Capital stack

Balancing Equity and Debt

You might think that equity is money that you invest yourself. But that is not the whole story.

Debt is money you raise by borrowing against the value of your hotel. The lender provides money and earns interest for letting you use the money. You repay the money through principal payments. Essentially, each principal payment buys you a little more equity. Lenders provide you money in return for interest payments; they make money from lending you money. Because the debt is secured by the value of the hotel, their risk is controlled (the hotel is the lender’s “collateral”). If you do not pay the mortgage (monthly principal/interest or the balance at maturity), the lender can foreclose on (take ownership of) the hotel.

If the loan is properly underwritten (the lender’s due diligence), the lender’s risk is small because the hotel is worth more than the loan. For example, if the lender provides what they consider a 60 percent loan-to-value, their underwritten value for the hotel would need to be over 40 percent to low for the lender’s investment to be substantially impacted.

Instead of lending money, the equity investor is providing money in return for owning a piece of the hotel. Instead of earning interest, the equity investor earns a share of the profits. Instead of you buying a little more equity with each principal payment, the equity investor expects the value of their investment to increase as the value of the hotel increases. Instead of securing the investment, the equity investor risks the investment because the lender always gets paid back first.

If the lender forecloses, the equity investor’s investment can be wiped out. Equity investments are not collateralized – backed by the asset – the way mortgages are. Since the equity investor takes a significantly higher risk than the lender, equity investments are expected to produce significantly higher returns than loans.

Think about returns for equity and debt from the standpoint of risk versus return. Equity returns may be 2x to 4x times higher than the interest rate on debt. If mortgage interest is in the range of 4 to 7 percent, an equity investor may anticipate a return of 10 to 20 percent. However, the lender is extremely likely to collect interest every year and ultimately get the principal returned. In contrast, the equity investor might get a share of profits from the hotel in some years, and nothing in others. If there is a capital call (when hotel owners put in additional money to keep the business afloat) then the equity investor is required to contribute cash to keep their pro rata share in the investment. In a bad year, the hotel’s value may decrease and causing the value of the equity investment to decrease. In a good year, the hotel’s value may increase and the value of the equity investment increases. Value can swing, sometimes dramatically, in any given year, so equity investors must have a higher risk tolerance compared to debt investors.

Structuring ownership

You structure ownership of your hotel with a mix of equity and debt. These are the variables you balance:

• The more equity you invest personally, the larger your share of ownership in the hotel.
• Debt is usually limited to between 50 and 70 percent of the value of the hotel for traditional lenders. This is referred to as 50 or 70 percent “LTV” which stands for Loan to Value. For debt that is particularly secure, for instance because it is backed by the SBA or by a very wealthy backer (a “strong balance sheet”), debt may reach 85 percent LTV. In each case, the lender wants to make sure that the hotel will always represent enough collateral to cover the debt, even during an economic or real estate market downturn.
• More leverage, which is the percentage of debt, usually means a higher return on equity – and a higher return on your investment. This is because of several factors. Debt is usually less expensive than equity because interest rates are lower than anticipated equity returns. The lender’s returns are capped based on their fees and interested collected, so any value/profit appreciation that exceeds the lender’s return adds to the equity investor’s return, which has no cap on the upside. Al else equal, under two scenarios where you take a 50 percent LTV and a 75 percent LTV loan, and the hotel makes the same profit; your returns would be higher under the 75 percent higher leverage scenario. A good hotel investment increases in value while the principal owed is paid down. As a result, the portion of the investment represented by debt tends to increase in value over time; that appreciation doesn’t go to the lender, instead it adds to the equity investor’s return.
• Debt is often personally guaranteed, particularly for new owners. This means you promise to pay back any shortfall if the debt is not paid off. Debt carries a risk for owners, even in LLC’s, LLP’s and corporations, because of the terms of the mortgages including guarantees.

Leverage

Leverage is generated by using borrowed capital as your funding source. This allows you to buy a larger asset and increase the potential return on your investment. Leverage enables you to make money on other people’s money. When leverage works, it does three things:

1. It allows you to do a larger hotel deal – which enables you to make more money from operations as well as more money from the asset than you could if you only had your personal equity to invest
2. It pays you the revenue upside – for example, if you pay 6 percent interest and hotel revenues would cover 14 percent, then the difference (8 percent) is the return for you and the equity investors
3. It pays you the asset upside – for example, if you invest $500,000 in the hotel yourself, and eventually sell the hotel for $2 million more than you use to pay the lender and other investors, you triple your equity investment

Of course, this must all pencil out in your financial projections and in the actual performance of the hotel. An onerous repayment schedule can outweigh the benefits of leverage.

