Transcript: Management Fees: Putting It All Together

Transcription

1 SHA564 Transcripts Transcript: Course Introduction Previous courses in the series were focused on real property, real property investments, real property financing. In this course, we explore the investment in, and valuation of the industry's intellectual property. Specifically, the value of franchise agreements and management agreements. This information is vital not only to franchise owners and operators, it is a vital interest to owners in their negotiations with those same franchise owners and operators. Using sophisticated spreadsheet tools, you will learn how to value management contracts and franchise agreements. In addition, you will explore how complex financing arrangements can engineer higher returns. And as a theme that's carried throughout the courses, we will balance the analytical tools with an appreciation for the qualitative elements of hotel investing. Transcript: Management Fees: Putting It All Together We are now ready to look at some scenarios to see how different base and incentive fee arrangements play out. Consider the second proposed Hungerford Hotel. It will be a 300- room full- service hotel that will occupy a premier location in a strong and growing market. The owners, TarHeel Development, is looking to sign a management contract with Hungerford Management Co. and has opened negotiations. Let's look at some different fee arrangements and compare the different possibilities. We'll look at three scenarios. Before we consider specific scenarios, let's start with some basic assumptions for this presentation. The operators of the Hungerford are looking for a 14% return. They peg the system- reimbursable expenses as 1.75% of the total revenues. We expect the operating expenses of the management company to be 75% of the management company's base fee. Finally, the operator is not contributing key money. Here we have the hotel revenues during the ten years of our projection period. Note that, in addition to the annual debt service, we have the system- reimbursable expenses, or SRE, for each year of the projection. 1

2 Consider a scenario where the operator is paid a base fee of 2.5% of revenues and an incentive fee of 8% of the cash flow from operations, or CFFO. We start with the calculation of the base fee. The total revenues, times the base fee percentage of 2.5%, equals the base fee. From that we have to subtract the operating expenses of the manager to arrive at the net base fee of $123,000 in year 1, $149,000 in year 2, $163,000 in year 3, and so on through the rest of the projection period. Note that the base fee grows rapidly along with hotel revenues. Next we calculate the incentive fee. We start with the adjusted cash flows from operations. This is the hotel GOP (or Gross Operating Profit) before deducting the management flows, shown in our annual flows assumptions above, less the base fee. For year 1 the adjusted cash flow is $5,163,000 less the base fee of $491,000, or $4,672,000. We multiply the adjusted cash flow by the incentive fee percentage of 8% to arrive at our incentive fee of $374,000. Next, we add the net base fee and the incentive fee to arrive at our total management fee of $497,000 for year 1. We perform the same calculation for each year in the projection period, then sum the result to arrive at a ten- year total annual cash flow to the manager of $9,073,000. The NPV of those flows at the managers' 14% desired return is $4,439,000. We will use this NPV as a point of comparison with other possible incentive fee arrangements. For our second scenario, consider the same 2.5% base fee. But this time the incentive fee is 14.75% of the cash flows after debt service (or CFADS). The base fee calculation is, of course, exactly the same. This time we calculate the incentive fee by starting with the adjusted CFFO, then subtracting the debt service to arrive at CFADS % of the CFADS gives us an incentive 2

3 fee of $139,000 in year 1, $561,000 in year 2, $766,000 in year 3, and so on. Note that the incentive fee grows much quicker in this scenario. Again we add the incentive fee to the base fee, sum the total fees, and derive the Net Present Value. Here the ten- year total is $9,777,000 and the NPV is $4,593,000. The totals for an incentive fee of 14.75% of CFADS are slightly greater than those of the incentive fee of 8% of the CFFO. How about a third scenario? Here we have, again, a 2.5% base fee, but this time it is combined with an incentive fee that is 32.5% of cash flows, taken after the owners' priority return of 10%. In this scenario 10% priority equals $6.6 million. Let's do the calculations. The base fee calculation is exactly the same. For the incentive fee, we begin again with the adjusted cash flows. This time we subtract out the owners' priority. Then, we take the incentive fee of 32.5% of the cash flows after the owners' priority. The result is the incentive fee. Note that the incentive fee is 0 in the first year, but then escalates rapidly: $303,000 in year 2 to $970,000 in year 5. Add the incentive fee to the base fee, sum the results, and derive the NPV. In this case, the ten- year total is $10,778,000 and the NPV is $4,777. So the NPV for this scenario, with an incentive fee taken after the owners' priority, yields the highest ten- year total and NPV of the three scenarios. 3

