to expect that underwriting standards will be eased, as that would jeopardize the originator’s ability to resell the loan in secondary or CMBS markets.

According to Salomon Smith Barney and John B. Levy & Co., hotel delinquencies jumped from 1.4 percent at the end of 2000 to 4.9 percent in 2001 (Exhibit 12, overleaf), which is still very low compared to the peak of 16 percent in 1992. The indicated spike in 2001 highlights the current need for debt restructuring.

Orlando has the largest cumulative share of troubled hotel loans in the country, totalling $700 million at the end of the fourth quarter of 200 1, up from $322 million at the beginning of the period, according to a recent study by

Traditional Mezzanine Structure Structure

Funding Senior debt $12,000,000, 60% Mezzanine debt $0, 0% Equrty $8,000,000, 40% Total $20,000,000

Pricing

Base rate 4.5% Senior debt margin 3.5% Mezzanine debt margin 0%

Leverage Ratios

Senior debt LTV 60% Total debt LTV -

Sale proceeds (after 6 years at 12.5-percent terminal cap)

Sales proceeds $21,800,000 Less remanning debt $10,800,000 Proceeds to equity $11 ,ooo,ooo

Returns

Leveraged internal rate of 21.5% return (pre-tax)

$12.000.000, 60% $4.000.000, 20% $4.000.000, 20%

$20.000.000

4.5% 3.5% 17%

60% 80%

$21.800.000 $14,800,000 $7.000.000

25.2%

Mezzanine financing

Advantages

Cheaper than equity

Capital efficiency

Payment flexibrlrty

Passive management

Increased leverage

Retain upside

Cost savings

Funding diversification

Disadvantages

Higher margins and fees

Performance controls

Documentation

Potential negative leverage

Senior debt negotratrons

Conflict between various lenders and borrowers

Short-term finance



Commercial real estate, loan-delinquency rates

18% 16 14 12 IO 8 6 4 2 0

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

--c Hotels --4-- All commercial real estate

Source: Standard & Poor’s, Salomon Smith Barney, and John B. Levy & Co.

Standard & Poor’s. With almost 105,000 hotel

rooms, Orlando is the second-largest lodging

market in the United States, after Las Vegas.

By the end of 2001 the Orlando area had 14

hotel properties in arrears on loans worth $170 million, many of which fell into delinquency af-

ter September 11 .5

That represented about a quarter of the

troubled hotel loans nationwide, the largest of

any market in the nation.

The properties with delinquent loans in Or-

lando include some of the area’s largest hotels.

After September 11, the Hotel Royal Plaza be-

came delinquent on a $35million loan, and the

Hyatt Orlando in Kissimmee became delinquent

on a $23-million loan. Both properties are in

debt-restructuring negotiations.”

Many hotel loans are bundled and sold to in-

vestors as CMBS, which are usually grouped by

property type and location. For example, an in-

vestor may buy securities backed by mortgages on hotels in Orlando, retail space in Dallas, and

industrial space in Chicago, yet perhaps “over weight” on hotels in Orlando.

5 “Delinquent Hotel Loans Soar in Orlando,” Orlando Sentinel, January 11, 2002.

Fitch, Inc., an international financial-rating

company, ranks Orlando second only to Las Ve-

gas on its list of most vulnerable metropolitan

statistical areas for CMBS, due to the area’s em-

ployment base being heavily tied to tourism and

especially vulnerable to economic downturns. A

factor that should be considered when analyzing

the risk of a CMBS deal is the geographical di-

versification of the underlying loans. The reason

for what is termed “spatial diversification” is that

the default risk of the underlying pool of loans is

lessened if the loans are made on properties in

different regions of the country.’

Rather than have the entire portfolio of loans

being subject to an idiosyncratic risk factor (e.g.,

the demise of the tourism sector and the cave-in

of the Orlando hotel market, or the decline of

the high-tech sector and the crumbling of the

San Jose-Silicon Valley real-estate market), the

portfolio can spread its risks across numerous

economies. As such, a collapse of the San Jose

real-estate market (which may lead to higher de-

faults on commercial loans) will be less of a con-

cern if the commercial-property markets in Chi-

cago, New York, and Miami remain strong. In

addition to spatial diversification, CMBS pools

can be diversified across property types. Rating

agencies tend to give higher ratings to deals that

contain property diversification, since a pool that

is diversified across office, industrial, retail, and

hotel sectors will likely avoid the potential of over-

supply in one of those areas. An example of

CMBS diversification is provided in Exhibit 13,

highlighting the percentage of the aggregate loan

amount by property type for the General Mo-

tors Acceptance Corporation (GMAC) 1999-C3

deal, underwritten jointly by Deutsche Bank and Goldman Sachs.

