The 2018 federal tax law is a real boon for the lodging industry, providing major tax benefits for hoteliers that elect to immediately “expense” upgrading versus depreciating it over time. But taking advantage of the law’s favorable capital expenditure expensing provisions may put your mortgage into default if you’re not careful. This is something you must discuss with your lender.
Briefly, in most loan documents there’s a clause that focuses on requiring the borrower to maintain a reasonable profit “cushion.” This is called the DSCR, or debt service coverage ratio, clause. It looks at the hotel’s earnings before interest, taxes, depreciation and amortization and its post-mortgage-debt-service cash flow. The goal is to assure that there’s an adequate profit cushion to keep the business from being too highly leveraged. Depreciation, not being a cash expense, is waived as a business expense for purposes of arriving at your loan’s DSCR. (Remember this important piece of the formula as the column unfolds).
Let’s use numbers. Say your predebt-service EBITDA is $1 million, your mortgage debt service is $700,000 and your cash flow is $300,000. That approximates a 1.4 DSCR, meaning your cash flow is roundly 1.4 times its debt service; enough to satisfy most lenders. Please note that’s before a depreciation deduction which, if included, would have reduced the profit to zero, though it still would have had $300,000 of cash flow.
Here’s the conundrum that I recently ran into during a hotel refinancing. I explained to the lender that I’d be investing roundly $1 million of CapEx modernization funds and would be immediately “expensing,” or writing it off, on our next tax return. The lender said that it’s standard DSCR clause language permitted me to add back depreciation to the formula but if I “expensed” (rather than depreciated) the investment on our profit-and-loss statement, it would result in a business loss that would put the loan into technical default.
This is simply a “paper” loss and all I’m doing is taking advantage of the CapEx immediate write-off provisions of the new law. But the DSCR clause language in the bank’s standard mortgage documents hadn’t been rewritten to reflect current tax accounting allowances.
I’ll bet that if you read your own mortgage docs you’ll find that most of you are in exactly the same situation as me. And when the bank does its annual audit, it may well find you to be in technical mortgage default of the DSCR clause for the reasons described; the bank must then inform its regulator. My advice is that you call your lender and address the matter head on so you know exactly what the impact your tax accounting decisions may have on your mortgage loan.
Jeff Wilder is president of Wilder Ventures Hotel Investments and an adjunct professor at NYU’s Tisch Center for Hospitality, Tourism, and Sports Management. Contact him at [email protected].