On Finance: What to do if you're underwater, need rescue capital

Given the current landscape in the hospitality industry, "underwater" can mean many things and take on several different shapes and sizes. It is an issue countless owners and operators are dealing with, despite the recent upward trends, and can put a strain on your hotel"s performance and your personal well-being.

The issues may range from:
◾ first mortgage maturing on a performing asset;
◾ a construction loan coming due on a still-ramping property;
◾ an interest-only period ending and amortization beginning;
◾ a failure to cover debt service from cash flow;
◾ tripping covenants even though the property is covering debt service;
◾ franchise default by failing to meet brand standards; or
◾ equity partners failing to make capital calls or otherwise needing imminent liquidity.

The list goes on and in many cases these issues are not mutually exclusive. So in the event a lender is willing to provide some relief but is requiring a capital infusion, what should a borrower be thinking about to attract capital and climb out of the hole?

First and foremost, most lenders will be highly sensitive to preserving their initial principal, or as much as they possibly can. If the plan in place puts them in the best position to achieve this goal, the negotiating walls may begin to lower. Often this means new capital investment in the hotel and admitting a new partner as part of the equity structure. Admitting a new equity member, however, makes for some complicated issues. Lenders will be sensitive to the structure of their reconstituted borrower and their recourse for "bad-boy" events and related indemnifications. All parties need to be sensitive to lender issues to make a deal work.

For an existing borrower, equity may be all but gone. However, to reach a deal a new capital provider may be "willing to provide some form of credit for that sunk equity, often referred to as a 'hope certificate.'" It’s essentially a way for the previous owner to stay in the deal and earn some of the investment back if the hotel is turned around by the new capital provider. Also, a new capital provider may not be quite as tax-driven and agree to special allocations to buffer the existing owner’s tax burden, i.e. income from forgiveness of debt. Keeping a deal alive and avoiding severe tax consequences for the existing owner may, in itself, provide the impetus for a successful restructured transaction.

Mezzanine financing may be an attractive way to structure a rescue capital investment. This can allow for fresh capital to be used to turn the property around and keep the doors open until it can stabilize. The lender will assess the risk/reward of the investment and will need to be paid for the added risk of being behind the first mortgage in the capital stack. Mezzanine financing can be attractive to owners because they maintain control of the asset, provided the servicing costs are kept current.

Preferred equity can be more flexible than mezzanine debt but the existing owner may have to allow the new investor to participate in the upside of the property while also providing some form of current pay.

It is important to balance the needs of all parties involved. Reasonable compromise from all parties is the key.