By Nicole Di Tomasso
At its core, a hotel’s capital structure refers to the mix of debt and equity used to finance its operations, investments and expansions. Achieving an optimal capital structure is similar to crafting the perfect recipe, balancing the need for financial flexibility, risk management and shareholder returns.
Debt financing serves as a cornerstone for many hotel ventures. Hotels often rely on debt to fund property acquisitions, renovations, and other capital-intensive projects. However, navigating the debt landscape requires a cautious approach. Too much debt can burden a hotel with high-interest payments, reducing profitability and hindering growth opportunities. Furthermore, the cyclical nature of the hospitality industry poses additional risks, making it imperative for hoteliers to maintain sufficient liquidity to weather economic downturns.
“The more debt you can get, the higher your return would be for the hotel owners involved. Some of the disadvantages with debt financing could be more underwriting, periodic reporting and insurance requirements,” says Cameron Woof, AVP, Hotels & Syndication, CWB Franchise Finance. “Security is almost always first priority with mortgages for traditional lenders. If the mortgage isn’t paid, then technically the lender can take possession of the asset entirely. An ownership group needs to analyze how much leverage to optimize the return on the asset compared to the risk of not being able to meet financial covenants or pay
the mortgage.”
Equity financing, on the other hand, offers a different avenue for capital infusion. Whether through private investors, institutional funds or public offerings, equity provides hotels with capital without the obligation of re-payment. Moreover, equity investors often bring valuable expertise and networks to the table, fostering strategic partnerships and unlocking new growth opportunities. Despite its advantages, relying solely on equity financing may dilute ownership stakes and limit managerial autonomy, prompting hoteliers to strike a delicate balance between equity and debt.
“For most owners, traditional debt financing is the most efficient way to finance a hotel,” says Woof. “The reason for that is in the current rate environment, you’re probably around six to seven per cent in interest rate. Compared to typical return on equity expectations (for somebody that’s participating in the equity component), that six to seven per cent is much less.”
“The average capital stack, which is capital stack as debt and equity for a project, [from the] average lender is around 65 per cent, and 35 per cent on the equity side. The average hotelier likes to borrow a bit more leverage,” says Mark Kay, principal broker and president, CFO Capital. “They’d like to achieve 65 per cent, but they’d also like to aim for 70 or 80 per cent in some situations because they put less equity down and feel they can get a higher return. The problem is if a hotelier goes from 65 to 80 per cent debt and the hotel doesn’t perform as well, there’s a higher probability that the hotel doesn’t meet covenant. In that case, the lender may not re-new the mortgage or asks to find another lender to re-finance the property. That’s where the balance of 65 per cent seems to work out in a normalization.”
Kay continues, “A 65 to 70 per cent loan to value, three-to-five-year term and 25-year amortization is pretty consistent for branded hotels or established cash flowing non-branded hotels.”
Crafting an optimal capital structure involves a number of strategic considerations and challenges. Firstly, hotel owners must assess their risk appetite and financial objectives, tailoring their capital mix to align with long-term growth plans. Factors such as market conditions, asset quality and competitive positioning also influence capital-structure decisions. Additionally, regulatory requirements, tax implications, and interest-rate fluctuations add layers of complexity, requiring careful financial planning and risk-management practices.
“There are other lending sources, such as non-traditional lenders, mezzanine debt and bridge financing,” says Woof. “These would typically be used for a shorter period of time to get an owner from purchasing a hotel to being able to pay it out and still be able to close on the transaction. But those are going to be higher interest, ranging between 10 to 14 per cent, sometimes more.”
In the current interest-rate environment, Woof says the choice between variable and fixed rate is top of mind for investors/owners.
“It depends on each individual investor’s business plan and how much risk they’re open to,” says Woof. “I can see interest rates coming down over the next year or two, but I’m not sure that it’s going to be as much or as fast as we might hope it’ll be. It’s important for a hotel owner to think about how much the certainty of a fixed loan payment means to them.”
Generally speaking, lenders seem to agree that financing, while still difficult, has continuously improved, revealing heightened appetites in hotel mortgages. Similarly, lending conditions remain favourable for experienced borrowers.
“Various banks and lending institutions are starting to show more interest in hotel financing than they have over the last two years,” says Woof. “The financing landscape for hotels is improving, however, given the current interest-rate environment, it’s challenging to find loan structures that work at higher leverage.”
“The debt markets are very liquid, which means there’s a fair amount of capital available for hotels for construction, acquisition and re-financing,” says Kay.
Increasingly, hotels are viewed as a favourable asset class across commercial real estate. “There’s a lot of real-estate investors that, prior to COVID, weren’t interested in hotels as a real-estate asset class, but because of the high interest rates impacting the condo market and the soft office market, they’re now much more interested in hotels,” says Monique Rosszell, senior managing partner, HVS (Montreal and Toronto). “That’s given a boost to the value of hotels because there’s a greater pool of potential owners. It’s also put downward pressure on cap rates, whereas other lending parameters have put upward pressure, including interest rates and discount rates.”
However, Rosszell cautions, “There’s a lot of interest in hotels but there isn’t a lot for sale given there’s still a buyer/seller gap in values. There isn’t a lot of new supply because of high construction costs. As a result, hotels are cash flowing well given the additional barriers to entry, [such as] significant increases in land costs.”
Looking ahead, collaboration with financial advisors, industry experts and stakeholders is essential in devising robust financing strategies that withstand market volatility and economic uncertainties.
“There will be some economic headwinds that will create challenges for the hotel industry, but I think the health and experience within the industry in Canada will get us through that, and it’ll continue to be an interesting investment opportunity.“