4 Let's take a closer look at how these scenarios compare. Here we have the impact of the scenarios on equity cash flows (how each scenario effects the owners' returns), and the net management fee flows (how each scenario effects the operators' returns). There is a relationship between the two. Any increase in the operators' fees reduces the owners' returns. The operators benefit most from scenario three. The NPV for the third scenario is $4,777,000, compared with the NPV of $4,439,000 in scenario one. The owners, on the other hand, benefit most from scenario one. The Present Value at 14%, the owners' desired return, is $20,309,000 in scenario one, compared with $19,971,000 in scenario three. Note that the risk to the owner and the operator change. We'll return to this later. 4

5 Let's look at this graphically. Scenario one, with an incentive fee drawn from Cash Flow From Operations, provides better initial returns, but it quickly flattens out and provides lower returns over all. Scenario two, with the incentive fee from Cash Flow After Debt Service, begins with lower returns, but by year 3 it surpasses the first scenario. It then flattens out, with returns slowly increasing at a rate slightly greater than that of scenario one. Finally, we have scenario three, where the fee flows begin the lowest. By year 3, the fee flows equal those of the other scenarios, and they continue to increase strongly for the remainder of the projection period. What conclusions can we draw from this example? Clearly, in this example, the operators are rewarded for taking on more risk. The first scenario, where the incentive fee is drawn from Cash Flow From Operations, is the safest arrangement. It also provides the lowest NPV. The second scenario, the incentive fee drawn from Cash Flow After Debt Service, is riskier than the original, and provides a correspondingly higher NPV. The third scenario, where the operators' incentive fee is a strong percentage of cash flows after the owners' priority, is both the riskiest of the three options and the best rewarded with the highest NPV. From this example, if the goal is the highest overall return, the third option is clearly preferred. But remember, the actual hotel could perform worse than the projections. In the third scenario the operators take on much more of that risk, by taking their incentive fee after the owner takes a 10% priority return. 5

6 Transcript: Arriving at a Valuation We now have the pieces in place to produce a valuation of the management contract for the new Hungerford. When we calculated incentive fees, we used three different scenarios: fees as a percentage of cash flow from operations, fees as a larger percentage of cash flow after debt service, and finally, fees as a still larger percentage of cash flows after an owner's priority of 10%. It is this last scenario that we have adopted for the final valuation. The operator will be paid a base fee of 2.5% plus an incentive fee of 32.5% of cash flows after the owner's priority of 10%. In addition, we will account for the system- reimbursable expenses, charged as 1.75% of total revenues. Note that we assume that the costs of providing system- reimbursable services are 100% of the system- reimbursable revenues. In other words, we expect the system- reimbursable charges to zero themselves out: the operator will charge the owner the amount the operator spends. We also need to account for the length of the projection. When we calculated fees earlier, we only covered the ten years for which we projected revenues. Now, we need to project over the entire 20- year initial term of the management contract. For that, we need to provide multiples for the fees at the end of the analysis period. We apply a 6.0 multiple for the base fees and system- reimbursable charges, then discount them at 10% to account for risk. For the incentive fee, we apply a 4.5 multiple, then discount at 16% to account for the greater risk. With these assumptions in place, we can begin putting our valuation together. Here we have the annual flows from operations, broken down into hotel revenues and hotel Gross Operating Profit (or GOP) before deducting the management fees. These are summed to provide the cash value over the analysis period. We then reproduce the base fee calculation and the incentive fee calculation, which should look familiar. We calculate the base fee by multiplying hotel revenues by the base fee of 2.5% for each year in the projection. We sum those fees to produce the cash value of the base fee over the analysis period. Then we apply the discount rate of 10% to that number and take the present value. We arrive at a present value for the base fee of approximately $4,082,000. Dividing this by the 300 rooms, we have a value per room of $13,610. Next, the incentive fee calculation. We take the adjusted Cash Flow From Operations and subtract the owner's priority to arrive at cash flow after owner's priority. Then we multiply by 6