Leverage benefits you only when property values and operating cash flows are rising. Fortunately for real estate investors, these conditions often prevail. However, when values and/or rents stagnate or decline, the advantage provided by leverage can quickly disappear. This drives two key practices for leveraged investors.

• The first is performing comprehensive due diligence. How have property values trended in the area? What known factors, like the arrival or departure of a major employer, will influence the economy in the months, years and decades ahead? What are the expectations for the broader regional and national economy for the foreseeable future? The answers to these and related questions are critical to planning for the potential to benefit from leverage.
  
  
• The second is developing a sound investment strategy. Is this a short-term or long-term play? If it is a short-term tactic, what factors will signal that it is time to exit? If the goal is long-term gains, what can be done to “weather the storms” that are likely to occur? In either case, how is the deal structured to protect against downside risk?

To ensure that leverage is working for you rather than against you, keep these tips in mind:

• Be conservative in your appreciation expectation. Just because property values and rents have increased 5% annually in your target area in recent years does not necessarily mean they will this year or in the years ahead. It is safer to build your financial strategy around slightly lower expectations and then be pleasantly surprised if returns are higher than you anticipated.
  
  
• Get a payment you can live with. The idea of acquiring a hotel with a smaller down payment can be appealing, but the higher monthly obligation can become a problem down the road, especially if you have a period of poor performance (hotel markets can be volatile). It is important to find the right balance between equity and your mortgage payment.
  
  
• Keep your focus on cash flow. With hotel investments, the particulars of the transaction are important. However, so is the operating performance of the hotel. Can you keep the hotel occupied with revenues that more than cover your costs? Debt payment terms should leave a cushion in relation to income to protect inevitable periods of lower performance. The hotel business is seasonal, so some periods are predictably slow and may generate losses. The hotel business is also vulnerable to economic ups and downs.

Debt leverages your return on equity. This means that your rate of return on investment can be multiplied by a smaller investment going-in. However, that leverage is only positive as long as the value of the property does not drop below the loan amount upon the anticipated sale date. Take on only as much debt as you (your investment) can handle. Here is a video showing how leverage works by the numbers.

https://www.youtube.com/watch?v=jS2wsLsWbx4

Here is an article about structuring hotel deals.

https://ecommons.cornell.edu/bitstream/handle/1813/72261/deRoos1_Structuring_Hotel_Deals_final.pdf?sequence=1&isAllowed=y

 

The Capital Stack

The capital stack is the full set of financing instruments funding a hotel project. It is an intuitive concept. You can think of it like different money sources stacking on top of each other to get to your hotel’s total investment. The nuance about the capital stack is that the most secure sources of cash (usually the senior debt piece, which has your property as collateral in case of default) are at the bottom of the stack. As you “go up the stack,” each subsequent source of cash carries a higher risk and a commensurately higher return. This is because the individual sources of money are paid back from bottom to top in case of a default.

Four typical levels of a capital stack used to fund a hotel are summarized in this table. This is not an exhaustive list; there may be additional sources of capital from leases, management company sliver equity, franchisor key money, credit lines and others.

Stack	Risk	Secured	Repayment Priority	Expectations
Common equity	Highest	Unsecured	4th	Highest return expectation, uncapped potential returns
Preferred equity	Medium to high	Unsecured but may have recourse	3rd	Flexible, may have a fixed return and/or may also have a kicker to participate in financial upside
Mezzanine debt	Medium to high	Secured	2nd	Expects return significantly higher than senior debt
Senior debt	Lowest	Secured by mortgage or deed of trust	1st	Lowest return, ideally the largest piece of the stack

 

Building blocks for your capital stack

Your lender and equity investors are will want you to have “skin in the game,” or invested money of your own, especially if this is your first investment in a hotel. This protects them against moral hazard – a situation in which you take too much risk because you don’t have much to lose if the investment fails. Your piece is the peak of the capital stack. This money can come from savings, equity in your home, other investment properties and investment funds such as your 401K.

The second block in your capital stack is likely to be investment from friends, family, and individual investors. These are private offerings.

You can also raise funds from a broader group of investors through an offering. Reg D and Reg A+ are formats to raise money through public offerings.

