by RUSHI SHAH
As owners graduate to higher-quality assets, brand has a greater influence on their decision-making, operations, and ability to secure financing. This is because sophisticated, institutional, non-recourse lenders such as debt funds, CMBS conduits, and life insurance companies strive to remove any uncertainty from asset quality or guest experience from their underwriting. Debt and equity investors often underwrite to the worst-case scenario. They favor assets that are backstopped by a strong brand and its marketing and reservation systems because they know the owner will be required to maintain high standards of service and amenities. This reduces the risk that the lender will have to take over the asset, or at minimum, ensures the benefits of the brand will remain in place in the case of borrower default.
BRANDING THE GUEST EXPERIENCE
Hospitality is all about keeping properties updated and fresh for guests. The brands know this and have employed tactics to attract newer properties to their flag and to weed out older product, even terminating agreements or refusing renewal. This reinforces why owners should avoid the uncalculated risk of allowing recourse on their debt. In non-recourse loan transactions, a tri-party agreement is typically executed among the brand/franchisor, the hotel owner/franchisee, and the lender. This agreement, sometimes called a comfort letter, is the most critical component after the franchise agreement and loan documentation. Within the letter, the capital provider will typically require assurance that the hotel has no violations, and that if future transgressions arise it will be notified immediately that there is risk of the asset losing its flag before it is too late. A non-recourse loan ensures that your brand cannot just pull your flag because the lender has done the due diligence. And if unavoidable circumstances cause loss of flag, the owner’s personal wealth is not on the line.
SPEAKING FROM EXPERIENCE
One of the Chicago debt funds with whom we have a great relationship shared this classic example of why lenders don’t like any potential for loss of flag on an asset they are financing. After closing, the fund discovered its due diligence failed to uncover that the full-service, Sheraton hotel in Wisconsin was in “red zone” per Marriott. The hotel was vulnerable to losing its flag with little room for error. When the owner failed the quality inspection, Marriott revoked the owner’s license. Occupancy plummeted and the lender had to take back the asset and complete the necessary improvements to avoid losing the Sheraton flag permanently.
GOOD BRANDING, GOOD BUSINESS
Based on lenders’ aversion to risk, a good brand seems necessary for securing favorable financing, however, there are exceptions. Recently, boutique hotels have started to gain popularity. Hoteliers have moved away from cookie-cutter brands and toward creating unique destinations that provide specialized experiences for the millennial and other travelers. The majority of boutique hotels still have some sort of reservation system insulating their revenue stream, as well as governing quality standards, and with a little creativity can still be financed. For example, we recently closed a loan for a mid-scale hotel in St. Augustine, FL. The property had been brandless for a long time, yet we were able to arrange a non-recourse loan. We underwrote 14 percent of revenue as a theoretical expense or placeholder for industry standard franchise, marketing, and management fees. The property wasn’t required to pay this amount; it was only calculated towards the expense of the hotel as if it were being paid. The lender was comfortable with the arrangement because in the unlikely case of default where the lender would need to hire a management company or secure a brand to stabilize the asset, the property would be able to support those expenses.
Owning a hospitality asset is already a risky proposition. Removing uncertainties and unknowns from the equation by securing a brand or not signing recourse on a loan can help hotel owners handicap their risk.
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.