Mezzanine finance is that part of the capital structure between bank debt and equity. It has emerged as an enticing and in many cases “only” new finance option for hotel owners or buyers increasingly faced with a credit squeeze from banks. Market conditions have created an increasingly favorable climate for mezzanine debt financing, elevating it to critical component status.
This stems from the fact that Wall Street has a severely reduced appetite for large securitized, individual asset loans as well as development loans with inexperienced borrowers. Banks currently understand the local markets better and offer the best terms in many markets if they are still lending; however, they are not offering much leverage. This creates an opportunity for a “mezzanine debt fund.”
U.S. hospitality markets have begun to hit the bottom of the cycle and we are now in a period of slow growth. Banks have not yet assumed that an upturn is imminent. These banks will, however, eventually loan money again with tougher terms and conditions and increased spreads on existing or refinanced facilities when they do believe the cycle is coming back. Hoteliers will have the option of looking at new funding sources, including mezzanine finance.
Otherwise recognized as a subordinated or junior debt, most mezzanine finance is in the form of a debt instrument with equity characteristics – but could be in the form of preferred equity, as is often now the case in the United States.
Opportunities that might be candidates for mezzanine finance involvement include repositioning of existing product, including:
•Barriers to Entry
•Strong Internal rate of Return
Mezzanine finance provides a potential avenue of alternative hotel financing in today’s market since existing capital markets have fallen off the face of the earth for the most part. A review of today’s capital markets reveals the latest trends in public capital, private capital and foreign capital.
Sources of mezzanine funding today include hotel management companies, franchise companies, specialized advisory or finance companies or public companies looking for high yield, relatively safe investments. Governments, perhaps the Small Business Association (SBA) or other public entities may also be a source of mezzanine debt, usually on much better terms than capital market sources. Mezzanine debt terms are typically one to three years, and principal payments may be deferred until after senior debt is retired.
In addition to mezzanine debt, credit enhancement by a management company or other interested party can help provide lender comfort. A possible structure could look something like this:
Total Project Cost: $6.0M
First Mortgage: $3M
Mezzanine Debt or SBA loan: $2.4M
Equity Required $.6M
Mezzanine debt term sheets are typically based on the amount and predictability of cash flow required to service the senior and mezzanine debt. Pay rates can be anywhere from two to five percentage points more than senior debt, with most mezzanine lenders looking for internal rate of return hurdles predicated on the risk profile of the transaction. SBA loans are not designed for larger transactions but have very reasonable interest rates.
Mezzanine debt typically ranges in size from $1 million to $10 million. These loans are typically secured by an assignment of 100 percent ownership in the property. A capital structure that deploys mezzanine debt enables the developer or owner to retain control over day to day operations and the decision making process. As an example, an equity partner might require a lower return on investment, but shares significantly in the upside and might have direct input into the day-to-day management or development of the project. While mezzanine lenders may want to have a say in major decisions, day-to-day operations are left to the owner.
Real Estate Investment Trusts (REITs) will become active again in the future but are not likely to be doing deals anytime soon. Public REITs spent much of the past few years selling their non-core assets, giving new buyers much to digest and providing the REITs with capital to buy more accretive assets.
Most of the corporation hotel companies prefer to put small amounts of equity in deals to accomplish the objective of earning management fee income, improving distribution and increasing market clout. Today, hotel company valuations are in decline.
Generally, investors seeking hotel assets today prefer a cap rate north of 10 percent with an internal rate of return (IRR) in the 20+ and up range. Moreover, they seek target markets with high barriers to entry, preferably in central business districts. In many cases, they will align themselves with the c-corporation hotel operating companies.
Private capital has many sources. Some of the more prevalent are union and governmental pension funds, corporations, endowments, financial institutions, life companies and high net-worth individuals. Union pension funds are looking to create union jobs and are a good source when union activity is already prevalent in the market.
For private funds, deals occur more frequently with higher-end properties and resorts where barriers to entry remain high. Some organizations with concentrated portfolios have difficulty coping with large increases in competitive supply that are often found in the limited service sector.
Most funds seek equity yields in the high teens and up. Cap rates have had to rise with the lowering of growth rates assumed by these buyers. Many sellers are beginning to be convinced their future growth expectations are truly aggressive. Hence, less negotiation is required to agree on price. Our event on October 14, 2009 will clarify market conditions in San Diego which have hit new lows.
Robert A. Rauch, CHA