7 the incentive fee of 32.50% to determine our incentive fee. We sum those fees over the ten- year projection to produce the cash value of the incentive fee over the analysis period. Then we apply the discount rate, 16% this time, to the cash value and take the present value. The present value of our incentive fee is $3,535,000. Dividing this by 300 rooms, we have a value per room of $11,780 for our incentive fee. Now we perform the same calculation for the system- reimbursable charges. Hotel revenues, times the system reimbursable fee percentage of 1.75%, equals the system- reimbursable expense for each year. Summing them, we get the cash value. We take the present value at the 10% discount rate and determine a value of $9,530 per room. We can now total the revenues, by adding together the base fee, the incentive fee, and the system reimbursables. The result is a total value of $34,920 per room. Next we need to take out the base fee expenses. We assume the operating expenses will be 75% of the base fee; in practice, this assumption can vary from 40% to 80%, so our estimate is conservative. Multiplying this by the base fee gives us the operating overhead. We sum the result for each year, take the present value at our 10% discount rate, and arrive at a value of $10,210 per room. We also need to account for the base and incremental impact on the property. We have made these calculations already, in the section on impact. Here we have the base impact, the incremental impact, and the sum. We add up the impact for each year, take the present value, and end up with an impact value of $1,050 per room. The system- reimbursable calculation follows. Because we have assumed the actual system- reimbursable expense costs will be 100% of the charged system reimbursables, this analysis mirrors exactly our earlier calculation. We arrive at the same cash value, the same present value, and the same value per room of $9,530. We can then sum the expenses and costs of the management contract, adding together the operating expenses, the impact, and the system- reimbursable charges to arrive at the cash value of the total expenses, the present value of the total expenses, and a value of $20,780 per room. Putting it all together, we can sum the total expenses and costs. We can then deduct them from yearly revenues to arrive at the net annual flows. Again, we sum to arrive at the cash value over the analysis period; we take the present value and establish a value per room. In this case, the value per room for the net flows is $14,130. 7

8 We are now ready to take our end- of- the- analysis- period valuations. We begin with the end- of- the- analysis- period cash flows. They represent the present value of the expected fees from the end of year 10 through year 20, the end of the initial term. Thus they occur only at the end of year 10. Summing these flows gives us the total end- of- the- period values. We add the present value of the end- of- analysis total to the present value of the net annual flows to obtain a total present value per room of $5.956 million. Dividing by the number of rooms, we arrive at a present value per room of $19,850. Assume that Hungerford Hotels obtains an average present value per room of $15,000 for their contracts. Given this assumption, the addition of this hotel is a good deal. The value of this contract is almost 1/3 more than the average value. The net present value is almost $6.0 million, meaning that the addition of this contract adds $6.0 million to the value of the firm. The firm compares both of these metrics to other opportunities when faced with the decision to move forward on this contract or not. Before we leave the analysis, let's look at the impact of this contract on earnings per share. The firm has 100 million shares outstanding, and the overall impact of this contract is to add $0.15 to the value of the shares over the term of the contract, not considering the end- of- period valuations. Any given year adds between one- half cent to two cents per share. We would compare these figures to the impact of other contracts on the firm. Before making the final decision, return to the decision framework. First, estimate the annual and terminal fee flows from the contract. Second, value the fee flows and compare them to other opportunities. Third, explore the impact of this contract on the firm s relationships, both within and outside the market. In this case, the value of the flows compares favorably to other opportunities. In addition, the owner of the new hotel is the same as the owner of the existing hotel in the market that will bear the brunt of the impact. In fact, the owner of the existing hotel brought the new hotel to Hungerford for consideration. Thus, there is little to fear in terms of relationships in this market. Given the positive outcome on all three areas of consideration, Hungerford Hotels decides to proceed with this opportunity. Transcript: Contemporary Practices License: In this practice, a branded operator would like to separate the traditional base fee into two parts. Part one is the traditional base management fee that relates to managing the hotel, and part two relates to the royalty or license fee for the use of the brand on the hotel. Branded hotel operators have traditionally bundled the brand with the management, but now they are starting to unbundle the two sets of services. The net effect is to separate the intellectual property representing the management from the intellectual property representing the brand. 8

