by Rushi Shah
If you’re a successful hotel owner, you’ve likely invested years of blood, sweat, tears, and cash equity building value in your business. From spending money on cap-ex properties, to improving brands on your hotel assets, to developing management systems and engaging strong operational management to increase net operating income. When it’s time to monetize the value created, many hotel owners assume that selling is their only option. There is an alternative. By putting on prudent leverage and using disciplined recourse, you can effectively recapitalize your balance sheet and retain the asset you’ve worked hard to establish. When it’s really time to reap the rewards in the form of stabilized cash flow, owners tend to fold and book profits. There is a different way to monetize the value creation.
Refinance or sellf you’re a successful hotel owner, you’ve likely invested years of blood, sweat, tears, and cash equity building value in your business. From spending money on cap-ex properties, to improving brands on your hotel assets, to developing management systems and engaging strong operational management to increase net operating income. When it’s time to monetize the value created, many hotel owners assume that selling is their only option. There is an alternative. By putting on prudent leverage and using disciplined recourse, you can effectively recapitalize your balance sheet and retain the asset you’ve worked hard to establish. When it’s really time to reap the rewards in the form of stabilized cash flow, owners tend to fold and book profits. There is a different way to monetize the value creation.
The classic conundrum: sell vs. refi. As cap rates compress and liquidity is abundant, owners face a critical decision – sell and take cash out, or refinance, keep the property and recapitalize. Parting ways with an asset, after nurturing it to where it is at the optimal level of cash flow and occupancy, is usually a bad choice and can lead to risk that may not be immediately visible. First, not only are you giving up the benefit of stable cash flow, you may also face significant tax consequences. Second, just because you have mastered running your current asset in your current market, doesn’t mean you will be able to repeat that success with a new property in a new location. If you sell and execute a 1031 exchange to buy a new asset, you may ultimately expose yourself to risk factors that you typically did not underwrite. Third, selling and buying a hotel brings added dimension and increased complexity to the transaction. More complexity typically translates into added uncertainty. For example, on a recent purchase transaction, the prospective buyer found out the seller had represented that all the necessary capital expenditures were complete at the time of selling the property. He found out later, however, that the work was very low quality and only done to “window-dress” the deal for a quick sale. After peeling back the onion, the prospective owner discovered he would need to redo the majority of the seller’s work. This added expense would have wiped out five years of profits on the deal.
Why equity isn’t the answer
Another way to access your sweat equity is to bring in additional equity investors. There are two problems with this approach. First, equity investors typically ask for higher returns in exchange for the risk. Second, equity investors are likely to exert some control over you, the primary owner. For example, an outside or third-party investor who does not have a vested interest in the asset may restrict your ability to put in additional cash in the form of capital improvements. Even though it might make financial sense in the long run, they may feel it will place undue cash flow pressure on the asset in the short term. At the end of the day, there is almost always a conflict between control and non-control equity investors.
Make debt your friend instead
The most time-tested method to create wealth is by putting on prudent debt. Sophisticated hotel investors look to the capital markets to recapitalize their assets instead of selling. By refinancing their hotels to permanent debt, they are able to access the equity they’ve invested and maintain cash flow. Not to mention, with the help of the right intermediary, a refinance has more certainty of execution than a sale and purchase. Furthermore, since most capital market (non-community bank) mortgages are non-recourse, in addition to accessing their implied equity, owners get the valuable fringe benefit of reducing personal guarantee risk.
When structuring the capital stack, the most senior lien holder takes on the least amount of risk and subsequently also has the lowest return expectations. As we near the end of the economic cycle and continue to witness an uptick in long-term interest rates, savvy hotel owners will review their leverage and work with an experienced intermediary to recapitalize their existing debt. By putting on new, long-term debt owners can also create liquidity, stockpile cash, and better prepare to generate wealth during the next downturn. If the cost of the capital they have sitting on the sidelines is that of a long-term loan (currently at time of writing in the 5 percent range) owners will have sufficient means to take advantage of distressed situations with a higher certainty of closing when the right opportunity presents during the next downturn. That’s a surefire way to create wealth.
Brands vs. lenders
Experienced investors also use strategic debt to ensure they can access ready cash for critical capital improvements for a rebrand or reflag, or to give their assets a facelift when new competition and brand proliferation warrants it. Keep in mind, that when a corporate brand mandates a property improvement plan in the middle of the franchise term, it is typically the worst time to borrow more money on an asset. It’s a classic catch-22. The brand thinks spending money will boost cash flow. This is the exact point in time, however, when lenders do not want to speculate on the property by lending more money. Lenders are likely to pull back because they want predictability in the form of in-place cash flow. This puts investors in a bind. Smart owners avoid this by taking advantage of “other people’s money” and leveraging their properties to the optimal level when in-place cash flows are the highest, and market cap rates are the lowest. For example, in a recent closing of a Hampton Inn in Gulf Shores, Alabama, the developer was able to recapture almost all of the cost to build the hotel by putting on a 10-year, fixed-rate, non-recourse loan as soon as he achieved 100 percent RevPAR penetration (when the subject property is penetrating 100 percent of the competitive set’s RevPAR as defined by STR). This allowed our client to take valuable cash off the table as soon as possible. Shortly after closing, two new-construction hotels with the potential to cannibalize the property’s demand drivers were announced. Even though our client must cope with the new competition from an operations standpoint, by using prudent leverage he was able to hedge his financing risk from the threat of excessive supply in his market.
Leverage for succession planning
Using prudent leverage for succession planning is another key strategy available for successful hotel owners. Fixed-rate, permanent, non-recourse loans can effectively insulate both the current generation and next generation against interest rate risk. Merely owning a commercial real estate asset (including hotels) already brings significant market and operational risk. There is no added benefit to take on any more risk than what is absolutely necessary to make the target returns. This is why organizations of all sizes should work with an expert in the field with access to sophisticated tools and innovative financing products to meet their goals.
Owners who have spent their lives creating wealth through owning of one type of business or real estate can also benefit from diversifying their portfolios. By taking cash out from their assets and re-investing in other investment opportunities they may be able to generate more predictable, risk-adjusted returns. For example, we recently helped a client refinance three hotels in one market to provide cash out. The client invested the cash in private equity investment strategies outside of commercial real estate without exposure to the stock market. The client is now able to use this new income stream to enjoy peace-of-mind and sustain his lifestyle.