Depending on the size of your project and the amount of funding needed, the next level of equity alternatives includes:

• Equity house or family office: If your project is large enough to require a substantial third block of equity, these are enterprises in the business of investing equity in desirable high return projects
• Crowdsourced (crowdfunded) funds: Are raised over the Internet and can be equity or debt depending on the structure of the raise. WeFunder, StartEngine, Republic are examples of equity crowdfunding sites which LendingClub and Prosper fund through debt.
• EB-5 investments are equity brought into projects from foreign investors. For these investors part of the benefit from EB-5 is access to a Green card for immigration.
• Key money is a term used for equity contributions from the brand intended to secure a franchise.
• Sliver equity is a term most often used for a small investment from a management company intended to secure a long-term management contract.
• Angel investors and venture capitalists are equity investors in some hotels.

Next in the capital stack are various forms of expensive debt used to complete funding for the hotel. These include mezzanine debt, FF&E leases and loans.

Finally, the base and largest source of funding for the project should be a mortgage. Depending on the project this could be from a bank, insurance company (for large projects) or other lending institution. For smaller and first-time hotel projects, SBA loans are a common source. In rural locations, USDA loans can be used.

Outside of the capital stack, but important for your financial planning are additional aspects of debt and equity:

• While you must have “skin in the game”, owners also earn equity through the value of their work on the project. This is called “sweat equity” and is incorporated into the deal structure. It is not usually recognized as part of the project budget but is realized as the asset appreciates.
• If you plan a major renovation or new construction hotel, you will need financing during the construction period. This is called “construction financing” and is eventually “taken out” by your mortgage.
• While you operate your hotel, you will need financial flexibility. This is provided through a debt instrument called a working capital loan. Its purpose is to provide you the flexibility to ride out the normal cash flow pattern of your operation.
• Sometimes businesses run short of cash. This can be caused by an unexpected extended downturn in business (like COVID) or by unexpected capital requirements like major repairs, FF&E replacements, or system replacements (such as an elevator or roof). If these requirements exceed the limit of your working capital, you will need additional equity or additional debt. This can come from your initial equity investors. Alternatively, you may bring in additional equity investors. The additional money affects how much of the hotel each investor owns, so it is a carefully negotiated process.

Balancing Equity and Debt

You might think that equity is money that you invest yourself. But that is not the whole story.

Debt is money you raise by borrowing against the value of your hotel. The lender provides money and earns interest for letting you use the money. You repay the money through principal payments. Essentially, each principal payment buys you a little more equity. Lenders provide you money in return for interest payments; they make money from lending you money. Because the debt is secured by the value of the hotel, their risk is controlled (the hotel is the lender’s “collateral”). If you do not pay the mortgage (monthly principal/interest or the balance at maturity), the lender can foreclose on (take ownership of) the hotel.

If the loan is properly underwritten (the lender’s due diligence), the lender’s risk is small because the hotel is worth more than the loan. For example, if the lender provides what they consider a 60 percent loan-to-value, their underwritten value for the hotel would need to be over 40 percent to low for the lender’s investment to be substantially impacted.

Instead of lending money, the equity investor is providing money in return for owning a piece of the hotel. Instead of earning interest, the equity investor earns a share of the profits. Instead of you buying a little more equity with each principal payment, the equity investor expects the value of their investment to increase as the value of the hotel increases. Instead of securing the investment, the equity investor risks the investment because the lender always gets paid back first.

If the lender forecloses, the equity investor’s investment can be wiped out. Equity investments are not collateralized – backed by the asset – the way mortgages are. Since the equity investor takes a significantly higher risk than the lender, equity investments are expected to produce significantly higher returns than loans.

Think about returns for equity and debt from the standpoint of risk versus return. Equity returns may be 2x to 4x times higher than the interest rate on debt. If mortgage interest is in the range of 4 to 7 percent, an equity investor may anticipate a return of 10 to 20 percent. However, the lender is extremely likely to collect interest every year and ultimately get the principal returned. In contrast, the equity investor might get a share of profits from the hotel in some years, and nothing in others. If there is a capital call (when hotel owners put in additional money to keep the business afloat) then the equity investor is required to contribute cash to keep their pro rata share in the investment. In a bad year, the hotel’s value may decrease and causing the value of the equity investment to decrease. In a good year, the hotel’s value may increase and the value of the equity investment increases. Value can swing, sometimes dramatically, in any given year, so equity investors must have a higher risk tolerance compared to debt investors.