9 Some firms make the language of a license fee or royalty part of the management contract. Other firms execute a separate license agreement in addition to a management contract. These license or royalty fees have become more commonplace over the last decade, and they are more common among the four- and five- star hotel brands than they are in two- and three- star brands. "Manchise": Here we have a different approach to licensing. Consider owners who want the ability to sell their hotel unencumbered with the management contract. If the hotel has a brand, termination of the manager would traditionally mean terminating the brand as well. The alternative, embraced by both the owner and the branded operator, is to execute what is known as a "manchise." The owner signs two agreements, the management contract and a franchise that run concurrently on the property. The owner then has the ability to sell the hotel, terminating the management contract, but the franchise agreement must stay in place. This creates liquidity for the owners, and it allows them to sell the hotel to a larger potential set of buyers, including buyers who would like to be owner- operators. But it also protects the brand by keeping the brand associated with this hotel long- term. In many markets and for many brands, the ability to keep the brand on the hotel via the franchise agreement also protects the owner. Many hotels are purpose- built for a certain brand for example, Embassy Suites or Aloft. If the brand were to terminate with the sale of the hotel, it would be to the detriment of the owner. Manchises are common for select- service, all- suite, and extended- stay brands that are fairly small, the 100- to 300- room properties that have traditionally been operated by the owner- operator community. Relationship Management: Let's return to the three- step process for evaluating a management contract. The first step is to value the management contract itself. The second is to compare the value of this contract to other opportunities. And the third step is to examine how this opportunity affects relationships in this market and elsewhere. Here we return to the relationship story. When senior management of a hotel company considers an opportunity, they are all good "deals." The analysts and vice presidents who run the business development departments of these firms simply don't let senior management consider anything that is not a positive financial deal. So when senior management considers the deals, they are all good. What senior managers know is that every market is competitive. Different owners are competing with each other to bring that specific brand and operator into the market. And the operators generally consider more opportunities than the market can support. So how does the 9

10 operator's senior management deal with these two competing interests? How do they decide among them when they have two owners or two developers bringing them opportunities? The operators know they can only accept one proposal because the market couldn't absorb them all. This is the art of the practice, which must be considered in addition to the science of evaluating, valuing, and comparing contracts. Consider a scenario about one great site that has many potential developers. Only one developer is going to "win." Suppose it is a waterfront site where the city has put out a request for proposals from developers. We have five developers considering the site. Three of the five are proposing products from brand X's family. How does brand X deal with the three developers, all of which offer strong proposals that exceed the financial hurdles? The decision involves a long- term analysis of which developer has the potential to offer the best set of future opportunities, and which developer has proven to be reliable partner in the past. It is not the strongest of the three proposals financially that necessarily gets a deal. The calculus expands to embrace the relationships and the best long- term prospects for the hotel operator. Transcript: Making the Valuation The hotel company that franchises Hillwood Inns needs to value the franchise agreement for a prospective Hillwood. Let's look at the process. Recall that we described the steps as follows: First, estimate the annual flows to the brand from this opportunity. Second, estimate the annual costs associated with the fee flows. These two steps require most of the work. Then we need to estimate the value of this opportunity and compare it to other deals of a similar size or nature that might be available. And finally, we consider the impact this hotel might have on the brand's relationship with others among the brand's hotel owners. Let's begin with our assumptions for analysis. We'll call the date of the valuation year 0, with the hotel due to open in year 3. The hotel is a 250- room property. We assume that the central reservation system will contribute 28% of the reservations, 15% will be booked by travel agents, and 20% of the guests will be members of the loyalty program. The hurdle rate, or desired rate of return, is 12.0%. This means Hillwood expects a better than 12.0% return from this franchise to compensate them for the risk. Also, we will perform a 10- year analysis, but the contract needs to be valued over a 20- year period. We'll use an end- of- the- analysis- period multiple of 5.5 to extend the flows out for 20 years. This multiple is applied to the 10- year net flow to estimate the value of the franchise fees from years Finally, we will want to know the impact of this franchise on the company's overall share value. For that, we need to know the number of shares outstanding. 10

