Negotiating replacement reserve helps cash-flow issues

The first mortgagee's replacement reserve clause can have major cash-flow implications for a hotel operator. Many lenders require a monthly replacement reserve often approximating 4 percent of gross sales, which can be a significant sum.

To appreciate the dollars involved, if your hotel grosses $2.5 million annually and you've received a $3-million loan proposal, your annual mortgage debt service would probably be $200,000 to $250,000. If your lender requires a 4-percent replacement reserve, that's $100,000 per year. Replacement reserves can range from 25 percent to 50 percent of your total mortgage payment. So, negotiating the particulars of this clause requires considerable attention, especially because there are times of the year when you're tight for cash. So, what are some different ways to approach negotiating this clause with your lender?

First, let's review alternative dollar amount formulas to propose. I've often done deals where the lender has accepted a lower percentage level, a fixed dollar amount, or no initial reserve escrow requirement so long as you provide your franchisor's quality-assurance report to the lender on an ongoing basis and agree to complete all work required by the brand's periodic report within a specified period of time.

Some lenders, such as those providing commercial mortgage backed securities, have limited flexibility in negotiating replacement reserve escrow levels because their ability to resell the loans to end buyers is dependent on getting the debt rated by a credit-rating agency, such as Moody's or Standard & Poor's. These agencies impose tight requirements that inhibit the loan originator's ability to negotiate terms. On the other hand, banks and insurance companies, which usually act as principals rather than loan resellers (euphemistically called mortgage bankers), can negotiate reserve escrow levels. The ability to negotiate this one clause might be the determining reason to borrow from an institution, as opposed to a CMBS loan reseller.

Secondly, a major replacement reserve clause is the definition of exactly what you are able to draw money out to cover. This is very important because you, as the borrower, want to be able to tap into escrowed replacement reserve funds for as much as possible.

Most lenders, whether they intend to keep the loan on their books or credit-enhance and resell it, have a lot of leeway in negotiating the breadth of items that qualify for reimbursement.

Thirdly, you want to define when you can gain the benefit of the use of your escrowed cash. You'd do well not to wait for reimbursement of funds that you were required to expend before being repaid, but would want the lender to agree to pay against invoices or contracts, even though the goods might not yet be on the property. Also, you will want to get a quick turnaround on funds, say within 10 business days.

Lastly, you should receive interest on your escrowed replacement reserve funds at the highest rates offered by the lender.

Wise reinvestment in continually upgrading your property is good business but during slow periods, every dollar you have in your own pocket is a useful asset.

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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