Determining how management structure affects financing options
by Rushi Shah
A common attribute of the most successful owners of hotels and other commercial real estate is their entrepreneurial attitude and willingness to put in the required effort to achieve results. Many of our clients started with one motel or a small, independent hotel and then, through hard work, the expertise of trusted advisers, and savvy decision making, grew that single property into an empire, usually graduating to larger assets with better flags in bigger markets.
One strategic and structural factor these success stories have in common is that most of them have isolated their risk and have had more financing opportunities open to them by separating the hotel’s management from the real-estate-investment aspect of the business.
Separating a hotel’s management activities doesn’t mean owners have to hand them over to a third party. An alternative is to fund a separate management company that is controlled by the same owners as the hotel but is its own entity that charges a fee back to the hotel ownership company. By creating this arm’s-length relationship between the real estate company and the operating company, the property-management risk can be better isolated from non-operations risks such as market, credit, interest-rate, and legal risk.
Owners who go this route not only demonstrate an elevated level of sophistication and professionalism, they also set the stage for growth, as most high-end brands require this separation.
ASSESSING FINANCING OPTIONS
There is a common myth that for a property to qualify for CMBS or other institutional capital, it must be managed by a third party. In reality, as long as an owner of a franchise hotel can demonstrate a history of success, the lender can approve the loan with either a self-managed operator or a management company that is related to the hotel owners in place. For example, we recently closed a deal in Winston-Salem, N.C., for a select-service asset where the client is self-managing. We were able to convince the lender to approve the loan, while still allowing the owner to manage the hotel after closing.
It is important to note that bona-fide institutional lenders with strong track records and large balance sheets will always underwrite a management fee of at least 3 percent of the hotel’s gross revenue. This metric is an industry standard and is taken into account regardless of whether the owner actually charges himself a management fee.
When determining loan eligibility and size, it is therefore prudent for owners to account for this expense, whether they have enlisted a third-party management company or not.
When seeking financing for larger assets that are full service and operationally intensive, however, a separate management company is almost always required.
For owners with extensive real estate portfolios, establishing a separate management company can deliver operational and expense efficiencies that benefit their assets across the board. In this situation, the principal can charge each of his assets a management fee and then invest in overhead that is spread out pro rata across the multiple assets.
For example, having a controller overseeing bookkeeping and processing lender payments can be beneficial under a management-company infrastructure because of the pooled income stream. A shared general counsel working for the management company can save the cost of one-off attorneys’ fees for small matters. Additional operational efficiencies and cost savings can be achieved with centralized IT software, services, and human-resources functions.
Establishing a separate management company is critical for generational business owners looking to expand their portfolios. This is especially true for those who aspire to attract outside capital by forming a real estate investment trust (REIT) or private equity fund where investors are in a limited-partnership general-partnership relationship. The centralized platform afforded by a separate management company facilitates the transparency and control required to attract and manage other people’s money that is not from friends or family.
While setting up this structure may be onerous in the short term, there are long-term payoffs. For example, having it in place helps investors more accurately calculate the returns generated from the real estate, as opposed to commingling income from the real estate and business operations. This exercise allows REIT, equity and/or bond investors to properly compare a hotel’s return to the return of other asset classes such as apartments, office, retail, and self-storage.
For hotels in secondary or tertiary markets, where owners may have a tougher time convincing an institutional investor to accept the property’s projections, having a third-party management company or owner-affiliated management company instead of an in-house, unstructured owner/operator can be a difference maker. Consensus on the street is that a better-managed asset with revenue-management, accounting, and performance-measurement systems in place will be more likely to generate optimal outcomes after any major capital-expenditure projects.
Lenders also believe in the mantra, “Let specialists do what they do.” According to this philosophy, plumbers will be better at plumbing, electricians will be better at electrical work, and a dedicated hotel management company will be better at managing a hotel. This is especially true for full-service or lifestyle hotels. This strategic delegation also frees up owners to focus on other critical topics, such as optimal capital and legal structure and making better investment decisions.
For SBA loans, however, owners cannot use a third-party management company. While the market recognizes that, for some owners, an SBA loan is the only option, for more sophisticated owners who have grander plans for growth and are ready to recycle some of their own equity through a cash-out, nonrecourse loan or attract outside capital by forming a REIT, having a separate management company is the optimal structure.
And just like enlisting a specialized management company can improve hotel operations, cut costs, and create efficiencies for owners, engaging a financing specialist in the form of an expert intermediary or investment banker can expand financing options, eliminate obstacles, avoid costly mistakes, prevent headaches, and improve outcomes.
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.