Of note is that geographic and economic di-

versification is not the same. A loan pool can be

geographically diverse, yet the economies can be driven by common industry concentrations.

Geographic and economic diversity help to pro- tect a CMBS pool from the risk of single-market

declines. An example of the benefits of economic diversity is the recent downturn in the tourism

‘Anthony B. Sanders, “Commercial Mortgage-backed Se- curities,” unpublished paper, The Ohio State University, June 1999, p. 7.


DEBT STRUCTURES I FINANCE

industry. Loan pools with heavier concentrations

answer regarding the industry mix include:

in Las Vegas and Orlando, even though they are geographically diverse, are more likely to incur a high level of stress, all other things being equal.

-To what extent does the industry mix in the

Each of the rating agencies assesses a pool’s economic diversity; Moody’s approach is structured to capture three dimensions of economic diver-

total pool resemble (or depart from) the U.S.

sity for a pool:

benchmark?

(1) Industry mix,

-To what extent is any given industry under-

(2) MSA-level diversity, and

weighted or over-weighted in the pool as com-

(3) Geographic dispersion. Some of the questions that Moody’s seeks to

pared to the same industry in the U.S. economy as a whole?

Example of CMBS diversification

Property type

Apartment

Offlce

Retall

Hotel

Warehouse

Percentage of CMBS pool

22.6 percent

27.9 percent

30.4 percent

9.2 percent

8.6 percent

-When an industry concentration occurs, is it in cities that are generally diversified or in cities that are singularly dominated by that industry?’

Additional examples of post-September 11 hotel defaults include the following: -After opening the 286-room luxury Westin

Beechwood hotel in October 200 1, the owner of the property succumbed to foreclosure. Lender CoServ Realty Holdings, a CoServ Electric subsidiary, has taken over possession from Beechwood Company and is now the owner of the $53.5-million hotel and the Creeks at Beechwood golf course. CoServ of- ficially purchased the hotel and golf course in a Denton County auction. Both the hotel and the golf course are still open and remain under the management of Starwood Hotels and Resorts. The changeover occurred following failed negotiations over restructuring the multi-million-dollar package of loans on the properties.

-In late 200 1, Hyatt Hotels of St. Lucia, man-

Other

ager of the Hyatt Regency St. Lucia, was no-

1.3 percent

tified by Pigeon Point Hotel Ltd. (the hotel’s owning company at that time) and Royal Mer-

Total

chant Bank and Finance Co. Ltd. (the pri-

lOOpercent

mary lender) that PricewaterhouseCoopers had been appointed as receiver for Pigeon

Source: Charter Research

Point Hotel Ltd. In May 2002 the property was acquired by Sandals Resorts for a substan- tially discounted price of $40 million.

“ramp up” period, the hotel will re-open as the second JW Marriott facility in the west- ern United States.

-Federal Bankruptcy Court Judge Clive Jones ordered the $80-million sale of the troubled Regent Las Vegas to Hotspur Resorts, a Ca- nadian investment firm and subsidiary of Larco Investments Ltd. After a predicted short

-A Boston bank filed a lawsuit to take over ownership of the 221-room downtown Ramada Inn Brunswick Conference Center because the hotel’s owner has fallen behind on debt payments.

-The Richmond, Virginia, Marriott has filed for Chapter-l 1 bankruptcy protection. The owner, Mutual Benefit-Marriott Hotel Asso- ciates defaulted on a $10.4-million loan, as well as a second- and third-mortgage valued at $19.5 million.

-Downtown Phoenix’s Crowne Plaza Hotel is facing foreclosure after falling behind on its loan payments by $1.35 million. The 533- room property’s financial problems are tied to a 1 O-year, $19-million loan obtained in May 2000 from Lennar Partners, Inc. The Crowne

8 Jeff Williams, “CMBS Market Update,” Lend Lease Real Plaza has tried to negotiate a repayment sched- Estate Investments, Vol. 5, No. 2 (February l&2002). ule for its loan, which has not been paid down



for five months, but has objected to the terms sought by Lennar. Lennar wants a default interest rate that would add four points to the 9.25 percent loan. Along with the late fees and other costs, such a structure would add close to $1 million to the loan. The lender also wants a so-called lockbox agreement in which Lennar would take control of the hotel’s revenue and distribute funds to keep the Crowne Plaza operating. A trustee sale for the property was set for May 2002.

