It is important to understand the terminology (or look it up) as you ask questions, negotiate and enter into contracts. Luckily, due to the widespread existence of all types of debt, there are resources including these websites with glossaries and the explanations following:
Key characteristics and terminology to understand include:
- Amortization: The schedule over which principal is repaid is called amortization. Amortization means that part of the monthly mortgage payment is a paydown of the principal. In other words, in addition to paying interest on the outstanding loan amount, a portion of the outstanding principal is paid back as well. At the start of a loan period, most of the monthly payment goes to interest. As the loan amortizes (i.e., as the principal is paid down), the interest portion becomes a smaller portion of the payment and the principal a larger portion. Nevertheless, the monthly payment is constant.
For hotels, loan amortization is likely to be longer than the loan term. This is good for both the borrower and the lender. For the borrower, it would be impractical to pay back the entire principal within a loan term of 5 or 10 years. Very few hotels could generate that much cash flow. Instead, the borrower pays back enough principal to reflect obsolescence or wear and tear on the hotel over time. The goal is to always have enough value in the asset to pay back the principal. Lenders are in business to make money from interest on loans. They want to be sure that the hotel can be sold for enough to cover the principal, but they are in business to earn interest on outstanding principal. To benefit both borrower and lender, principal on hotel loans is amortized, or spread, over 20 or 30 years while the loan term may be 5 or 10 years. This makes loan payments manageable for the borrower because the principal component is relatively small and can be covered from the hotel’s cash flow. This gives the lender outstanding principal on which to collect interest. Every 5 or 10 years when the loan comes due, both the lender and the borrower have a reset. At this time, new loan terms are established, and a new amortization clock starts. Or you can choose to refinance with a different lender who may be offering better terms.
A loan can be interest-only, which means that there is no amortization during the loan period, just interest. At the end of the loan, there is a balloon payment for the entire principal amount. This is most common in short-term loans and construction loans.
An amortization schedule shows the month-by-month principal and interest due for the term of the mortgage. These are provided by lenders. You can also calculate amortization in a spreadsheet as well.
- Balloon: The principal left at the end of a 5 to 10-year loan term is called the “balloon”. This is the payment that comes due when the loan ends but has remaining principal to pay. Balloons are the result of the timing difference between the term of the loan (5 to 10 years) and the amortization of the loan (20 to 30 years). Balloons are refinanced into a new mortgage or they are cleared (paid off) by the sale of the hotel.
- Basis points: “Bps” (sometimes spoken as “bips”) are a unit of measure equal to 1/100th of 1 percent or 0.01 percent or 0.0001. It denotes the percent change in a financial instrument. (see also Interest Rates).
- Collateral: Loans allow lenders to lay claim to assets if the borrower defaults on their obligation to repay their debt. This is the loan collateral. Lenders want access to more collateral than the loan amount in case the value of the asset is lower than anticipated.
- Default: A default is a situation in which the property cannot service its debt and is sold to salvage what value remains. As each investor is made whole, the next-highest investor in the capital stack gets their investment returned, and so on up the stack until the salvaged cash runs out. Sometimes, in the case of a default, the mezzanine lender or someone else in the capital stack, pays off a mortgage or buys out another participant in order to improve their own position.
- Fees: A loan will have (sometimes numerous) upfront fees. Understand all the fees you will be responsible for and include them in your underwriting. Some of these are:
- Annual fees: These are commonly found on lines of credit and are charged by the lender to keep your line of credit open. A line of credit uses up some of the lender’s capacity to make loans. The annual fee compensates the lender for using their capacity you haven’t drawn.
- Closing costs: These may include application fees, appraisal fees, attorney’s fees, credit reports, recording fees, wire transfer fees, underwriting fees, packaging fees, etc. The lender will specify all fees in their proposal.
- Loan guarantee fee: SBA loans guarantee the lender that they will get their portion of the loan back, even if there is a default. There is sometimes a fee to cover the cost of the guarantee.
- Origination fee: Some lenders charge an origination fee and a typical fee is in the range of 0.5 to 2 percent. This is compensation to the lender or the sales representative for arranging the loan.
- Referral or broker fees: These are convenience fees for referring an application to an appropriate lender and assisting with the funding process.
- Taxes: Lenders secure notes by recording the security instrument in the county records in which the real estate is located. There is a recording tax or tax on the loan in some jurisdictions.
- Holding period: For commercial properties, including hotels, the loan period approximately mirrors the holding period. When you enter a hotel deal, you have an idea of how long you intend to own the asset. You may anticipate selling around the time you retire or after a certain number years based on tax planning (usually driven by depreciation) or driven by other considerations. Your franchise term or an anticipated renovation requirement may influence your holding period plan. While you should have an exit plan from the beginning of the investment, you can’t “time the market”. So, your holding period plan should have some flexibility built in.
