Hotel Financing Basics
Types of Hotel Mortgage Debt
The first layer of the hotel capital stack typically includes two forms of mortgage debt–senior and junior (which is also known as subordinate). These mortgages feature either fixed interest rates or floating interest rates. They produce the lowest returns to the debt holder (lowest interest rates) because they are paid first in the case of borrower default, and so they have the lowest risks.
What is the Difference Between a Junior & Senior Mortgage?
What distinguishes a senior from a junior mortgage is priority of payment. For any property, the mortgage that is paid first in the case of borrower default is called the senior mortgage. It’s the mortgage that is paid before all other payments to capital. Any other mortgage on the property is considered a junior mortgage because it is paid only after the senior mortgage has been paid.
Typically, you use junior mortgages when the senior mortgage has a long, advantageous term and you do not want to pay it off and replace it with a new, larger mortgage to harvest cash equity to deploy into another project. Senior mortgage holders generally have to agree to the addition of a junior mortgage. Many times a junior mortgage is obtained to fund a PIP renovation or pay for the furniture, fixtures, and equipment (FF&E) component of a new development. Additionally, as mentioned above, junior mortgages are frequently obtained by hotel owners so they can harvest the value of their equity (and get “cash out”) to buy or build another hotel or for any legitimate purpose.
Hotel Equity: Preferred & Sponsored
At the other end of the hotel capital stack is located equity, which is also divided into two types–preferred and sponsored (which is also known as common, direct, or JV equity). Equity has the highest returns for investors because they get paid last in the case of the failure of the business, and therefore they have the highest risks, and they are compensated accordingly.
The fundamental difference between preferred equity and sponsored equity is that the preferred equity generally has a minimum return requirement, and they get paid a minimum return first, and then the sponsored, or common, equity gets whatever is left over. The sponsored equity, on the other hand, is entitled to the highest returns. Because they are paid absolutely last, after all the other capital stack participants are paid, they get the highest return.
Hotel Mezzanine Debt
Between mortgage debt and equity is located “mezzanine” debt. With its origin in the Latin language, the word mezzanine means “in the middle.” Mezzanine funds generally constitute no more than 20% to 30% of the total capital stack, and the owner of the property generally sees obtaining mezzanine debt as a substitute for giving up ownership equity. Mezzanine debt may be a desirable substitute for equity because it is slightly less expensive than equity, and you do not have to take the mezzanine lender on as an equity partner. Mezzanine loans generate significantly higher returns (have higher interest rates) than mortgages. In the event of a borrower default they are paid second, in the middle, after the senior and junior mortgage holders and before the equity investors. Thus, their risk and reward is in the middle. They have moderate returns and moderate risks in exchange for being paid after the debt capital but before the equity capital.
Hotel investors prefer to use debt financing to fill most of their capital stack for three main reasons:
1) mortgage interest expenses are a large tax deductible business expense and significantly reduces the company’s income tax exposure
2) the leverage allows a relatively small amount of an investor’s cash equity (usually 15-30% of the total project amount) to be used to build or acquire and control a sizable income producing commercial real estate asset
3) Bringing in more equity partners will dilute the ownership percentage and control of the current owners.
This is usually a financially expensive and also emotionally burdensome proposition because the goals, priorities, and expectations for your business of any new investor many times will be different than your own.