by Rushi Shah
Recent and expected future Fed interest rate hikes continue to weigh heavily on hotel owners as they look to refinance their portfolios, or decide whether to sell or purchase properties. While the peace-of-mind gained by locking into a long-term interest rate and minimizing personal risk is attractive, some hotel owners are cautious about entering into a long-term CMBS fixed-rate loan even though long-term interest rates are historically low compared to the short-term rates. Both experienced and inexperienced borrowers often have misconceptions about how these sophisticated loan types operate.
Borrower argument: Long-term, non-recourse fixed-rate, permanent loans (CMBS loans) are inflexible when it’s time to pre-pay and they can cost a lot.
Bottom line, there is no free lunch. When the loan docs are executed, borrowers promise to pay until maturity and investors expect them to hold up their end of the bargain. The good news is, non-recourse, CMBS fixed-rate loans (unlike any other types of loans) are fully-assumable by a buyer in the event of a sale. If the buyer does not want to assume the loan, it can be pre-paid at either a penalty or benefit depending on the levels of interest rate at the time of pre-payment. This is not necessarily a negative, if you plan to hold your asset long term anyway. Also, the loan can turn into an asset especially if you have a low interest rate. Plus, in exchange you receive a low rate without recourse for a 10-year period, and at a much higher leverage than any comparable solution out in the market.
Borrower argument: CMBS loan servicers are very difficult to deal with and the lender will take your property if you miss a payment.
Not true. Lenders are in the business of making a loan for the bond holders, the servicers are in the business of collecting the payment on behalf of the bond holders. No link in the food chain has any absolute interest to take over the property. If they do ever have to take the property, it’s an indicator that they have failed, as it costs significantly more to take over the property than to keep receiving payments. At the end of the day, servicers are simply abiding by what was in the loan agreement established upfront between the lender and the borrower. There would have to be significant deterioration in the asset’s performance to result in loss of the property. Not to mention, other failsafe mechanisms are in place from the very beginning to prevent such an occurrence (i.e. cash management). Historically, in every case where a borrower has lost the property, it has been fully because it was the borrower’s intention to give it back/cut their losses. In addition, with increased competition amongst servicers, servicers that don’t provide good borrower service, won’t receive future servicing assignments from lenders.
Borrower argument: CMBS loan costs are expensive and my local bank can give me a better deal.
Expenses for CMBS loans are usually slightly higher than those done by the local bank because they are non-recourse and there is additional paperwork needed to “perfect” the collateral for the Lender. Without the cushion of borrower recourse, only the property is at risk to satisfy the loan. As a result, property due diligence is extremely thorough and lenders require a national appraisal company (which it’s interesting to note can result in higher appraised values from time-to-time) and more sophisticated lender legal counsel. Engineering and environmental reports are also typically slightly more expensive because Lenders rely on them to make reserve decisions. However, for comparable terms, banks can’t give borrowers a better deal. Due to regulatory restrictions, it is significantly more expensive or most of the time impossible for banks to provide a 10-year loan for a hospitality asset at as high of leverage as a CMBS loan. Bank loans will typically be shorter term, lower leverage, restrict cash out and require full borrower recourse. Because these are such inferior terms, the bank’s risk is lower and that’s why they can offer borrowers a lower rate than a non-recourse, 10-year, fixed-rate loan. Plus keep in mind that these one-time costs are amortized over the 10 years of interest rate savings your CMBS financing will enable. While the costs of a bank loan may be lower now, you’ll end up paying them all over again when you refinance in five years.
Because CMBS loans are non-recourse, any small increase in rate over a bank loan you do end up paying for the CMBS loan, can lead to a big payoff in the form of accessing trapped equity. Banks don’t usually allow cash out. For an incremental cost of maybe 0.5 percent over what their bank offered, we’ve seen CMBS borrowers free up millions of dollars in accrued equity. As a fundamental rule of finance, debt capital is always cheaper than equity capital. Furthermore, because of the availability of capital and by leveraging the influence of an expert investment banker or financing intermediary in today’s marketplace, owners can be more assured of closing by going down the CMBS path, than relying on local bank credit committees who have proven to be flakey at times.
Borrower argument: CMBS loan reserve requirements are burdensome.
To protect investors’ rate of return, CMBS conduit lenders push and pull levers to mitigate risk that would otherwise bar borrowers from the closing table. For example, if a hotel PIP is coming due, or historically the property has seasonal dips in cash flow, the lender may require a borrower to set aside ready capital as reserves. These disciplinary savings belong to you and are accessible when you need them, but also assure the lender that your property will weather these costs without cannibalizing your ability to make loan payments. A knowledgeable intermediary may be able to negotiate a lower amount, roll the reserves into the loan so they are financed at the lower long-term interest rate, or even devise a more creative loan structure that eliminates reserves altogether.
Borrower argument: The CMBS loan cash management process is too restrictive.
CMBS loans require borrowers to set up a disciplined cash management process to ensure timely payments in the event of distress. As long as the property performs, a good intermediary should be able to negotiate that all hotel income is treated as business as usual. In the case where the hotel’s cash flow drops below a certain threshold, the income will merely pass through a lender-mandated account to your operating account. If performance further deteriorates below set thresholds for two consecutive quarters, the income is held in an account controlled by both you and the lender and any surplus cash flow is passed to you after all the expenses to run the hotel are paid, reserves are funded, and monthly P&I payments are made. The original cash flow resumes once performance returns to acceptable levels for an appropriate length of time. Hotels with good management and consistent income won’t need to worry about triggering this check and balance. Your accountant can also work with you to ensure expenses are categorized properly since Capital Expenditures, non-recurring or extraordinary expenses, and personal expenses don’t count towards ongoing expenses.
Borrower argument: Intermediaries only push CMBS loans when we ask for non-recourse loans; that’s the only option available in the marketplace.
At $100 billion per year, the CMBS market represents the largest volume of all loan types. For qualified assets, however, there are many other flexible, non-recourse debt options available through experienced investment bankers with wide relationships. These include debt funds, life companies, Mortgage REITs, Credit Unions, balance sheet lenders, investment banks’ direct lending business units, non-bank finance companies, large family offices, and private equity companies. These alternative capital sources are usually less regulated than community banks and offer attractive features.