Sanjeev Misra explores Conduit Financing for Hotel & Motel Management
28/02/07 10:00 Filed in: Article
FOR IMMEDIATE RELEASE:
Sanjeev Misra Explores Conduit Financing for www.hotelmotel.com
February 12th, 2007:
Leveraging investments: Conduit financing vs. Conventional financing
Financing can multiply the ability and reach of equity investments. As the hotel industry is a very asset-intensive industry requiring significant upfront expenditure, debt financing becomes a critical factor in the success of the hotel owner. The manner in which you choose to finance your hotel property can directly affect your equity return, your risk of foreclosure, the timing of the asset sale and your ability to operate the hotel.
In today’s lending environment there are some financing issues that are especially relevant. The use of conduit financing versus conventional financing is a great way to obtain a lower cost of financing for your hotel given the current rates. However, conduit loans are not suitable for every hotel owner and work best for those interested in long-term financial growth.
Conduit Financing versus Conventional Financing
One of the innovations that occurred in the last decade was the growth of commercial mortgage based securities (CMBS). These instruments allow lenders to underwrite a hotel asset, and then sell off the loan to be packaged into a large pool of loans to be securitized as bonds. The economies of scale created by combining multiple loans allow these financing instruments to offer more attractive rates than conventional financing sources, such as local banks.
For example, in today’s environment, a conduit loan could have rates that are 50 to 100 basis points below the rates offered from your traditional bank lender. For a $10 million loan, that difference could impact your cash flow to the tune of $50,000 to $100,000 per year. As you look at potential acquisitions, that variation could mean the difference between meeting your return hurdles and buying a hotel or not.
So how to you know if conduit financing is the right type of financing for you? First, you have to be aware that this type of financing has its drawbacks. The structure has very strict requirements for the borrower. In many cases, the borrower is limited in his ability to add additional secondary debt, including mezzanine financing. Many of these loans also place restrictions on changing the hotel’s franchise affiliation, management company and ownership structure. Most importantly, there are significant costs associated with paying off a conduit loan before maturity.
The cost to defease, or pay off, a conduit loan has two components outside of the principal balance. First, there is a defeasance premium that equals the difference between the cost to purchase the securities and the outstanding balance on the loan. This is basically to account for the difference in interest rate between when the loan was securitized and when it is being paid off prematurely. Secondly, there are significant transaction costs related to “unpacking” the loan from the pool of loans. These costs can be very expensive.
These costs become more significant in a declining interest rate environment. The greater the decrease in interest rates, the greater the “defeasance premium.”
Many hoteliers used this type of financing in the late 1990s to obtain low interest rates, but then suffered greatly when they sold the hotels before loan maturity with expensive defeasance prices. This was because interest rates declined significantly at that time. In today’s situation, interest rates are still very low compared to historical averages. Therefore, while no one can predict interest rates, the risk of high defeasance costs down the road is less likely.
A good fit
So when is conduit financing a good fit? Conduit financing is a good fit for hotels that have a stable income flow, a stable hotel brand affiliation and where the owner does not expect volatility in the market nor expect significant required renovation. It is an especially good fit for hotel investors who are mostly focused on the annual annuity-like cash flow of the property and are less likely to sell the hotel early to realize capital gains. Finally, it is best to obtain the conduit loan when the property is close to the peak trailing 12-month performance to achieve the maximum loan amount.
With all these factors in mind, conduit financing is a great way to obtain a lower cost of financing for your hotel compared to traditional lending sources given the current rates. It is best suited for acquisitions of stable-performing, top branded hotels in which the owner plans to hold the property for an extended duration.