11 A big part of our task involves determining how to estimate franchise revenues. Based on Hillwood's brand standards, this is what our analysis has determined. The initial fee is $400 per room, which will be due at the beginning of year 1. Royalty fees are 5.0% of rooms revenue, and advertising fees are 1.675% of rooms revenue. We calculate reservation fees in three parts: as a percentage of rooms revenue, plus $3.00 per reservation taken through the CRS, plus an $8.65 charge per room per month. Hillwood charges franchisees a travel agent transaction fee of 42 cents per reservation, and a loyalty programs fee of 6.0% of the rooms revenue brought in by the loyalty program. There is a $120,000 fee for the property management system due with the initial fee. And there are additional fees for software, Internet and network services, and other items. Note that any of these charges that are not pegged to rooms revenues, such as the travel agent transaction fee or the training and conference fee, must be adjusted for inflation. We do this by adding the 3% inflation to the estimate every year. Charges based on rooms revenue do not need this adjustment, because inflation is factored into rooms revenue. Next, we need to consider the cost to Hillwood for each of these charges. Do these charges merely cover the brand's costs, or is there profit built in? For this example, we assume that costs are 100% of the franchise revenues. The only exceptions are the initial fee, which is 80% of the initial costs, and the royalty fees, which are 30% of the costs. It is in these two items, the initial fee and the royalty fee, that Hillwood is generating profits. 11

12 Now let's look at our hotel statistics. We estimate occupancy to begin, in year 3, at 60%, and to increase over the next few years before stabilizing at 70% in year 6. The average daily rate begins at $200, increasing thereafter. By year 6 it has stabilized at a 3% increase each year, the same as the inflation rate. Multiplying the occupancy rate by 365 days open a year and 250 rooms gives us our rooms occupied for each year of the analysis. We have already estimated the percentage of rooms contributed by the CRS, travel agents, and the loyalty program, so we can determine the number of reservations from each. Finally, we can multiply by the ADR to estimate room revenue for each year. We end up with a cash value of room revenue over the analysis period of $145,345,429, or $581,382 per room. Next, we estimate the franchise fee revenues. The initial fee occurs in year 1, as do the property management fees. The remaining fees recur each year. Let's take the royalty fee as an example. We specified that the royalty fee is 5% of room revenues. Room revenues in year 3 are $10,950,000, and 5% of that is $547,500. We make the same calculation for each year of the analysis, and repeat the same process for each fee. We then sum the total revenues that will flow to the brand from the franchisee. For each fee we also calculate the cash value over the analysis period, and the cash value per room. We end up with a cash value of the franchise fees over the analysis period of $14,552,760. This is a cash value of $58,211 per room for the franchise fees. Of course, this is before we subtract the annual costs. Remember, we specified that costs were 100% of the fee for most of the franchise fees. Thus, for most items, the costs are exactly the same as the fee. The only exceptions are the initial fee and the royalty fee. The cost of the initial fee is 80% of the fee, or $80,000. The cost of the royalty fee is 30% of the fee. Thus the royalty fee is $547,500 in year 3, but the cost is $164,250. We then sum the costs for each year. And, we determine the cash value of the costs for the analysis period. We end with a cash value of the franchise fee costs of $9,445,670, or $37,783 per room. Recall that this is the first Hillwood Inn to open in the Research Triangle area, so we need not consider the costs of impact on other Hillwood Inns. If there were other Hillwood Inns in the market area, the analysis would have to explicitly consider the base and incremental impact on these other hotels as a cost. We now have everything we need for a valuation. Subtracting the costs from the fee gives us the net annual flow. Remember, this is essentially the difference in the initial fee and the royalty fee. Now we account for the remaining ten years, by multiplying the flow from year 12 by the end- of- analysis multiple of 5.5. We add the resulting $3,259,402 to the year 12 flows to arrive at our total net flows to Hillwood. We have a total cash value of $8,366,492, or $33,466 per room. We are ready to value the franchise agreement. The net present value is $3,054,213. This works out to an NPV of $12,217 per room. This is the first number Hillwood needs to make its decision. What is the NPV per room for this new franchise? Brands such as Hillwood look for a 12