- Interest rate: Interest rates are set by the lender based on their competitive market (the competition for your business) and their requirement to make money above their cost of capital. Rates may be quoted as a fixed number such as 5 percent or 8 percent. They may also be quoted relative to a benchmark. The benchmark may be LIBOR, the T-Bill rate (short-term government rate) or a longer-term US Treasury Bond rate plus some percent interest. Consider a loan that is quoted at LIBOR + 2.75% (275 bps) The total interest rate would be the LIBOR rate at the time agreed, plus 2.75 percent.
Rates can be fixed or variable. If you believe that interest rates will go down and/or have a short investment horizon, you may prefer a floating or variable rate. If you choose floating-rate debt, you may consider buying a cap to mitigate your risk of interest rates going up. The cost of that cap should be factored into your financial analysis. Having a fixed-rate loan (especially in a low-interest-rate environment) provides more reliable cash flow projections and reduces risk. If the loan is assumable, this can also be an incentive for a buyer if rates available at the time of the sale have gone up from your fixed rate.
- Kicker: An equity kicker is an incentive to encourage the lender to provide a lower interest rate or more desirable loan terms in exchange for an equity position in the hotel company. These are typically structured as conditional rewards so the lender gets the equity at a future date when the hotel meets specific performance hurdles. A kicker could pay the lender a percentage of earnings above a certain amount, give the lender a share of the proceeds on selling the business or have other features. Kickers have the effect of reducing your share of equity in return for reducing mortgage payments. Similarly, kickers may be part of negotiations with management companies.
- Prepayment penalty or defeasance: A loan may include a prepayment penalty or defeasance if the loan is paid off before the end of the term. Some loans, particularly CMBS and SBA 504 loans, provide their holders (the investor providing the principal) with a guaranteed long-term rate of return. The investor gets a return even if the loan is paid off early and the prepayment penalty covers that possibility. Keep this in mind when negotiating your loan as the penalty can be steep and can restrict your options about selling or refinancing. Prepayment penalties and defeasance are calculated differently, but have the same effect. They commonly diminish as you pay down the loan significantly, or get near the end of the loan term, because the value of the guarantee to the holders diminishes as the remaining time for which interest is guaranteed burns off.
- Principal: The lender loans the borrower a sum of money up front to buy or build the hotel. This is known as the initial principal. Over time the principal gets paid down or reduced (see Amortization).
- Recourse: A loan can be recourse or non-recourse. The lender can lay claim to the assets securing the mortgage, collateral such as the hotel real estate, furnishings and operating business. In a non-recourse loan, the lender is limited to the collateral securing the mortgage (the hotel). With a recourse loan, the principals are personally responsible for the loan payments and the lender can lay claim to the assets of the borrower if the collateral is insufficient to satisfy the loan. From a lender’s perspective, recourse reduces loan risk. From a borrower’s perspective, recourse increases risk.
- Take out: When a loan, such as a construction loan, is replaced by permanent financing, it is said to be taken out.
- Term: The borrower pays the principal back to the lender over a specified time-period or term. The borrower chooses the time-period based on their objectives; the lender quotes terms based on the borrower’s needs. A loan term of 5 or 10 years is common in the hotel industry. However, the borrower is not expected to have paid back the entire principal in 5 or 10 years. Instead, the borrower expects to sell or refinance the loan after 5 or 10 years and use the proceeds to pay the remaining principal balance. This reduces the lender’s risk because they are only committing to a given interest rate for 5 or 10 years, which is more predictable than 20 or 30 years. It also benefits the borrower because it aligns with likely financing events. The borrower is likely to need financing for a renovation, choose to sell, or want to refinance to take out equity in a 5 to 10-year time frame. To give you more flexibility, a loan may come with one or two extensions. Extensions are typically accompanied by a fee but may be beneficial and less expensive and time-consuming than refinancing.
- Term sheet: Investors and owners/entrepreneurs use terms sheets to outline the basic terms and conditions of the investment. Term sheets are non-binding. They may be used to attract investors. A lender’s term sheet may be called a conditional commitment letter. It summarizes primary terms and options such as the loan amount, interest rate, maturity, collateral and fee. It is not a commitment but is a positive indication.
Underwriting is the research and assessment of deal before a lender takes on the risk of a loan (or an investor takes on the risk of investing equity). Underwriters evaluate prospective loans to determine the likelihood that the borrow will pay as promised and that there is sufficient collateral in case of default.
Loan underwriting includes evaluating credit, analyzing the value of an asset through an independent appraisal, and studying the information provided in the financing package, and may include requests for additional information. Underwriting is a key determinant of the loan terms. If the underwriter perceives a higher level of risk, the loan may require a higher interest rate or more equity.
Underwriting can take weeks because it involves getting an appraisal which may be a six-week process after the appraisal is commissioned. Appraisals are commissioned by the lender although the borrower pays for the appraisal. This is so the underwriter knows that the appraisal is not biased by the borrower. Underwriting also involves getting surveys, sometimes environmental impact studies, credit reports and other information about the borrower or property.
The faster and more complete you can be with information requested by the underwriter, the faster the underwriting will be. Credibility is an important part of the underwriting process. Inaccurate or incomplete information can raise suspicions with the underwriter which, in turn, can increase the cost of borrowing.