Mezzanine financing's role changes as recovery unfolds

Hotel & Motel Management, Jan 12, 2004 by Tony Dela Cruz

As the hotel industry cautiously moves toward a consensus belief about a sustained recovery, the role of mezzanine financing must also evolve. After all, this is the financing vehicle that has traditionally served as the hedge against economic uncertainty. Hotel buyers use it to bridge the pricing gap their first-mortgage lenders decline to cover, while capital providers view mezzanine financing as a way to underwrite hotels on a limited basis with shorter-term, higher-yield loans.

Experts are careful to divide the world of mezzanine financing between larger, so-called trophy properties, which by their sheer size will limit the number of lenders willing or able to participate in their financing, and smaller properties, for which there's more market equilibrium among lending sources.

The deal setting the tenor for mezzanine financing for trophy properties is a $10-million junior mezzanine loan to the owning interests of the Hilton Times Square in New York. The loan was provided to FC 42 Mezzanine, an affiliate of developer Forest City Ratner Companies, by Ashford Hospitality Trust. Ashford, a recently formed real-estate investment trust based in Dallas, acquired the loan from Bear Stearns Commercial Mortgage, the originator of the first mortgage, senior mezzanine and junior mezzanine loans. Financing for the property includes a first mortgage of about $42.9 million, a senior mezzanine loan of about $26.1 million, and the $10-million junior mezzanine loan held by Ashford.

Doug Kessler, c.o.o. and head of acquisitions for Ashford, said the deal demonstrates the REIT's diversified investment strategy, which also includes direct ownership, first mortgages and sale-lease- back programs in addition to mezzanine financing. Other than acquiring two hotel portfolios for $80 million, Ashford is focusing primarily on mezzanine financing because the interest rate spread is attractive for the REIT's shareholders, Kessler said.

"We feel we can deploy our capital at a spread ranging from 750 basis points to 1,200 basis points or more over [London interbank-offered rates]," he said. "The bandwidth of that spread can decrease or increase depending on where we are on the loan-to-value scale."

Kessler said that while most mezzanine capital is deployed on deals that have a 70 percent to 85 percent loan-to-value ratio, Ashford is willing to participate in deals with an LTV ratio of as high as 90 percent to 95 percent.

"Owners feel that their hotels are on the cusp of recovery," he said.

Neil Teplica, managing director of the hotel group for Greenwich Group International LLC in New York, said that although Greenwich is limiting its mezzanine financing to the office-building sector, there are many groups that had redlined the hotel sector that aren't anymore.

Teplica said the decrease of perceived risk of lending to the lodging industry comes from several factors, including the sense that the industry's post-9/11 woes have bottomed out, an overall increase in capital among lenders and that some lenders, who are unable to find suitable investments in other sectors, are finding the potential returns higher in the hotel industry.

Teplica said a REIT such as Ashford, which was formed by industry veterans who have been buying and selling hotels since the early 1990s, can leverage its industry knowledge and underwrite more aggressively, and because they can be more aggressive, they can write higher LTV loans.

Ronald Silva, president and c.e.o. of Fillmore Capital Partners in San Francisco, specializes in trophy transactions and said that at that level, aggressive might not adequately describe the underwriting.

"Our average mezzanine deal size is $30 million, and you have to bid toward uncomfortable," Silva said. "We are bidding spread terms that are very aggressive compared to what we were doing in the last round of mezzanine financing."

Silva said this is the direct result of liquidity in the hotel marketplace.

"This is good news for borrowers and cautionary news for lenders," he said.

Silva said he also regards Ashford's mezzanine program as one that pushes toward ownership.

"Loan-to-own programs have been around forever," he said. "Ashford is deploying it because of a lack of equity capital."

Kessler said it's not uncommon for a specialist in foreclosure to stand between the primary lenders and the hotel borrower.

"If a loan goes into default, then the other lenders like that, in case someone has to step in and work the asset," he said. "Our view is that we are in a recovering market. We are not in a loan-to-own program. We are a public company. We don't want to report that loans have gone into default."

Mark Elliott, managing director of Hodges Ward Elliott, a hotel brokerage firm based in Atlanta, said mezzanine providers have to work their wares because the hotel capital markets are more rational than they have been in recent years.

"In this cycle, the market is more educated than in the past, and there is an adequate amount of first mortgage capital and a large amount of mezzanine financing available," he said. Despite the competitive environment for lenders, mezzanine financing doesn't dry up, but the opportunity diminishes, Elliott said.