Don’t get stuck high and dry

Understanding the importance of brand when financing a hotel

by RUSHI SHAH

In the institutional capital markets world, having an asset with predictable cash flow is the name of the game. When evaluating a debt or equity deal, capital sources are looking to minimize risk and need assurances the property will deliver the expected future cashflow. As a result, assets lacking a brand affiliation are more difficult to underwrite than those encumbered by a franchise. Notwithstanding any market dislocations, this is because branded assets have a significant following and benefit from the constant flow of customers the parent company’s marketing muscle generates.

There are exceptions to this rule, however. For example, brand and the need for a corporate reservation system may have less weight for high-quality assets and/or those located in a desirable location. Likewise, boutique hotels in destination markets can often garner attractive financing terms.

Knowing how much the brand power behind an asset can affect risk and return, and – to ensure there is no lapse in franchise – capital markets structure around any potential franchise expiration within the term of the loan. To hedge against a lapse, lenders will require enough capital to cover any potential brand-imposed performance improvement plan (PIP) requirements. In lieu of these upfront reserves, some capital sources will offer creative structures such as adding limited recourse or an ongoing reserve for a fixed amount through a cashflow sweep.

Here are four additional best practices to consider when pursuing financing for a property.

1. Invest Now to Benefit Later
Everyone involved in the transaction process, including the brand, b-piece buyers, rating agencies, and lender, recognizes the importance of property upkeep and will encourage owners to budget 4% of an asset’s annual revenues toward maintenance. Long-term data suggests that when the 4% is actually spent to maintain brand standards, that property is less likely to fail quality inspections and more likely to maintain high guest satisfaction. This correlation is why lenders prefer having a reserve buffer, because assets with sufficient reserves are a lower risk for default. This was especially evidenced during the pandemic when many borrowers were allowed to draw on their reserves to cover mortgage payments.

2. Be Open to Change
Because of the importance of brand-to-asset success, when acquiring or refinancing a property, owners should negotiate the right to rebrand in the future. Not only should they have the ability to rebrand, they should be able to do so with or without the lender’s permission and to choose a perspective brand on the same STR chain scale. Owners facing a rebrand also can negotiate a debt-service-coverage ratio-testing holiday. This allows lenders to waive cash management testing until the reflagging process is completed. This structure protects owners from being stuck with a non-performing brand.

3. Consider What’s Next
One of the biggest challenges hotel owners face is the constant redesign and reimagining of brand standards. While innovation usually is good news for consumers, upgraded brand standards throw a wrench into the financing process because lenders must ensure owners have accumulated enough capital to fund brand-imposed makeovers at price tags as high as $15,000 to $30,000 per key. To attract demand, extended stay hotels have emerged as a popular select-service segment, and brands are frequently adding hotels with kitchenette products to their portfolios.

Another popular trend is to buy a lesser brand hotel and convert it to an extended stay product. Travelers appreciate having a kitchen, especially post-pandemic, and capital sources love the sticky demand and 15- to 45-day average length of stays. Extended stay brands also have a slower ramp up time and rely less on brand contribution. As quasi apartments, they also help combat our country’s ongoing rental property shortage.

4. Prepare for Success
Due to brand importance, it’s prudent to include an expert in any hotel financing transaction. There are many features that an experienced intermediary can negotiate. Their knowledge is especially critical addressing elements related to the franchise agreement and comfort letter, as these are complex tri-party agreements executed between lender, franchisor, and franchisee.