In Part 4 of his series, Lawrence Meyers and Monty Bennett discuss Ashford’s unique methods to profit from hotel down cycles.

By: Lawrence Meyers

L:  Let’s examine what happens with Ashford Hospitality Trust (NYSE: AHT) during the hotel industry’s down cycle, which is occurring now. You’ve said during those times you’re much more likely to invest in loans and sale-leasebacks (both secured by hotels.)  Let’s talk about sale-leasebacks first.  In this structure, say you buy a hotel for $10 million. You get a $6 million mortgage at maybe 7.0%.  You put $4 million of your money into the deal.  You turn around and sign someone else to a long-term lease on the property, right?

M:  Exactly. We’ll get, say, 9% on that hotel lease, that’s $900,000 per year.  If your mortgage is 7.0%, then you’re paying $420,000 per year in interest expense.  So your profit, or “scrape”, is $480,000.  But when you divide that by your $4 million of invested capital, that’s a 12% return.  That’s pretty darn good in an environment when the industry is doing poorly.  And you’ll get that 12% all throughout your lease.

L:  The only trick is you must lease to someone with good credit.

M:  Correct.  Now, are sale-leasebacks that sexy?  Some don’t think so.  But look at Hospitality Properties Trust (NYSE: HPT). All they do is sale-leasebacks. They’ve done very well in the tough times.  But our strategy is to be like different companies at different times.  Now, we’ll never be 100% in one type of investment.  We’ll always keep some of our very best, really terrific hotels.  We’ll keep recycling our capital.  That makes us different from everyone else.

L:  Okay, let’s move on to your lending platform.  Here you are essentially acting as a bank, lending money to people who want to own a hotel.  The natural question is, why would people come to Ashford for a first mortgage instead of a bank?

M:  A lot of it is just being there in front of your customers. Hustling.  Also, if you’re more aggressive, such as offering a higher loan-to-value than a bank, you’ll win more business. You’ll also win more business if you’re more flexible with your terms. Speed is also a factor, to get through an approval quickly. And of course, we are hotel experts.

L:  When the hotel cycle really is in full decline, what strategy do you employ?

M:  When the market is in full decline, we’ll wait for the trough before we start buying again. So until then we’ll be making mezzanine loans.  In fact, we can make those throughout the cycle. 

L:  Let’s talk about mezzanine loans.  It’s really just a fancy term for a second mortgage, save a few legal and technical points, isn’t it?

M:  Yes.  Basically, if a lender loans out 60% of a hotel’s value but the borrower wants to borrow 80%, they’ll go to a mezzanine lender to get that portion. 

L:  What kind of terms will you, as a mezzanine lender, offer?

M:  So far this year, we’ve done four mezzanine deals at an average of about LIBOR + 1,300 basis points, which is about 15 – 16%.

L: Is a mezzanine loan unsecured?

M:  It’s secured by what’s called the partnership interest.  For example, if Mr. Larry and Dr. Ben go buy a hotel, then you each own 50% of the hotel through your partnership.  The partnership goes and pays $10 million for a hotel.  You get a first mortgage for $6 million, a mezz loan from Ashford for $2 million, and you and Dr. BenJoe each put in $1 million.  If the deal went bad, the first mortgage holder can foreclose on the hotel.  But Ashford, as the mezz lender, can foreclose on the partnership interests.  So, if Ashford foreclosed we’d endeavor to keep that first mortgage in place and to keep that lender happy, and because of our corporate structure, we have the cash to keep paying that first lender.From there, we decide what to do with the property. Typically, the reason the borrower defaulted is because the property was not producing enough income. 

So we ask,  “Do we sell the property?  Change management or brand?  Put capital into it?” Our experience is also a big selling point to first mortgage lenders.  See, if there’s a default, they don’t want the hotel. They aren’t hotel experts.  They don’t have the time or money or energy to deal with it.  But when we come in as a mezz lender, we’re telling the first lender that they get two bites at the apple.  If the first borrower can’t pay, then you have a financially solvent entity with an expertise in the hotel and its operation to take over the mortgage. In fact, for some of our mezz loans, the first lender would not even make the loan without us as mezzanine lender.  A bank sees that if something goes wrong, they already have a turnaround specialist in place, with capital already in the property, who can come in and help out if need be.  The first mortgage lender puts their loan documents in a drawer and forgets about them because they know that we are there.

L:  So in evaluating a potential mezzanine loan, you almost don’t care who you are loaning to.  If they default, you may very well end up running the hotel yourself.

M:  Yes. We look less at the sponsorship compared to other mezz lenders, but ask what it would mean if we owned this hotel, as if we were buying it ourselves.  That’s unique in our business.

L:  Have any mezz loans gone bad?

M:  No, and we’re happy that way.  We are not in the loan-to-own business, we just have the expertise on hand as a back-up if need be. 

L:  And the money you use to make the mezz loan itself, where does it come from?

M:  We can use some of our own capital, or go to our credit lines to get it.  It doesn’t take much leverage to get a great return when you’re lending money at 12% plus.

Stay tuned for Part 5, where Lawrence Meyers and Monty Bennett discuss Ashford’s deployment of its corporate strategy.

Lawrence Meyers is a former writer for the Motley Fool, and is President of PDLCapital, a private equity firm (www.pdlcapital.com). He currently owns shares of Ashford Hospitality Trust. This article is only an expression of the author’s opinion, may contain inaccuracies, and is not a solicitation to buy or sell any security. All readers are advised to consult with a financial advisor prior to making any investment. The author may be contacted at pdlcapital@earthlink.net

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