HOUSTON — Deal-making in the hotel industry is not a simple process, as both new and experienced investors have to navigate a challenging path to success.
During the "Financing structures, legal landmines and deal risk" panel at the Hospitality Law Conference, hotel industry and legal experts shared their advice on what any investor needs to know when trying to make a deal.
The debt game
Getting financing for a new-build project is different from financing for a stabilized property, said John Keeling, executive vice president of Valencia Hotel Group. For the types of hotel development projects that Valencia does, the company works mostly with regional banks. These banks stepped back for a few years after the pandemic but have been coming back to the market.
Without them, another option would be to go to a debt fund, which is “very expensive and has all kinds of ugly things that you have to settle for,” he said.
The most recent funding Valencia received for a hotel project came in December from a regional bank the company has had a working relationship with for years, he said. Funding from regional banks can be expensive, and many projects have a loan-to-value of about 65%, and borrowers will want to get a lower rate with a higher debt-to-value percentage.
For Valencia, that means going to commercial mortgage-backed securities loans, which “is basically syndicated debt,” he said. It can be unattractive because CMBS will lock a borrower into the debt for 10 years, so if they want to sell in six years, they have to make the lender whole in what was expected out of 10 years.
“We have the advantage of never selling, so we can go into a CMBS loan at 70% loan to value and be happy as a clam because we have no intention of selling,” he said.
A potential problem is if the CMBS loan closed in a high interest rate market and rates drop, so the borrower wants to refinance, he said. Over the last year or so, CMBS loans have become available in five-year deals because everyone expects the rates to go down and nobody wants to lock themselves in for long.
When setting the loan-to-value rate term size, there’s no one right answer as it’s dependent on the property, said Jonathan Falik, founder and CEO of JF Capital Advisors. Some people have lower leverage tolerance while others have higher.
One differentiating factor is if the sponsor or affiliate of the sponsor is willing to provide a certain amount of recourse, he said. If the loan is fully non-recourse, there are certain lenders who cap out at a finite level. His company has worked on deals that are anywhere from 50% to 80% loan to value.
When working with clients on deciding which loan to pursue, Falik said his firm often advises against the cheapest or lowest interest rate loans. These are usually the least flexible.
“It is very difficult for hotels, which is an operating business sitting on a piece of real estate where things are cyclical, things are seasonal, things change,” he said. “So, we rarely advocate for the lowest cost of debt. We think much more about which is the most flexible in terms of matching our portfolio or our asset.”
CMBS debt is great until there’s a problem, said Dan Lesser, co-founder, president and CEO of LW Hospitality Advisors. When there’s a problem, even as a long-term holder, there’s no one to talk to about it.
When the pandemic hit, hoteliers were trying to figure out what to do, Falik said. Operators weren’t sure whether to hold on to employees or furloughed or lay them off and shut down the hotels when demand dropped out.
“There's local guidance, there's state guidance, there's national guidance on what to do,” he said. “We're looking at our loan documents, where we have a covenant to continuously operate the hotel, but we also have a covenant to basically to safeguard and protect.”
Working with lenders also means having all the bases covered. Jennifer Nellany, member at the law firm Cozen O'Connor, said she was representing a lender in a hotel deal that was ready to close, but the borrower ran into litigation when someone at the property fell off scaffolding and died. The details of it weren’t exactly clear, but New York has strict liability for scaffolding requiring specific insurance coverage for scaffolding.
The borrower did not have it, and they didn’t do their due diligence in the general contractor agreement, because the general contractor didn’t have it either, she said.
“So, we as the lender turned around and said to them, ‘OK, fine, there’s no insurance for this. There's only one answer: personal guarantee,’” she said.
The borrower was able to find the coverage from a credit-worthy guarantor, and after a three-month-long delay, the deal is on track to close, she said.
Points of negotiation
As an attorney, Nellany said she wants to look at all of her clients’ term sheets. There are typically debt term sheets, joint-venture term sheets, acquisition term sheets and more.
“There are different parties to all of them, and you need to be mindful of who you’re representing,” she said. “If you’re representing the buyer, you may be representing a joint venture, and if you’re representing the joint venture, which side of the joint venture are you representing in the negotiation of the joint venture agreement? So, it’s gets a little complicated.”
Careful reviews of the term sheets by an attorney are necessary because a single missing word or an extra word or two can change the economics or risk profile meaningfully, Falik said. This is important to remember for people new to making deals as well as those who have experience in other real estate segments but not hotels.
“They're going to miss things in the term sheet that are important, they may choose to forego in the term sheet, but if they haven't had a smart conversation with counsel about it, they're going to pay later on.”
Working with counsel and industry advisers can help those new to the hotel deals market catch things they’d like miss on their own, Nellany said. Conditions can change rapidly, not just in what the market is but how someone is situated in the market.
“What’s your relative negotiating strength?” she asked.
Even though they may be smart and sophisticated investors, those new to the hotel industry will often receive term sheets from brand and management companies only to hear that they can't make changes, Lesser said.
"If they go back and say, 'Well, you know, what about this?' and the brand or the management company says to them, 'We've never done that before,'" he said. "I can't tell you how many times I've heard that. 'We've never done it before.' And then we get involved. We're like, wait a second. We can give you five Marriott deals we did [that] do this."
If they don't have good counsel or even just good advice, many times new investors get hit with unreasonable terms, Lesser said.
One of the problems in dealing with the brand franchise agreements is few people have actually reviewed every page, Falik said.
“They haven’t read through the franchise disclosure document in its entirety, which is usually 350 to 450 pages,” he said.
If they don’t fully understand what’s in them, they may see things later on that they don’t agree with when the time for negotiations has ended, Falik said.
“There are things that are negotiable, but there are plenty of things that are not, and it’s very painful if you figure that out five or 10 years later,” he said.
Lesser said he’s been working with a client on a small hotel portfolio to figure out the highest and best brand and highest and best management. They were able to negotiate with two big players to get key money and five-year deal offers.
“When's the last time you heard about a five-year franchise deal?” he said. “Usually they're 20 years, but they were dealing with sophisticated folks between the sponsor and us, and these were highly desirable assets. We created a competitive bid process where they thought it was worth their while to get their name on it for a bid of five years.”