The project has been analyzed, its market feasibility attributes discussed, the developability of the project has been assured, and now the ultimate questions are regarding project finance. What type of financing will be available to the developer to allow him to conclude the project on economically feasible terms? As we noted earlier, there is a relationship between project cost and achievable rates and occupancies to determine project performance. Similarly, in the area of project finance, the amount of money that will be available (i.e., what percentage of the project cost can be financed) and the applicable rate of interest (i.e., what is the debt service on the project going to be) have a bearing on the feasibility of a proposed lodging facility.
Prior to the debacle in the industry of the late 1980s and early 1990s, real estate financing remained an orderly, standardized practice that matched developers with investors and lenders. As the lodging industry matured in the late 70s and early 1980s, the financing process, stimulated by favorable tax incentives and high inflation rates, increasingly involved financial institutions becoming equity or quasi-equity partners.
When the impact of overbuilding in all areas of real estate, including hotels, made itself felt in the late 1980s and early 1990s, financial institutions and lenders of all kinds found themselves reluctant owners of properties for which there was no market, except at drastically reduced prices. This situation gave rise to the fall of the savings and loan industry and the collapse of many long- recognized commercial banking institutions. Many hotel properties found themselves in the hands of regulators with the FDIC, FSLIC, or the Resolution Trust Corporation (RTC). It was not until the mid 1990s that much of the distressed hotel inventory was sold off and prices began to stabilize in stronger markets. With the revival in the industry, new construction has once again begun and lenders, albeit slowly, are returning to the marketplace. In addition to the traditional sources of funding, mortgage conduits and other forms of debt are being provided to the lodging industry through Wall Street sources.
Financing of lodging properties does not resemble that of office, industrial or residential projects. Lodging properties rely on the success of a business. They are often viewed as high-risk investments with potentially tremendous up-side potential. Lenders, therefore, tend to concentrate on those projects that are well-conceived, well-located and that involve experienced developers and operating companies. The cash flow from a lodging property available for debt service depends on local and national economic conditions, quality of management and unpredictable travel patterns.
The type of project financing depends upon the specific project and the needs of the developers, Typically, developers will secure 100% of their project cost through construction or interim financing, assuming that there is a take-out or some form of permanent financing with a loan-to-value ratio of 75% or less. The most common short-to-intermediate-term debt instruments available for financing hotel projects today include the following: construction loans, combined construction and term loans, and term and bullet loans.
The six major long term debt instruments include convertible mortgages, land sale lease backs and leasehold loans, permanent loans, mortgages with a kicker, wrap around mortgages and other long term debt instruments. Briefly, the type of financing provided by each of the aforementioned instruments is as follows:
• Convertible mortgages. One hundred percent of the project's development cost is provided to the developer, as is control of the property for a definitive term of years. The loan, while either at or below market rate, provides for the lender to receive a fixed interest return with a participation (usually 10 to 50%) of the cash flow after debt service. Additionally, the lender would receive the right to convert the mortgage into 50% of the equity at an agreed upon conversion date. This type of instrument is used more by insurance companies, pension funds and foreign trusts as opposed to more conventional and commercial lending institutions.
• Land sale leasebacks and leasehold loans. Under this scenario, the lender acquires from the developer the land at market value and then leases it back at a low rate (10 percent to 13 percent of the land value; 3 percent to 4 percent of gross room sales) for forty to fifty years. The lender participates in loan term capital appreciation through payments by the developer of future cash flows and a share of the property's appreciation.
• Permanent loans. Permanent financing takes all forms in today's environment, ranging in term length from as few as three years to as many as thirty. In some cases, the longer the term, the greater the requirement on the part of the lender to participate in cash flows. Loan principle amounts depend on a debt coverage ratio usually of 1.10 to 1.35 times the projected cash flow before debt service. In some cases shorter term loans have bullet provisions with interest only payments for five to seven years with the principle balance be- ing due and payable at the end of the term.
• Mortgages with a kicker. This financing method provides the developer with a loan at market or below market rate but with a long or extra long term. The amount of the loan depends on the coverage. The lender will participate not only in future cash flows (10 to 50%), but also in part of the residuals or, in some cases both.
• Wrap-around mortgages. Typically, this type of financing is provided by sellers or credit companies and entail a fixed rate on the underlying wrap mortgage plus a share of the residuals, a kicker, or both.
• Other long-term debt instruments. These types of financing include seller financings, exchanges, second mortgages and standby mortgages. In most cases, these forms of financing are primarily used when other, more favorable, financing methods will not cover all development costs, operating deficits, cost overruns or land acquisition costs.
Sound feasibility attributes, realistic performance projections evidencing sup-portable coverage ratios combined with sound credentials for the hotel operator are all essential to obtaining project financing in today's environment. Lenders want as-