REQUIRED READING: Hotel Buyers And Sellers Turn To Specialized Structures

Written by Earle Wason
on February 11, 2009 No Comments
Categories : Required Reading

In today's challenging commercial real estate market, appropriately utilizing creatively structured transactions is becoming a necessity. Understanding what steps need to be taken is a complex task, and having a facilitator – such as a commercial real estate broker – is an essential part of closing both simple and complicated sales.

Among numerous financing strategies for hospitality properties, the Small Business Administration's (SBA) 504 loans and wraparound mortgages are two beneficial and widely used tactics for transacting a sale. The SBA loan program is designed to assist small and midsize businesses with obtaining real estate. In tougher lending environments – as is the case in our current market – lenders are more likely to favor SBA 504 if it is available.

These loans offer greater protection for the lender and usually have lower fixed rates and a longer payback term for the buyer. According to the SBA, a buyer's new business will qualify for this program if it has a tangible net worth less than $7.5 million and has average net income of less than $2.5 million after taxes for the preceding two years. Loans are not offered to businesses engaged in speculation or investment in rental real estate.

The idea behind the SBA 504 is that as businesses grow, they add staff and look to expand. According to the National Association of Development Companies, SBA 504 loans are linked to job creation. A small business owner must create and retain jobs or meet a public policy or community development goal – such as having a minority-owned, veteran-owned or woman-owned business – in order to qualify for an SBA 504 loan.

The SBA 504 loan program serves as a long-term financing tool for economic development within a community. It provides growing businesses with long-term, fixed-rate financing for major fixed assets.

The SBA 504 utilizes a traditional bank mortgage on 50% of the cost, and the SBA takes a second mortgage for 30% to 40% of the cost. The buyer must then supply the remaining 10% to 20% of the purchase costs. These costs could include land price, construction costs, equipment and fixtures, soft costs and closing costs.

A Certified Development Company (CDC) is a nonprofit corporation set up to contribute to the economic development of its community. CDCs work in conjunction with the SBA and private lenders to provide financing to qualified businesses. Roughly 270 CDCs exist nationwide, and each one covers a designated region. The funds for the 504 loans are generated through the sale of government-guaranteed bonds.

SBA in action
Using this type of loan enables hospitality buyers who would not necessarily have the ability to acquire a typical mortgage, as the SBA 504 loan typically requires less cash for purchase. In addition to featuring little to no down payment, a 504 loan typically locks in at a favorable rate for a term of 20 years.

It is the responsibility of the broker to ensure that SBA 504 loans are utilized successfully to the benefit of the buyer and to enhance the seller's opportunity to sell at the higher end of the value range.
Furthermore, these loans will prove beneficial in a purchase by being assumable to the next purchaser. The SBA will allow a third mortgage – from seller to buyer – provided that all meet debt-coverage requirements (the percentage of annual debt service to the net operating income).

Although SBA 504 loans are frequently a good choice for financing, there are some negative aspects that may deter a purchaser from using this service. First, prepayment penalties will apply if the property is sold within the first five years. While seller financing can be provided, the principal balance cannot be paid off before the end of the term of the note without approval from the SBA.

A good example of this type of transaction is the recent sale of the Comfort Inn, located in Merrimack, N.H. The recently renovated 68-room hotel was sold by 242 Merrimack Corp. and was purchased by Narayan Hotel LLC. The hotel sold on April 10, 2008, and made use of an SBA 504 mortgage for $1,155,000 – behind a first mortgage of $1,650,000 – on a sale price of $3,250,000.

Another recent hospitality transaction using the SBA's 504 was the sale of the Best Western Granite Inn. This 104-room hotel, located in Nashua, N.H., was sold to Karen Enterprises Inc., an established New Hampshire hotel company.

Major renovations had recently been completed to the rooms, lobby and porte-cochere of the hotel. Coincidentally, the transaction encountered complications due to a fire that partially destroyed 50 of the guest rooms, just three days after the execution of a purchase agreement. This unusual incident provoked an extensive negotiation process, while still utilizing the SBA 504.

Installment sale
Another valuable hospitality financing tactic is to use wraparound mortgages to structure transactions. A form of seller financing, a wraparound mortgage requires a purchaser to make payments on the previous owner's debt, as well as an additional loan that amounts to the purchase price less any cash down payment.

This arrangement can be highly beneficial to the seller, who can charge an additional percentage on the buyer's payments to the original mortgage.

Additionally, a seller may insist that the purchaser cannot prepay the loan without a penalty, especially if the seller is benefiting from an installment sale. Real estate professionals will commonly suggest this process for a buyer who cannot acquire a mortgage, does not have the funds to pay closing costs or wishes to create an installment sale for the seller.

Wraparound mortgages often enable the seller to get a better price and an advantage in the event of default by the buyer versus having a second mortgage behind a new mortgage of greater amount. According to BusinessFinance.com, "A wraparound mortgage benefits the seller, because they earn money on the interest payment each month because the seller would charge a higher interest rate to you, the buyer."

A wraparound mortgage is also particularly advantageous to a property owner who plans to sell within three to five years. Refinancing a property well in advance of a sale enables the acquisition of tax-free dollars prior to the sale. A real estate broker who is experienced with wraparound mortgages can further lay out appropriate steps for individual business owners to ensure a stronger bottom line at the time of sale.

Wraparound mortgages create an installment sale and, therefore, an annuity to the seller. Most wraparound mortgages work through a clearing account in the financial institution that holds the first mortgage.

The buyer makes payments to the clearing account, and the bank automatically disperses payments to the lender (first-mortgage holder). The balance of the buyer's payment is then paid to the seller. Although this is considered a type of an installment sale, it is important to understand the specifics.

In a wraparound mortgage, the buyer does get ownership of the property. This finance method thus allows a buyer to purchase property without having to qualify for a loan or pay closing costs. Instead, the contract is made between the buyer and seller, and the seller remains on the original mortgage.

In case of default
The actual payment terms of a wraparound mortgage protect the buyer, as he knows that the first mortgage is paid properly through the clearing account at the current lender. Should the buyer default on payments to the clearing account, the seller would be liable for the original loan.

It is likely, however, that the loan amount would still be less than that of a new first mortgage and, therefore, it would allow the seller to continue to make mortgage payments while involved in the foreclosure process.

Although wraparound can be a great option for many sellers of hospitality properties, some lenders will only allow wraparound mortgages after extensive negotiation. Be sure to consult with a broker or someone else with experience in wraparound mortgages to learn what options are available before seriously considering a sale or purchase of this nature.

There are many motivated and qualified hospitality real estate buyers in today's real estate market. As long as the price makes economic sense, commercial real estate will continue to provide incredibly viable investment opportunities. Because current financing alternatives have recently been diluted, ultimately closing a transaction will often call for creative financing solutions.

Earle Wason is president and owner of Wason Associates Hospitality Real Estate Brokers. He can be reached at (603) 539-5545 or earle@earlewason.com

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