Structuring ownership

You structure ownership of your hotel with a mix of equity and debt. These are the variables you balance:

• The more equity you invest personally, the larger your share of ownership in the hotel.
• Debt is usually limited to between 50 and 70 percent of the value of the hotel for traditional lenders. This is referred to as 50 or 70 percent “LTV” which stands for Loan to Value. For debt that is particularly secure, for instance because it is backed by the SBA or by a very wealthy backer (a “strong balance sheet”), debt may reach 85 percent LTV. In each case, the lender wants to make sure that the hotel will always represent enough collateral to cover the debt, even during an economic or real estate market downturn.
• More leverage, which is the percentage of debt, usually means a higher return on equity – and a higher return on your investment. This is because of several factors. Debt is usually less expensive than equity because interest rates are lower than anticipated equity returns. The lender’s returns are capped based on their fees and interested collected, so any value/profit appreciation that exceeds the lender’s return adds to the equity investor’s return, which has no cap on the upside. Al else equal, under two scenarios where you take a 50 percent LTV and a 75 percent LTV loan, and the hotel makes the same profit; your returns would be higher under the 75 percent higher leverage scenario. A good hotel investment increases in value while the principal owed is paid down. As a result, the portion of the investment represented by debt tends to increase in value over time; that appreciation doesn’t go to the lender, instead it adds to the equity investor’s return.
• Debt is often personally guaranteed, particularly for new owners. This means you promise to pay back any shortfall if the debt is not paid off. Debt carries a risk for owners, even in LLC’s, LLP’s and corporations, because of the terms of the mortgages including guarantees.

Leverage

Leverage is generated by using borrowed capital as your funding source. This allows you to buy a larger asset and increase the potential return on your investment. Leverage enables you to make money on other people’s money. When leverage works, it does three things:

1. It allows you to do a larger hotel deal – which enables you to make more money from operations as well as more money from the asset than you could if you only had your personal equity to invest
2. It pays you the revenue upside – for example, if you pay 6 percent interest and hotel revenues would cover 14 percent, then the difference (8 percent) is the return for you and the equity investors
3. It pays you the asset upside – for example, if you invest $500,000 in the hotel yourself, and eventually sell the hotel for $2 million more than you use to pay the lender and other investors, you triple your equity investment

Of course, this must all pencil out in your financial projections and in the actual performance of the hotel. An onerous repayment schedule can outweigh the benefits of leverage.

Leverage benefits you only when property values and operating cash flows are rising. Fortunately for real estate investors, these conditions often prevail. However, when values and/or rents stagnate or decline, the advantage provided by leverage can quickly disappear. This drives two key practices for leveraged investors.

• The first is performing comprehensive due diligence. How have property values trended in the area? What known factors, like the arrival or departure of a major employer, will influence the economy in the months, years and decades ahead? What are the expectations for the broader regional and national economy for the foreseeable future? The answers to these and related questions are critical to planning for the potential to benefit from leverage.

• The second is developing a sound investment strategy. Is this a short-term or long-term play? If it is a short-term tactic, what factors will signal that it is time to exit? If the goal is long-term gains, what can be done to “weather the storms” that are likely to occur? In either case, how is the deal structured to protect against downside risk?

To ensure that leverage is working for you rather than against you, keep these tips in mind:

• Be conservative in your appreciation expectation. Just because property values and rents have increased 5% annually in your target area in recent years does not necessarily mean they will this year or in the years ahead. It is safer to build your financial strategy around slightly lower expectations and then be pleasantly surprised if returns are higher than you anticipated.

• Get a payment you can live with. The idea of acquiring a hotel with a smaller down payment can be appealing, but the higher monthly obligation can become a problem down the road, especially if you have a period of poor performance (hotel markets can be volatile). It is important to find the right balance between equity and your mortgage payment.

• Keep your focus on cash flow. With hotel investments, the particulars of the transaction are important. However, so is the operating performance of the hotel. Can you keep the hotel occupied with revenues that more than cover your costs? Debt payment terms should leave a cushion in relation to income to protect inevitable periods of lower performance. The hotel business is seasonal, so some periods are predictably slow and may generate losses. The hotel business is also vulnerable to economic ups and downs.