-The Marquis Hotel and Resort in Palm Springs has been pushed into bankruptcy. The owner, Palm Springs Marquis, Inc., filed for Chapter-l 1 protection from creditors in U.S. Bankruptcy Court in Riverside, California, on March 15. According to the bankruptcy petition, the Marquis owes about 170 creditors $10 million to $50 million. The petition lists the value of Marquis’ assets as $10 million to $50 million.

-Orlando Hyatt Hotel Associates LP of Rockville, Maryland, owns the Hyatt Orlando in Kissimmee. The company filed its reorganization petition in U.S. Bankruptcy Court in Orlando on April 26. Hyatt Corporation manages the 919-room hotel, but isn’t an owner. LaSalle Bank of Illinois foreclosed on the Orlando Hyatt in January after the company missed a mortgage payment. State Cir- cuit Court records in Kissimmee show the Orlando Hyatt owing the bank $29.5 million, including penalties and interest. It is expected that the owning company will be challenging that amount in bankruptcy court.

Debt-restructuring Fundamentals During the period 2001-2002 quite a few hotel owners have not been able to meet their debt payments. This has caused a number of companies and properties to consider restructuring their debts. Some of those hotels may be able to re- solve their situation with their creditors, in what is known as a “workout,” without resorting to court proceedings. Other hotels may be forced to file Chapter-l 1 petitions.

Compared to Chapter-l 1 filings, however, workouts can often cost less money in attorney’s fees, accountant’s fees, and lost time due to ex- tensive court hearings. Moreover, debt re-

structurings can enable a company to survive if key components are kept in focus. For example, the debtor must realize that timing is paramount. If a hotel company waits until it cannot cover payroll, it is probably too late for anyone else to provide assistance, implying that reorganization efforts need to commence as soon as possible. In addition, a company must address any balance-sheet issues fairly quickly. These normally include long-term debt (mortgages); short-term debt (lines of credit); trade debt (debt owed to food vendors); and employee claims (insurance). Balance-sheet issues can be addressed by project- ing the amount of cash that will be available to repay creditors, and by constructing a repayment plan that will fit those projections. However, if the projections bring to light the fact that the company is better off liquidating than continuing operations, then the company may have a legal obligation to cease operating and liquidate for the benefit of its creditors.

Debt restructuring really means creative J;- naming. Becoming creative tends to become necessary when a hotel is unable to produce the cash flow required to cover an owner’s debt service. Quite often, creative financing is also applied to assist owners in accepting substantial equity losses at the point of sale and to move on. In either event, the lender-owner takes a hit on his or her capital or suffers lower-than-market-rate yields as a result of the debt restructuring.

General Categories Restructuring primarily involves selling busi- nesses, renegotiating loans, and raising additional capital. Warren Buffet’s mid-2001 bailout of troubled commercial real-estate lender Finova involved the reorganization of more than $10 billion of debt, the majority of which involved bad loans.

The term “hotel debt restructuring” refers to general reformation cases, as well as to troubled- debt restructuring. General-debt restructuring simply refers to debt reformation whereby the lender has incurred no losses from the restructuring of debt. That is, where creditors have granted concessions by reducing the interest rate (1) to reflect changes in market fundamentals; (2) to maintain the relationship with the debtor; (3) by extending the repayment period, or


DEBT STRUCTURES I

FINANCE

(4) granting a grace period. During the grace period the debtor continues to pay interest only at the original contractual interest rate in cases where the creditors’ analyses have shown that the debtor is able to repay the full amount of the loan (principal and interest) as agreed in the original loan contract.

On the other hand, troubled-debt restructuring refers to cases where financial institutions incur losses from the restructuring due to one or a combination of the following variables.

(1)

(2)

(3)

(4)

Reduction of the principal or accrued interest. Loss from restructuring through acceptance of a transfer of assets in debt repayment where fair value of assets is lower than the credit written off. Concessions in the terms of loan repayment resulting in a fall in the present value of cash flows such that this value is lower than the sum of book value of the credits outstanding and the accrued interest. Loss from the debt-restructuring calcula- tions based on the market value of the debtor’s business, the fair value of the collateral asset, or loss from other techniques in debt restructuring, such as from debt- to-equity swaps.