13 minimum of $10,000 per room for a hotel in this brand scale. So this looks like a good project. The second thing Hillwood wants to know: How much value will this franchise add to the value of the firm? Here we consider the earnings per share. Over the first ten years, this particular franchise will add a little more than 8 cents to the share price for Hillwood. We have now estimated the franchise fee flows and we have valued the flows. For a thorough analysis, two steps remain. From our analysis, we can conclude that this is an attractive new franchise for Hillwood. But before we make a final decision, we need to compare this prospective franchise with other opportunities that may be available. We would need to complete an identical analysis for each prospective new franchise before we could pick this Hillwood with confidence. Finally, we need to remember that these decisions are not always made strictly by the numbers. Just as when we considered management contracts, the brand must concern itself with the relationships it has with existing and prospective franchisees. It is not difficult to conceive of situations where a franchisor may choose the less financially attractive franchisee if that choice brings with it other benefits, such as better long- term growth potential. As with all hotel investing, good analysis requires extensive financial analysis, embedded in a sophisticated understanding of the strategic goals of the firm. Transcript: Introduction to Debt Financing At what I call the smallest level, you can use debt financing to promote growth within a property. You can borrow funds to do a renovation, to add density, or to change the way spaces are used within a hotel. Typical examples of density include a new guestroom wing, a meeting space addition, or the addition of residential units. Examples of changes to space utilization include the conversion of underutilized space into spa facilities or a business center, or the expansion or reconcepting of restaurants, clubs, and lounges. To acquire new properties takes larger loans, and this is a second use for debt financing. This is a classic growth story: a hotel company finds additional opportunities in the market and can grow by taking advantage of opportunities presented to successful entrepreneurs. Given the historical equity capital constraints of entrepreneurs and the beauty of positive financial leverage, debt capital is central to most firms' acquisition growth strategies. Lenders have long supported lending to borrowers who wish to use debt capital to grow their businesses as an alternative to injecting additional equity capital. However, there is a challenge in choosing whether to use debt or equity capital. In making this decision, owners must consider issues of control, speed of growth, and risk. In general, you can move much more 13

14 quickly using equity capital than you can using debt capital, because the debt capital market requires an underwriting and approval process in addition to the equity decision process. A very common approach is to use equity strategically, perform the expansion or acquisition, and then recapitalize the hotel or the firm later. You harvest the equity by adding debt to the property once you have completed the expansion or the acquisition. In addition to funding changes in the property or acquisitions of new properties, you can use debt capital to recapitalize the firm. This changes the relative amounts of debt and equity within the capital structure, based on the firm's needs. Ordinarily, the firm adds debt and reduces equity adding debt to harvest equity for other uses. An additional way to think about using capital is to change the capital structure of the firm to make the firm, or individual assets within the firm, much easier to sell. In other words, you're creating a capital structure that is conducive to a transaction. In one of the most common forms, this involves taking a set of partnership interests, which may be diverse across different investments, into a limited liability corporation or limited liability partnership structure that can easily be sold as an equity interest. Once the LLC or LLP structure is in place, the debt capital spread across a number of individual investments can be replaced with a consolidated debt package that is easily prepaid if the company is sold. Transcript: Mortgage Calculation Workshop Here we use an example to illustrate how you can use the mortgage calculation tool. Follow the example here, then try entering new values into the spreadsheet and analyzing their impact. We begin with an investor who needs $30 million to build a new hotel. The investor expects to borrow $20 million as a first mortgage. That would leave $10 million in equity. The investor may consider trying to borrow an additional $2 million using mezzanine financing, which would leave an $8 million equity contribution. Let's begin with what we'll call the base case mortgage. You are borrowing $20 million at an 8.0% interest rate, for a 10- year term, with a 25- year amortization. The loan requires monthly payments, or 12 payments per year. Note that the entire loan must be paid back at the end of 10 years. Using Excel's payment (PMT) function, we can determine that each payment will be $154,363, for an annual cash payout of $1,852,359. At the end of the 10- year term, that leaves us with a remaining mortgage balance of $16,152,661. The effective cost of borrowing over the 10- year term is the same as the interest rate, or 8.0%. Note that the RMB can be calculated using either Excel's PV or FV function. Using the PV function, the remaining mortgage balance is the present value of the remaining 180 monthly mortgage payments of $154,363, discounted at the mortgage interest rate of 8.0%. Using the FV function, the remaining mortgage balance is 14

