When Faced with Complexity, Try Creativity
Switzerland is justly famous for many things; from stunning natural beauty to watches and diplomacy but perhaps most notably are their banks. Inscrutable, discrete and going about their business for centuries with a watchful eye over both profit and risk. Perhaps coincidentally, another great Swiss icon is the eponymous multi-faceted Army Knife; an item noted for versatility and adaptability.
When debt is readily available, the borrowing process can be straightforward. When times get tough and the shutters come down, however, borrowers need to work harder to secure the debt they need. To use an analogy, faced with such challenges, it can pay to consider those attributes associated with the Swiss Army Knife. You need to use every tool at your disposal to prize every pound, dollar or euro from your balance sheet to impress a lender and stress upon them that you are a satisfactory risk. It can also pay to approach the process with a degree of creativity.
Hotels have often been regarded as a higher risk compared to commercial property, due to the operational element meaning that the ability of the owner to pay the interest is determined by the operational success or failure of that property. This has always been factored into consideration when underwriting but lenders, supported by specialised debt teams, have been happy to support hospitality.
The paradigm has been shifting. The operational situation is becoming more challenging, combined with the effects of inflation and rising interest rates impacting asset values. Many traditional lenders are under pressure to entrench their positions in terms of risk. If your lender is one of these, or even pulling out of the market all together, what can be done?
Our role, when a client is going into a refinancing, is to prepare them to face their banker and put forward the best possible impression of their business. Whilst many owners will be experienced in preparing documentation for the impending discussions with their lenders, there may well be ways of maximizing the optics to enhance the appearance of your asset beyond simple record keeping. A lender will require access to full financial data and the clearer and more accurate this data can be, the more favourably it will be received, especially if adhering to international accounting standards.
How do you prepare yourself? The first step in preparation is to have your asset manager run a health check through the balance sheet, to see if there are any elements that can be enhanced or improved that add to the bottom line and improve the story. This is not an exercise in reporting data but rather working for the hotel to make practical and actionable recommendations for enhancement. There may even be a case for capex, which can demonstrate strong ROI through significant resultant performance uptick.
This process will come up against the two critical considerations of the debt process.
The first – loan to value – is important to the borrower. Say you own a £50m hotel, and you’re borrowing at 60%, when the bank turns around and says that in view of the current investment climate, they’re reducing the loan to value to 50%. You have to bridge that gap and where a capital injection is unlikely or unpopular , a creative alternative may be the answer.
The ability to get creative will open you up to a wider variety of lenders, including debt funds, insurers and pension funds, and venture capitalists. Some caution is needed here if choosing a more exotic alternative, as structures will become more complex and more expensive. That shouldn’t be a barrier in and of itself, as combined loans from primary and secondary sources may still generate an acceptable blended rate so that the overall cost of borrowing should still be quite manageable.
“The important point is making sure that the structure is a safe one. There are certain debt funds out there who will adopt a loan-to-own policy, so if you’re going into that type of structure, you need help, advice and support and need to have your eyes wide open.
The information which must be gathered is extensive. You’ll need future revenue forecasts, profitability forecasts, and a valuation to convince the lender that you are a good bet, and that you will perform. This can be done by the hotel with oversight from your asset manager – and then checked by the bank’s own people.”
The second critical element is the debt service coverage ratio, which is usually a multiple of net earnings. For example, at 50% LTV, these are typically around 1.2 to 1.3 times earnings with existing lenders who know a business well but rising to 1.75 to 2.0 times in respect of new relationships. Of course, if earnings are falling and debt costs are increasing, that debt service coverage ratio is compressed, and therefore a regular pressure point in the negotiations.
Refinancing is not a fait accompli, based on a snapshot in time valuation of the asset, you should ideally plan to begin the process 6 to 12 months out. We would also advocate looking beyond the “usual suspects”. Beyond the traditional lenders there are abundant multiple alternative sources of capital, with investors willing to take a long-term view and support hospitality assets outside the more typical lending restraints. To gain access to this alternative lending arena, we work with some superb highly specialized brokers, with a beyond the limits creative approach matched by access to multiple alternative lending sources.
Creativity can result in complexity. You will need to have a strong team of advisors; lawyers, accountants and hotel asset managers. Don’t be afraid to seek advice and to do so as early as possible.
Whilst preparing, beyond reviewing above the line performance, two key areas which may be overlooked are insurance costs and business rates (depending on your location). For the former, it’s about having your house in order so that you don’t have incidents and liabilities and ensuring that the hotel team is on top of recording incidents that might cause a claim which results in an increase in policy cost. It helps if you own several properties which you can cluster under one policy, spreading the risk and gaining economies of scale (and don’t forget cyber security insurance).
Regarding business rates, it can be worth hiring an external expert to make the case for a review so rates can be revised downwards in which case ensure an appeal is made. It may not seem significant but it’s all about improving your bottom line and some properties have closed under the weight of business rates.
We have also found that it can be very reassuring to a lender to know that a hotel owner is working with a strong asset management team, to make sure that we keep everyone focused on performance and profitability, and the process on track. We work for the hotel as well as its owner. We’re there to maximize the operational capacity of that hotel for the owner, the operator and brand, and to give reassurance to the lender.
While the lending environment may be keeping many hotel owners from their sleep, the current cycle presents opportunity for acquisition and there is plenty of capital seeking a deal. With cap rates up, bringing values down, the starting point for investment will look appealing when taking a five-year view. Existing owners can sell into this investment cycle, or they can seek to support the growth story in their hotels themselves – choosing whether to be hunter or prey?
That said, the cost of capital (as well as debt) is up, and any deals done will need to support appropriate IRR expectations, again putting downward pressure on value. Support is available, both in securing debt and in asset managing properties to maximise value both at the time of financing and beyond.
To refer to the earlier analogy, an asset manager can be your Swiss Army Knife – useful to have, with a range of dependable and innovate items to get the job done!
Alex Sogno
CEO & Senior Hotel Asset Manager
Global Asset Solutions