Obj ecrives Debt restructuring should be carried out to maximize the creditor’s chances of getting repayment subject to the debtor’s ability to repay the loan, or in some other way improve on the conditions set out in the parties’ original contract. In particular, hotel-debt restructuring should be carried out to help debtors who have difficulties repaying a loan due to adverse market conditions or property-level mismanagement, but are expected to recover in the future. The lender will ensure that restructuring is not carried out with the objective of postponing or avoiding debt classification or provisioning requirements, or the avoidance of stopping interest accruals.

Distressed-debt investors who buy into restructuring processes have several advantages. Since they, along with their capital-markets advisor, are controlling the negotiations, they are protected to an extent from external-market conditions. They are also in control when restruc-

tured debt is returned to the market, which is when its full potential value will be realized. However, the challenge is to anticipate correctly the time and difficulty likely to be involved in a restructuring. The real test of a successful restructuring is the ability for the market to pick up on the residual package, whether it is debt or hybrid or equity, and trade it.

Strategies Financial institutions can contract an independent party such as a specialized group of experi- enced hotel-debt restructuring strategists. Hotel real-estate investment banks can establish a for- mal strategy for debt restructuring, whereby the highest level of management should participate directly in formulating this strategy.

The degree of creativity necessary to allow a hotel business to be financially independent often depends on fiscal pressures pressing down on either the debtor or creditor. For instance, a bank that has written down a hotel loan and taken back the property will be able to accept a market-level price for it, but may demand “concessions” to provide financing. On the other hand, a brittle seller owning a hotel that has not fulfilled the debt obligations to the lender may be in no position to negotiate. He or she may have to accept a soft note with minimal payments if the equity in the property is insecure. In both instances, a sale is contemplated.

Characteristically, the first two or three years after a sale or restructuring allow for a “breather” period and for conservative debt- service levels, often at below-market rates. Occa- sionally, the difference between the cash-payment debt schedule and a market interest rate is accrued and stapled on to the principal amount of the loan. The due date of the accrual, while negotiable, is normally deferred until the loan matures.

After the breather period, the creditor may expect an interest-rate incentive (kicker) in con- sideration of his or her earlier patience. For example, the creatively recast debt might bear an 8.5-percent base interest rate with additional interest equal to a percentage of gross room sales. Conceptually, that implies that when the business improves, the creditor is expected to share in the upside.



Hotel-debt restructuring alternatives

Extend loan term and defer principal payment

Adjust interest rate

Cross-collateral and cross-default provisions

Subordination of borrower profits for debt service

Re-amortization of the loan Additional borrower guarantees

Balloon arrearage Limit project scope (if for a new-build hotel, or expansion)

Repayment of arrearage from operating profits

Continued funding

Lender agrees to forbear from assigning a receiver

Automatic transfer of title if restructure is not successful

Additional funding Pre-foreclosure sale

Borrower sources other funds Deed in lieu of foreclosure (i.e. corporate bonds)

Debt-equity swaps Assumption of the debt bv a new borrower

Use of additional collateral

Lender takes an Interest in the property via a third

party

In addition to this bonus-payment plan, or instead of it, the creditor (or the advisor) may negotiate to receive a percentage of the hotel’s future resale price. This often falls in the 25- percent range, and can be a helpful inducement to convince a creditor to be patient today. A clear definition of how this future bonus is paid and calculated is important to avoid future problems.

Alternatives Since creative financing is usually done during times of financial stress, most participants go into a negotiation feeling that refinancing with fresh outside capital is unlikely. Therefore, the need to weigh the different options is prudent. The wide array of hotel-debt restructuring alternatives is summarized in Exhibit 14.9

LSD and Lai Sun Hotels International (LSH) streamlined their operations through reclassifi- cation of property and related investments to LSD and high-tech investments to LSH. By Au- gust 2000 LSD repaid 15 percent to each of the bondholders partly from the proceeds of disposing of several Furama Hotels for $236 million. By January 2001, LSD repaid another 15 percent each to the bondholders from the proceeds of disposing of 50 million shares in Sunday (an affiliated entity) worth $8.4 million. By Decem- ber 31, 2002, LSD will repay the remaining 70 percent if bondholders exercise their put rights. In addition, LSD will pay restructuring fees of 1.5 percent on the remaining 85 percent after the initial 15-percent cash repayment. Lastly, LSD proposed to post a portfolio of collateral for the benefits of the bondholders, with an esti- mated value covering approximately 40 percent of the total outstanding of the exchangeable and convertible debt.”

