How sale-leasebacks can help hotels in need of liquid capital

From small inns to large national hotel chains, 2020 has been a year of unprecedented challenges for businesses in the hospitality industry. Following a virtually nonexistent summer tourism season and several months of minimal corporate travel, countless hotels are facing severe revenue losses and are struggling to stay current on debt service payments.

As a result, there is a dire need for flexible financing options to help struggling hotels maintain liquidity. Serving as an attractive alternative to traditional financing arrangements, hotel sale-leasebacks may offer a multibeneficial solution for many businesses. 

Traditional Hotel Financing Options

Traditionally, hotels have had access to the following two options for financing:

  • Preferred equity. In a preferred equity arrangement, all of the hotel’s cash flows are paid back to preferred investors, who have provided venture capital to the hotel so that it can operate, until a preferred return has been reached. Today, most preferred equity investors are seeking returns between 9 and 12 percent, along with warrants and/or kickers—meaning that ultimately, desired returns fall in the mid-teens. This arrangement carries various pros and cons for hoteliers and investors alike. For example, it tends to be an expensive method of financing, and it is recommended that hotel owners have at least two years of interest reserves. Preferred equity investors lack voting rights, but may have veto power over major operational decisions and can exercise the right to force a sale or become a managing member. While there is no dividend growth, the risk is relatively low for investors.
  • Debt recapitalization. This method allows owners to take cash out of the hotel and transfer the risk of investment to other asset classes, while an outside financing source, such as a bank, provides debt capital in the form of senior and/or mezzanine debt. This debt is then distributed to the business owners through dividends or other mechanisms that provide cash. While debt recapitalization carries limited options, these options include Small Business Administration and bridge loans. However, this method of financing may be less feasible in the wake of the pandemic: many banks and commercial mortgage-backed securities originators are not back in business, so debt is coming from private funds that may charge a premium spread on loans. For example, businesses are finding that the price of debt is currently ranging from L+500-1000, with loan-to-value ratios between 50 and 60 percent. 

Benefits of Hotel Sale-Leasebacks

Hotel sale-leasebacks may provide the ideal alternative to traditional financing methods—particularly in today’s landscape. Popular in the hospitality industries of Europe and Australia for more than 100 years, hotel sale-leasebacks are gradually gaining attention in the U.S. This arrangement allows the seller of a hotel to become a lessee to the new owner. After title is transferred, the parties sign a lease—typically for 20 to 40 years—in which the seller agrees to make monthly payments to the owner while maintaining a brand flag and management rights. The lease often contains options for renewal or repurchase and can be expanded and extended as needed. 

Related: Why the sale-leaseback model is gaining ground in America

Hotel sale-leasebacks are considered a win-win situation, with the benefits for both parties including the following:

  • Dormant equity in the hotel may be readily converted to liquidity. Sellers receive the proceeds from the sale upfront, enabling them to pay off debt or reinvest the money in continued growth and expansion. Unlike with traditional loans—now offering loan-to-value ratios of only 50 to 60 percent—sellers often receive 100 percent of the hotel’s fair market value. This arrangement may be particularly attractive for hotel developers who want to cash out early. 
  • Buyers may receive above-market returns on the lease while keeping a management team with experience operating the hotel in place.
  • Hotel sale-leasebacks offer a potential source of discounted payoff financing.
  • The time frame for the due diligence and closing period tends to be relatively quick with hotel sale-leasebacks. 
  • Both parties to the transaction are eligible for tax benefits.
  • For operators, hotel sale-leasebacks open the possibility for value-add acquisition deals in certain markets and repositions under replacement costs. If they can find purchase opportunities with below-market replacement cost, operators may be able to gain significant returns once the market has stabilized. 

As hotel owners and investors alike become aware of the many benefits of hotel sale-leasebacks—particularly as compared to traditional financing options in the post-COVID landscape—the method is likely to continue expanding across the U.S. 

"Once we were educated and guided through the sale-leaseback model process and general terms, we realized that it checked most of the boxes within our investment criteria,” said Patrick Clifton, principal of Highland Hospitality Partners. “This model is a refreshing option in the hotel financing space that offers our firm another way to conserve equity and expand our platform through cash conservation and acquisitions. We are bullish on the sale-leaseback model and are currently using it to identify new opportunities and efficiencies. We feel it will soon be a common financing vehicle nationwide.”

When handled properly, there are no significant downsides to hotel sale-leasebacks. While investors always face the risk that the hotel will not perform as well as it did before the sale, this risk is minimal due to the continuity in management. The seller/lessee faces no real financial risk. However, sale-leasebacks may not be ideal for hotels with high leverage to value, as there will be minimal equity remaining after closing costs and escrows of property improvement plan reserves or rental reserves. 

As hotels navigate the post-COVID market while coping with a severe decline in cash flow, sale-leasebacks provide an excellent option for unlocking equity in the hotel and generating immediate liquid capital that can be used to pay off debt, cover costs, and invest in profitable new ventures. With hotel owners and investors beginning to learn about the many benefits, the hotel sale-leaseback model is poised to become far more common in the U.S. in the coming years. 

Stephen Y. Schwanz is president and CEO of ZEL Capital Partners. Jeffery I. Cohen is SVP of ZEL Capital Partners.