by Rushi Shah
All business owners are used to the concept of risk and return. They understand the need to evaluate potential trade-offs before taking action and use this method of decision-making every day. How skilled owners are at quantifying that risk, however, varies widely. Owners who just focus on returns may miscalculate the situation, putting their assets and personal wealth in peril or leaving money on the table. The more skilled entrepreneurs, on the other hand, understand when to take calculated risks and in turn achieve commensurate returns. Getting it right can be the springboard to success, while getting it wrong can have crushing consequences. Owning a hotel is inherently risky because owners’ success is dependent on many elements outside their control. Owners face operations risk, human resources risk, market risk, franchise risk, credit risk, and interest rate risk. If not addressed correctly, these risks can quickly grow into full-blown financial liabilities and tarnish your reputation.
OVERLOOKING THE IMPORTANCE OF NON-RECOURSE DEBT
Hotel owners tell us all the time that they don’t need or value non-recourse debt. Yet, the majority of the required capital used to procure their assets comes from debt, and those debt balances are typically in multiples of the owners’ net worth. By signing a personal guaranty and essentially pledging to cover the loan with their personal wealth, owners expose themselves to unnecessary risk – risk that can morph into liability that could wipe out what they’ve built. There are plenty of risks that cannot be handicapped and hence, many hotel owners make outsized returns. An astute hotel owner, however, should limit his or her personal liabilities and engage an expert intermediary to leverage the multitude of available mechanisms in today’s market.
WITH PEOPLE COME RISKS
Managing labor is one of the most challenging aspects of owning, operating, and managing a hotel. Employing a large number of people entails dealing with risks such as local, state, and federal labor laws, human resources management issues, line-level employee challenges, and vendor management issues, as well as employees’ individual needs and personalities. Forward-looking hotel owners will create a separate management company to deal with these issues and isolate the risk so it can’t interfere with the rest of the business. This is critical, as capital providers, especially equity investors and non-recourse lenders, care about track record. They will scrutinize an owner’s ability to manage these operational risks and avoid future liabilities. By working with sophisticated and large-scale lenders, hotel owners are more likely to have the necessary infrastructure to limit any liabilities that may arise from operational mishaps.
The ability to rent rooms by the night means hotel owners are constantly exposed to the threat of fluctuating supply-and-demand economics in the local market, most of which are beyond their control. Contributing to a hotel’s market risk include the inability to control supply due to low barriers to entry, slower-than-projected room absorption, and proliferation of brands. Changes to the local area landscape due to government mandates or city planning, as well as Mother Nature, also can have an impact. For example, one of our recent clients owned a large, well-branded, select-service hotel in a good area of the North Carolina market next to a busy interstate exit. The city reconfigured the location of the exit, moving it almost a mile away from the hotel. The reduced access to the property translated into reduced demand and ultimately reduced cash flow. This presented market risk for the owner that turned into liability because he had an existing SBA 504 loan on the asset. Neither the SBA nor the bank was sympathetic to his situation and it ended up wiping out our client’s entire life’s worth of savings and profits from his other hotel assets.
Since many of these risks cannot be underwritten, having an experienced intermediary that can quantify and creatively structure around the risk is critical when seeking capital. Prudent hotel owners also can use optimal financing strategies as a shield against uncontrollable market risks. One surefire way to accomplish this is through non-recourse debt from sophisticated capital providers where you are truly using other people’s money to take off a portion of your own risk. When non-recourse debt is in place, these risks don’t become liabilities; the hotel owner stands to profit from the outsize returns. If the risks do turn into liabilities, then the non-recourse debt structure will serve as a backstop to protect the owner’s personal wealth. It’s a valuable insurance policy that doesn’t cost extra.
Franchise is a cornerstone to a hotel owner’s success. Having a franchise on a hotel equates to having a lease in place for an office building or retail shopping center. The franchise is the ultimate safety net for the owner, lender, and investor, as its marketing muscle, stringent quality standards, and mandatory controls increase the likelihood that the loan will be paid as agreed upon until maturity. This predictability brings comfort to potential capital sources.
Because it is so important to all sides of the transaction table, if a franchise isn’t properly managed, it can quickly turn into a liability. A subsequent drop in revenue could lead to an interruption in payments, which could sour lender-borrower interactions and even sever the relationship. Having a non-recourse loan on an asset ensures that the franchiser will push the franchisee to be in compliance, which prevents the risk from turning into a liability.
LOWER RATES, LESS RISK
Interest rates are the backbone of financing and leverage, and managing them is one of the key principles of asset liability matching. Interest-rate risk can be lethal to a hotel’s current returns, as well as to its ability to grow in the future. The most prudent way to manage interest-rate risk is to put on fixed-rate debt, without recourse, for the longest term possible. For hotels, this typically means a 10-year loan with a 30-year amortization. This lets owners hedge away any interest-rate risk or uncertainty arising from interest-rate fluctuations for a significant portion of the asset’s life. Conversely, entering into loans that are tied to prime or other floating-rate instruments (typically provided by a government programs such as SBA or USDA) is playing with fire. There is no reason for hotel owners to shoulder the unnecessary risk of rates rising and expose themselves to a liability nightmare instead of leveraging the insulating properties of non-recourse loans.
We can make the same arguments for credit risk. Credit risk is the risk of payment of the loan balance. Short-sighted hotel owners tend to resort to loan alternatives that are typically the highest leverage, such as government-backed SBA 504 or 7a loans, or USDA loans. Lured by the ability to maximize leverage, they discount the potentially dangerous personal guaranties that come with it. From a credit-risk standpoint, one mishap could bankrupt a hotel owner’s highly correlated portfolio of holdings. Hotel owners should think more long term and choose credit options such as floating-rate bridge loans provided by debt funds, credit union loans, life insurance company loans, and CMBS loans. These types of credit facilities can protect the owner against the ticking time bomb of future liability.
REPUTATION IS EVERYTHING
With society’s ability to share bad information at lightning speed, it’s no wonder that one of the biggest worries weighing on hotel owners is reputation risk. Reputation risk can arise from anything and everything a hotel owner does as, in, or for his or her business. During favorable economic times, owners tend to forget what can happen during a market downturn. When owners resort to bankruptcy or foreclosure, there are direct and indirect costs to dealing with creditors. The direct costs can be easily calculated, while the indirect costs, such as reputation damage and impact on future growth, are simply unquantifiable. Safeguarding against all reputation risk is impossible. Therefore, the hotel owner’s simplest yet most impactful way to protect his or her reputation is to capitalize assets with an intelligent non-recourse debt solution. This way, in the event of foreclosure, only the asset is lost. Thanks to this strategy, the owner’s personal wealth, home, livelihood, family resources, and most important, his or her reputation, remain healthy and intact. Of course, there are things to consider when evaluating non-recourse financing options, such as reserve requirements, servicing issues, financial covenants, and higher costs. The long-term benefits, however, often outweigh these short-term pain points.
Rushi Shah is principal and CEO of the commercial mortgage and real estate investment banking firm and AAHOA Club Blue Member Mag Mile Capital. As a leader in hospitality financing, Shah specializes in structuring and placing high-leverage, non-recourse bridge and permanent debt with cash out for full- and limited-service hotels nationwide. Since joining the firm’s predecessor, Aries Capital, in 2015, Shah has structured and closed hundreds of millions in financing for all property types. Shah has held previous positions at Northern Trust and has an MBA from the University of Chicago’s Booth School of Business.