Be cautious when considering long-term effects of loans

The lender's mortgage proposal was on my desk--a proposal that had variable--and fixed-rate interest options to consider. I had to make a financial decision that would have a monthly impact on our hotel's cash flow for years.

My choice was a 15-year amortization schedule with a loan balloon after seven years, a fixed rate 175 basis points higher than the variable-rate option I could have taken advantage of, and a loan to value of 50 percent, though the lender was perfectly happy to go as high as 70 percent. The debt profile I opted for was, under the circumstances, unique to the hotel investment being mortgaged. But it got me thinking about the potential dangers tomorrow of accepting easy money today, with a focus on variable--or short-term fixed-rate loans with terms of less than 10 years.

Hotel entrepreneurs are in the fortunate position of being courted by an increasing number of lenders. Nominal interest rates on first mortgages are low, and as confidence in the economy and lodging industry improves, debt levels approaching 75 percent to 80 percent of value are more common. So, with cautious optimism in the air and much liquidity in the marketplace, borrowers are in a good position to negotiate on a relatively level playing field. But investors must be careful what they wish for.

Higher leveraged properties that are financed at today's low variable-rate first-mortgage debt levels, possibly combined with higher rate mezzanine debt or a quickly amortizing furniture, fixtures and equipment loan, run financial risks.

What might be the potential fallout of "reaching" to do an acquisition, development or refinancing deal, and justifying the economics by financing it with temporarily low priced variable--or short-term fixed-rate debt?

Variable-rate loans are priced at a compellingly attractive rate that's often 150 to 200 basis points lower than fixed-rate debt. Junior debt pricing can run between 450 and 1,200 basis points above London inter-bank offered rates. And, often the loan being offered is for a term of seven years or less.

What happens to your hotel's cash flow when the cost of your variable--or short-term fixed-rate loan jumps, perhaps because Asian nations stop buying hundreds of billions of dollars of our federal debt each year? Or, what if the Federal Reserve starts having to rein in inflation by jacking up interest rates? What's the degree to which hotel asset valuations decline when interest rates return to their more historic norm, roughly one-third higher than today's levels? What happens when you need money for the next round of upgrading and there's not enough equity available to borrow against because your senior debt provides insufficient cash flow coverage to a junior lender?

The answer to these questions is that your hotel's cash flow will get squeezed as your debt service significantly climbs, and you might face a large principal balloon payment that might have to be significantly paid down to get refinancing.

I closed on a conservative level of financing for a seven-year term at a fixed rate. I tried to push the lender to 10 years, but that option wasn't available.

hmm@advanstar.com

Jeff Wilder is president of Wilder Ventures LLP, a New York City-based asset management company, and an adjunct professor at New York University. E-mail him at jswilder1@aol.com.

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