Over the last 12 to 18 months, we have heard the same story told over and over again: Borrowers facing acquisition opportunities, product improvement plan (PIP) requirements/renovation, or refinancing of their hotels have found that loan proceeds, more often than not, fell short of the required amount. The culprit of this phenomenon is easy to explain. Property values, as a function of operating cash flow, have declined somewhat proportionately to the decline in top-line revenues. Moreover, in the face of uncertainties surrounding the outlook on asset’s operating bottom-line, inflation, and interest rates, lenders have taken a defensive stand and have begun applying more stringent underwriting parameters on loan applications. During roughly this same period, we have heard the ubiquitous buzz words: mezzanine finance. Mezzanine finance can be loosely defined as a type of debt financing in which a lender’s recourse is subordinate to that of the in-place senior loan. In response to the capital needs of the market, lenders, either acting individually or by teaming up with other capital sources, have devised a structure that allows borrowers to obtain their required loan proceeds, while still meeting the lenders’ strict underwriting parameters. Mezzanine finance presents an opportunity for borrowers to access additional capital above and beyond what conventional financing provides. Although not considered a new marvel of financial engineering, mezzanine finance has grown in popularity in the face of the recent hotel market downturn. We have seen a proliferation of lenders offering mezzanine financing in today’s hotel lending market. The wide-array of alternative financial products offered can broadly categorized as follows:
- Mezzanine loan; in its “true” form, the loan is secured by 100% ownership interests in the borrowing entity. Essentially, it is treated as a partnership loan and not recorded as a lien on the collateral property.
- Second lien mortgage; generally preferred by banks, this type of subordinated financing is secured by a second deed of trust on the collateral property.
- Preferred equity; it appears more like equity, but the return profile mimics that of debt. This form of subordinated financing collects its debt service in the form of a preferred return on the dollar invested. In many instances, debt service payments are cumulative.