15 the future value, borrowing the $20 million and making 120 monthly payments of $154,363, all using the mortgage interest rate of 8.0%. Okay, now let's move on to consider how points and a prepayment penalty affect the loan. Here we have the same basic terms, but with 2 points paid at origination and a prepayment penalty of 3% of the remaining mortgage balance. So, the net loan proceeds are the loan amount less the 2 points; mathematically, $20 million less $400,000 equals $19,600,000. The periodic payments are the same as in the base case loan, $154,363, the monthly payment on a $20,000,000 loan at 8.0% amortized for 25 years. The remaining mortgage balance at the end of 10 years is $16,152,661. The prepayment penalty is 3% of that, or $484,580. Adding the two together, we get the total payment at the end of the loan term of $16,637,241. We can now calculate the effective cost of borrowing. Using Excel's RATE function, it is 8.49%. Using the IRR function, it is 8.43%. The RATE function is the better method, because it accounts for the monthly payments; the IRR function assumes that the payments occur at the end of the year. The punchline? Adding the points and prepayment penalty turns a loan with an 8.0% interest rate into a loan with an effective cost of borrowing of 8.49%. Looking at this loan, the effective cost of borrowing seems high. You go to the lender looking for a lower interest rate. The bank is willing to comply in exchange for participating in the hotel's revenues. They offer a participating loan with a 7.75% interest rate in exchange for half of 1 percent (0.5%) of the hotel's revenues. What does this do to the effective cost of borrowing? We assume inflation will increase the annual revenues by 3% per year. We chart the increase in revenues, the participation flows to the lender, the loan cash flow, the remaining mortgage balance, and the prepayment. Summing them all up we arrive at the total flow to the lender. Using the IRR function, we have an effective cost of borrowing of 8.4%. We must use the IRR function here, because of the assumptions used in the analysis specifically, the assumption of yearly revenues. The RATE function requires each payment to be the same, but with growing revenues, the payments to the lender change each year. The participating loan with points and prepayment penalty offers slightly lower costs for the borrower than the same loan without the participation, given the expected revenues. 15

16 Let's consider another option. The lender offers a floating interest rate on a 3- year loan, extendable for 2 1- year periods. The lender charges 1 point at origination and a half- point for each of the extension options. This loan does not amortize; the borrower pays interest each year and owes the amount borrowed at the end of the loan term. Although the borrower may desire a loan for 10 years, lenders generally do not offer a 10- year floating- rate loan. Here the lender offers some flexibility: the loan term is 3 years, but the borrower can extend twice, each time for 1 year, by paying an additional extension fee that is 0.5% of the remaining balance. The interest rate will adjust each month based on LIBOR, or another floating- rate index. Let's look at the ECB of this loan for the basic 3- year holding period. The expected annual interest rate is 7.75% in year 1, 8.05% in year 2, and 8.25% in year 3. The loan cash flows adjust accordingly for each year. The loan is an interest- only loan, so the full RMB of $20,000,000 is due at the end of year 3. After summing the total flows, we have an IRR of 8.39%. This is a slightly better ECB for the borrower than the other options. What happens if we take the extension for one additional year? We estimate the interest rate as 7.95% for the fourth year. We also have to add in the extension fee of $100,000. Summing the flows, we have an IRR of 8.42%. The extension improves the terms for the bank, and worsens them for the borrower. A fifth year provides more of the same. Now the ECB is 8.43% for a 5- year holding period. The floating- rate loan provides some flexibility for the borrower to extend the loan. The extension fees provide a slight increase in ECB; they are the cost of the flexibility. We've seen a number of different scenarios for the primary mortgage. Now let's consider borrowing the additional $2,000,000 through a mezzanine lender. The mezzanine loan has a 7- year term, with one payment due each year. The mezzanine lender wants a 15% return on the loan. You know that payments based on a 15% interest rate will be difficult to pay, adding significantly to the possibility that debt service payments will be greater than cash flow from operations. You agree, therefore, to pay the loan based on a 12% interest rate and offer the lender a 15% "lookback" return. Basically, the lender is willing to accept the 12% interest rate over the 7- year term as long as you will "make him whole" for the 15% at the end of the term. This will require an exit fee of $664,008. On these terms you are looking at annual payments of $240,000 with $2,904,008 due at the end of the loan. The IRR is, of course, 15%, because that was the rate required by the mezzanine lender. To compare various loan options, borrowers must be able to calculate a loan's true cost, the effective cost of borrowing. The ability to make these calculations gives borrowers a clear and accurate idea of the cost of various loan features. If performed rigorously, borrowers can use the ECB to support their financing decisions. Good financing decisions can help to increase the borrower's wealth. 16