More specifically, Exhibit 15 brings to light the potential sequence of options that are available to lenders and borrowers when a hotel loan could be drifting toward foreclosure.”

Examples of Restructuring l Lodgian, Inc., struggling under a debt load of approximately $200 million, recently filed for

9Kathleen Sindel, The Handbook of Real Estate Lending, (Chicago, Irwin, 1996), p. 463.

l In 1989 a $1 OO-million loan was taken out to build the Neveskij Palace Hotel in St. Peters- burg, Russia. The 12-year, 7.5-percent loan was provided by Austria’s Creditanstalt-Bank to Germes, a company majority-owned by the City of St. Petersburg. In 1996 Creditanstalt de- manded that the city pay up to $40 million toward the overdue loan, and began assessing late fees. Together with fines and interest payments, the bank was asking for $156 million. As the city

“Jack Cummings, RealEstate Finance &InvestmentManual, ““Lai Sun Development Debt Restructure Proposal,” Debt (Paramus, NJ: Prentice Hall, 1997), pp. 508-509. Traders, June 7, 2000.

Chapter-l 1 bankruptcy protection. Lodgian, a hotel owner that has a portfolio of 106 hotels throughout the United States, raised $25 million in debtor-in-possession financing from a group of lenders. Lodgian’s financing should allow it to continue normal operations while it restructures.

l Lai Sun Development (LSD) announced in mid-2000 its restructuring plan to extend the put (sell) dates of its 5-percent exchangeable bonds due in 2004 and its 4-percent convertible bonds due in 2002 to December 3 1,2002. The restructuring plan consisted of: (a) an organizational restructure proposal; (b) a debt-repayment schedule; (c) restructuring fees of 1.5 percent; and (d) a collateral portfolio.


DEBT STRUCTURES I

FINANCE

was unable to meet its payments, a repayment

schedule was worked out. The City of St. Peters- burg asked the Vienna-based bank to drop half

of its claim of $156 million, and to restructure

the rest of the bill to be repaid between 1997

and 2017 at 4-percent interest. In return, the city

put into a trust as collateral shares in Germes and

various downtown St. Petersburg real estate.12

Debt: Rocket Booster or Anchor? A hotel investor will borrow because the interest

tax shield is valuable. At relatively low debt lev-

els, the probability of financial distress is low, and

the benefit from debt outweighs the cost. At very

high debt levels, h owever, the possibility of fi-

nancial distress is a chronic, ongoing problem for

a hotel, so the benefits from debt financing may

be more than offset by the financial-distress costs.

In other words, the Achilles’ heel of real estate is

too much debt, and a delicate balance between

those extremes needs to be attained.

A large amount of debt forces hotel managers to be careful with owners’ money, but even well-

run properties could face default if some event

beyond their control-such as a terrorist attack or a recession-occurs. H

Options available prior to foreclosure

1. The lender agrees to wait for the payment of the loan.

2. The borrower brings the mortgage current for Interest, but holds up on the principal portion of the payment.

3. A partral payment of interest is made, the Interest is accrued or added back to principal.

4. A lump sum of interest and principal IS made and the mortgage is adjusted to change the overall terms to provrde relief for later payments.

5. The borrower turns over all income, less operational expenses gained on the property, for application against the debt service.

6. The lender agrees to refinance the loan to provrde needed capital to bring the project back to its feet.

7. The lender advances funds on a secondary loan to cover the debt servrce.

8. The borrower adds additional securrty, the loan is extended Into a blanket mortgage, and additional cash is added by the lender to cover the debt service.

9. The borrower gives up partral ownership to the lender for a reduction of the debt.

10. A portion of the property is deeded to the lender as a partial or full satisfaction of the debt.

11. The lender allows time to try to sell the borrower’s interest in the property to another party.

12. The borrower seeks secondary financing from another lender.

13. A deed in lieu of foreclosure (voluntary deed) is granted by the borrower to the lender and the debt is satisfied.

““Era to Build the Nevskij Palace Hotel Now Overdue,” The St. Petersburg Times, January 7, 1990.

Anwar R. Elgonemy, M.B.A., IS an associate at Jones Lang LaSalle Hotels-Mrami ([email protected]).

0 2002, Cornell University. Refereed paper, sub- mitted on January 23, 2002; revisions requested on March 18, 2002; accepted on Aprrl 5, 2002.


debt-financing alternatives—refinancing and restructuring in the lodging industry

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