Debt leverages your return on equity. This means that your rate of return on investment can be multiplied by a smaller investment going-in. However, that leverage is only positive as long as the value of the property does not drop below the loan amount upon the anticipated sale date. Take on only as much debt as you (your investment) can handle. Here is a video showing how leverage works by the numbers.

https://www.youtube.com/watch?v=jS2wsLsWbx4

Here is an article about structuring hotel deals.

https://ecommons.cornell.edu/bitstream/handle/1813/72261/deRoos1_Structuring_Hotel_Deals_final.pdf?sequence=1&isAllowed=y

The Capital Stack

The capital stack is the full set of financing instruments funding a hotel project. It is an intuitive concept. You can think of it like different money sources stacking on top of each other to get to your hotel’s total investment. The nuance about the capital stack is that the most secure sources of cash (usually the senior debt piece, which has your property as collateral in case of default) are at the bottom of the stack. As you “go up the stack,” each subsequent source of cash carries a higher risk and a commensurately higher return. This is because the individual sources of money are paid back from bottom to top in case of a default.

Four typical levels of a capital stack used to fund a hotel are summarized in this table. This is not an exhaustive list; there may be additional sources of capital from leases, management company sliver equity, franchisor key money, credit lines and others.

Stack	Risk	Secured	Repayment Priority	Expectations
Common equity	Highest	Unsecured	4th	Highest return expectation, uncapped potential returns
Preferred equity	Medium to high	Unsecured but may have recourse	3rd	Flexible, may have a fixed return and/or may also have a kicker to participate in financial upside
Mezzanine debt	Medium to high	Secured	2nd	Expects return significantly higher than senior debt
Senior debt	Lowest	Secured by mortgage or deed of trust	1st	Lowest return, ideally the largest piece of the stack

Building blocks for your capital stack

Your lender and equity investors are will want you to have “skin in the game,” or invested money of your own, especially if this is your first investment in a hotel. This protects them against moral hazard – a situation in which you take too much risk because you don’t have much to lose if the investment fails. Your piece is the peak of the capital stack. This money can come from savings, equity in your home, other investment properties and investment funds such as your 401K.

The second block in your capital stack is likely to be investment from friends, family, and individual investors. These are private offerings.

You can also raise funds from a broader group of investors through an offering. Reg D and Reg A+ are formats to raise money through public offerings.

Depending on the size of your project and the amount of funding needed, the next level of equity alternatives includes:

• Equity house or family office: If your project is large enough to require a substantial third block of equity, these are enterprises in the business of investing equity in desirable high return projects
• Crowdsourced (crowdfunded) funds: Are raised over the Internet and can be equity or debt depending on the structure of the raise. WeFunder, StartEngine, Republic are examples of equity crowdfunding sites which LendingClub and Prosper fund through debt.
• EB-5 investments are equity brought into projects from foreign investors. For these investors part of the benefit from EB-5 is access to a Green card for immigration.
• Key money is a term used for equity contributions from the brand intended to secure a franchise.
• Sliver equity is a term most often used for a small investment from a management company intended to secure a long-term management contract.
• Angel investors and venture capitalists are equity investors in some hotels.

Next in the capital stack are various forms of expensive debt used to complete funding for the hotel. These include mezzanine debt, FF&E leases and loans.

Finally, the base and largest source of funding for the project should be a mortgage. Depending on the project this could be from a bank, insurance company (for large projects) or other lending institution. For smaller and first-time hotel projects, SBA loans are a common source. In rural locations, USDA loans can be used.

Outside of the capital stack, but important for your financial planning are additional aspects of debt and equity:

• While you must have “skin in the game”, owners also earn equity through the value of their work on the project. This is called “sweat equity” and is incorporated into the deal structure. It is not usually recognized as part of the project budget but is realized as the asset appreciates.
• If you plan a major renovation or new construction hotel, you will need financing during the construction period. This is called “construction financing” and is eventually “taken out” by your mortgage.
• While you operate your hotel, you will need financial flexibility. This is provided through a debt instrument called a working capital loan. Its purpose is to provide you the flexibility to ride out the normal cash flow pattern of your operation.
• Sometimes businesses run short of cash. This can be caused by an unexpected extended downturn in business (like COVID) or by unexpected capital requirements like major repairs, FF&E replacements, or system replacements (such as an elevator or roof). If these requirements exceed the limit of your working capital, you will need additional equity or additional debt. This can come from your initial equity investors. Alternatively, you may bring in additional equity investors. The additional money affects how much of the hotel each investor owns, so it is a carefully negotiated process.