Maximize loan levels by knowing the limitations of a lender

Today, with multiple financing sources often the norm, it's good to remember what factors tend to limit loan amounts, so that you can address these matters up front and make the right lender choice.

While a lender initially might offer to provide an acceptable loan amount, say 70 percent of value, each has a unique set of "collars" that might reduce the offered mortgage amount by closing time. The most common collars, or limitations, are debt service coverage ratios, pro forma set-asides for management fees and replacement reserves, definitions of stabilized profitability and the capitalization rate used in determining value.

Debt service coverage ratios: If the lender uses a 1.5 DSC ratio, that means the hotel's profitability needs to be no less than 150 percent of annual mortgage payments. For example, if hotel's profit was $450,000, then the lender could provide a loan with annual payments up to $300,000, but no more. Alternately, in using a 1.25 DSC ratio, $360,000 may be assigned to debt service because 125 percent of that is $450,000. In the second instance, the lender is willing to accept a lower profit cushion than in the first, or $90,000 versus $150,000. All things being equal, lean toward a lender requiring closer to the 1.25 DSC range in order to maximize your loan.

Pro forma set-asides: Net profit is central to determining value. While certain costs, such as utilities and labor, are historically verifiable, some are simply added in as pro forma expenses during the underwriting process. These line-item deductions are reasonable, but the amounts often are negotiable. For instance, one lender might input a 3 percent supervisory management fee and 5 percent replacement reserve, so 8 percent of the hotel's gross sales are deducted as a pro forma charge against profitability.

Another lender might include lower numbers, thereby raising pro forma profits and increasing your chance to maximize the loan request.

Stabilized profit: Often, financing proceeds are used, in part, to modernize property. In such cases, underwriters usually estimate post-upgrading profit as the basis for their loan offer. Seems pretty straightforward, but it's not. For example, will the underwriter use the projected profit several years out (and which year) or an average over a number of years? Naturally, the chosen metric influences the stabilized profit number and the value from which the loan amount is derived.

Appraiser's capitalization rate: Hotels historically are worth 7.5 to 10 times their defined profit. Hotel values, as with almost all businesses, are determined by earnings multiples, the reciprocal of which is the capitalization rate. So, a hotel earning $450,000 profit that is valued at eight times earnings means it carries a 12.5 cap rate, creating a value of $3.6 million; a 10 cap rate on that same hotel would value it at $4.5 million. While everyone might agree on the hotel's stabilized profit, the cap rate used will have a material impact on valuation. Because the lender will fund against a percentage of value, you'll want to learn, going in, the lender's general philosophy regarding its opinion of cap rates for hotel properties such as yours.

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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