Looking through the capital markets lens, how can hotel owners benefit from showing leadership?
With the tail winds of inflation, a national hotel supply down by 10 percent, and demand dynamics that favor commercial real estate owners, especially within hospitality, now is the time for asset owners to re-evaluate strategies and optimize for growth. All signals point to a healing in the capital markets and a stronger-than-expected economic recovery. Domestic travel is at an all-time high, while international travel continues to struggle, creating significant opportunities for savvy U.S. hotel owners who play their cards right. Those who understand risk-adjusted returns and take advantage of prudent leverage will find themselves well-positioned to succeed during what may be the roaring ‘20s of our generation. Furthermore, asset owners who are able to separate emotion from rational decision-making and demonstrate leadership in all aspects of their business, whether it be operations, management, or financing, will rise to the top.
As COVID-19 moves into the rearview mirror, owners are likely to make the mistake of being shortsighted in their operational decisions. If miscalculated, the quest for short-term gains can result in long-term problems. Take labor for instance. Using the pandemic as an excuse, a hotel owner may cut corners to drive bottom-line growth instead of ensuring labor is managed in a way that doesn’t impact quality of service.
Eliminating complimentary breakfast is another good example. While it may save money in the short-term, the long-term negative effects on customer satisfaction, reviews, and the hotel’s reputation may outweigh any immediate returns.
Capital availability continues to be a key constraint that hotel owners must address to take advantage of market conditions and position themselves for growth. Hotel leaders with a deep understanding of capital markets (or who engage a trusted industry expert) and who are able to remove themselves from the equation and view their assets objectively through the lens of the capital stack are likely to be more successful at securing financing. For example, many hotel owners who self-manage their hotels fail to charge a management fee or compensate themselves for their efforts. This practice is akin to providing a free service to the hotel entity and is an underwriting red flag for institutional capital sources who would have to pay a third party to manage the hotel in the event of the borrower’s default. Using the goods and services of people for the betterment of your asset without paying the commensurate wage or fee for their time is also extremely shortsighted and could be a value drain in the long run.
Hotel owners also can demonstrate leadership by recognizing the value of the risk an investor is taking when investing in the asset. If an equity investor is providing the lion’s share of capital needed to acquire an asset, that investor deserves to be paid the largest portion of the equity return. Therefore, a mezzanine debt lender or a preferred equity provider is going to expect a higher, double-digit return compared to a senior lender. Additionally, preferred equity investors will demand a preferred return and a share of outside profits since they are investing money at a higher level of the capital stack.
RECOURSE VS. NON-RECOURSE FINANCING
Most borrowers tend to approach the recourse vs. non-recourse financing decision very lightly. Prudent leadership, however, calls for disciplined recourse management by prudent borrowers. This means the contingent liabilities on a borrower’s personal financial statement are as important, if not more important, as the general liabilities on the borrower’s personal balance sheet. Yes, non-recourse debt comes with strings attached, but as per conventional wisdom, there are no free lunches. Because a hotel is an operating business, there is even more of a reason for hotel owners to manage recourse risk and free up their balance sheets to take advantage of the institutional capital markets.
As hotel assets re-establish strong trailing 12-month operating numbers, owners should re-evaluate whether their properties are candidates for recapitalization or refinancing to reposition for growth and manage risk.