The hospitality industry finished strong in 2018, with a 0.5 percent increase in occupancy and 2.4 percent growth in average daily rate, leading to an increase of 2.9 percent in revenue per available room. After 10 years of steady growth, however, some analysts expect demand to soften as the industry enters the late stages of the typical 10-year cycle. While growth and supply have been strong, if demand indeed begins to soften, industry participants will naturally become more conservative in their spending, making the financial piece of the hospitality industry more important than ever. With these potential changes on the horizon, a conservative financing approach is wiser than an aggressive one.
Top five borrowing mistakes
A conservative, judicious approach hinges on avoiding several common mistakes in the lending process:
- Overleveraging deals. Make sure your capital stack—both debt and equity—is buttoned down. Stress-test the viability of your projects.
- Taking short-term bridge loans. We are in the midst of a rising-rate environment for the first time in many years. When the rate rises, it affects hospitality borrowers’ bottom line and debt-servicing capabilities. Look for loans with permanent fixed rates, avoid short-term bridge loans, and give existing bridge construction loans a permanent home as soon as possible.
- Failing to have an attorney review construction agreements and promissory notes. Have an attorney or team of attorneys review these documents and explain any prepayment penalties, exit strategies, and default provisions. Failing to note or understand certain provisions can be extremely costly to borrowers. For example, an SBA loan’s promissory note may state that the interest rate during the construction phase is 8 percent and will fall to 6 percent after construction is complete. Such a loan could require all construction dollars to be repaid before the rate will be reduced—a significant hurdle for many borrowers.
- Neglecting to negotiate a provision for additional debt if needed. Some senior loans strictly prohibit taking on additional debt. If a hotel brand mandates renovations after a certain number of years, borrowers with these loans are forced to inject cash to avoid default or to refinance the hotel. A forward-thinking approach is to negotiate language permitting the borrower to add debt up to a certain amount to improve the property. Senior lenders can work this provision into their underwriting when they calculate the debt-coverage ratio.
- Failing to negotiate guarantees. Lenders typically require a personal guarantee as part of the loan. To mitigate risk, request to have burn-off written into the agreement—i.e., have the loan state that, once stabilization is achieved or certain benchmarks are met, the lender will release the borrower from the personal guarantee, entirely or in part.
Flexibility trumps rates
If borrowers can avoid these common financing mistakes, business continuity can be assured for both borrowers and lenders, and costly legal battles can be prevented. Having flexible provisions in place is ultimately best for both sides.
Obtaining a loan is always an exciting moment, but before celebrating, borrowers should pause to read the fine print. Negotiate not necessarily the best interest rate, but the best deal that gives you flexibility in a fluctuating economy.