Surviving the storm: Weighing the cost of mezzanine finance

The hotel sector has been on a rollercoaster ride in recent years, weathering the storms of a global pandemic, economic uncertainty, and now, a seismic shift in the financial landscape. With banks becoming increasingly risk averse and retreating from Europe's real estate markets in response to economic headwinds and mounting uncertainty, borrowers are increasingly looking at alternative financing options such as mezzanine finance to plug the funding gap. 

Tom Oakden, managing director at Hilltop Hospitality Advisors notes the hospitality sector is currently being monitored by a wide source of capital because it has proven to be resilient post-pandemic; however, the final quarter of 2022 brought with it a crisis - especially in the UK – in terms of interest rates shooting up and the loss of economic confidence. “Since then, it has been harder to get debt and the cost of debt has shot up compared to where it was six months ago.”  

Navigating the mezzanine finance landscape 

Jeanne de L’Espée, associate at Cushman & Wakefield explains that while banks would previously have offered a loan to value (LTV) of about 60 per cent, in today’s market condition they’re a bit more conservative about their positions and offering LTVs closer to 50 per cent. This shift in LTV puts borrowers in a precarious position, often requiring them to turn to alternative financing options. 

“This is where debt funds and mezzanine loans come into play,” de L’Espée says. However, she notes that while mezzanine finance's involvement in the hotel sector has the potential to bring much-needed capital, it's not without its challenges. “A lower LTV means that the debt is less expensive. However, because a mezzanine loan – which is much more expensive than a bank loan - is being added to the capital stack, a borrower’s total interest may double.” 

Weighing the consequences  

Brien Giuntini, partner, EMEA hospitality debt and structured finance at Cushman & Wakefield emphasizes that even before adding the mezzanine debt, the cost of procuring debt has doubled, and this presents challenges for borrowers who are staring down the barrel of refinancings.  

For those facing refinances in the near future, he warns that while mezzanine finance may be a lifeline, it comes at a higher cost and LTV above senior lending and understanding those implications is crucial. He stresses that borrowers must be aware of the potential consequences of taking on this additional debt and the difficulty of eventually refinancing or removing it from their capital structure. 

“The question is once you get them in there, are you able to get them out? You have to consider, if you get a mezzanine piece in there and the markets don’t improve, are you able to get a new loan to refinance them out? How do you essentially get rid of this rescue capital?,” he says. 

He predicts that the cost of debt will remain at its current level for the next few years and borrowers may still have to grapple with a shortfall on any mezzanine pieces in the future. “So even though in some cases, it appears to be a good way to rescue hotel assets, borrowers may be faced with loss making assets if they cannot improve the cash flow.” 

Strategic planning  

Giuntini advises that when making decisions on whether to take on mezzanine finance, borrowers will need to take a strategic look at their portfolios and decide whether taking on additional debt right now is the best move. “You would want to get rid of mezzanine lenders sooner rather than later and the exit is that you may have to sell down an asset in three or four years. My advice is borrowers should weigh up the merits of entering into a more complicated structure relative to whether they can plug that gap themselves, even if that means making a strategic sale now. ” 

He adds: “It may be worth reimagining what your portfolio looks like in five years. There are going to be assets that are better performers, assets that are the must-have mission critical assets for the portfolio, and this is the exercise to save those.” 

For those who have no option but to take on mezzanine finance, widespread private equity interest in the hotel sector could work in favor of the borrower. 

Oakden says: “Hotels remain a desirable asset class and there’s more capital than ever that wants to invest in hotels. If you are an owner of a hotel, there are more sources of capital than probably ever before and in terms of your debt options, you equally have a wide opportunity.” 

de L’Espée echoes Oakden’s sentiment, adding, “From a borrower’s point of view, there’s still capital out there and there are quite a few private equity guys looking to place money. There’s some competition there and this could work in the favor of those seeking capital.” 

Giuntini advises having discussions with as many options as possible to find the best deal. “There are very different flavors of these debt funds. Many have hotel expertise that could be useful in the long run.”

Winners and losers 

Looking ahead, Oakden says, “We'll be kidding ourselves if we think we’re through the worst of it. The worst is probably yet to happen in terms of the market correction. Groups that have legacy positions in terms of debt that might have been negotiated before the recent crisis are best placed to preserve the status quo and keep owning those assets. Whereas those that have reasonably high levels of debt at low cost will face a difficult year if refinances are needed.” 

However, de L’Espée advises against sitting still and hoping for the debt landscape to get better. “Winners coming out of this are the ones who really analyze and assess their current situation. The more proactive you are whatever the decision is – whether refinancing or selling – the better. You are likely to lose out if you wait until you absolutely need to act.” 

Giuntini concurs, noting processes move much slower now than pre-pandemic. “Waiting three months before your loan expires is very dangerous now. A few years ago, it would have been possible to put things in place in three months, but we don’t see that happening now. Explore your options as soon as possible in order to make the right decision.” 

To conclude, experts stress it’s important to weigh the cost of either taking on mezzanine finance now and trying to find a solution in two to three years or selling today. “Check out all the options. Exits can be tricky. It’s all about shopping around as well as understanding all your options and the repercussions,” Giuntini advises.