17 Transcript: Why Securitization? SHA564: Valuing Hotel Intellectual Property and Structuring the Capital Stack So, why securitization? Well, consider David Bowie. Mr. Bowie created a large number of very popular songs in the 1970s and 1980s. He received a very nice royalty stream based on sales of those albums and the playing those songs over the airways. Mr. Bowie, however, didn t want his income to depend on how many people were buying his albums and how many radio stations were playing his songs. He decided to sell all of the rights to all of the royalties for all of his albums made to date in one sale. He was able to sell these rights as bonds, based on the royalty streams expected in the future, the so- called securitization process. And so, why securitization? Because he was paid upfront for work he had already performed. Now consider the champagne company, Lanson, which produces brands such as Lanson and Gautier. They make wine, they bottle it, they let it sit for seven to ten years, and then they sell a very nice product. But the nature of the product means you don't know the prices until you bring it to market, because different wines age in different ways. What Lanson wanted to do was get paid up front, when the champagne was bottled, not when it was sold. And so, why securitization? By securitizing, or selling the rights to the wine, they got paid in the year of production for producing their wine, and they transferred some of the risk of the ultimate pricing to investors, who were paying prices based on what they perceived the value of the champagne would be. Now consider the banks who are selling mortgages. They package a pool of mortgages, generally $1 billion pools. They want to get paid upfront for originating the mortgages and not wait for the payments to come in over the term of these mortgages. And so, why securitization? They want to transfer the risk of default and prepayment of these mortgages to the third party, to the investors in these mortgages. Another benefit of securitization is that we can perform some financial engineering and sell bonds backed by pools of mortgages for a larger sum than the value of the underlying mortgages. In securitization, you could sell, for instance, a $1 billion pool of mortgages for $1.01 billion, creating about 1% of value. Consider how this works. You have a set of mortgages with an average amortization of 25 years. The investors have to wait a full 25 years to get all the interest and principal on these mortgages. With securitization, you can create several different classes of bonds. One set of investors buys the interest only for the first five years, or principal and interest for the first five years. Another set of investors buys the principal interest payments for the second five years. And you could have another class of investors that buys the residual cash flows beyond year 10. The first set of bonds, principal on interest for the first five years, is the least risky set of mortgages, and investors might be want to pay a premium for these relative to the other sets of bonds. That financial engineering earns a premium for part of the overall package. It creates value. 17

18 So in summary, why securitization? First, the issuers of the security get paid up front for work that they have done. Second, the issuers can transfer risk to investors. Third, the issuers can financially engineer the cash flows to produce value. Transcript: Constructing a CMBS Deal It's often been said that there are two things you never want to see made: sausages and laws. Mortgage pools may not be that messy, but they are complicated. Let's see how to make mortgage- backed security "sausages." We'll take an example, a very artificial example that we're using for clarity. We have ten $10,000,000 mortgages that are earning 10% interest. These are all two- year mortgages, so you have to pay half of the mortgage balance this year and half of the mortgage balance next year. In year 1, we pay the principal of $50 million, but since the entire $100 million has been outstanding for the entire year at 10% interest, we have to pay $10 million worth of interest, which is 10% of $100 million. So the expected cash in the first year is $60 million. In the second year, total expected cash flow is $55 million- that is, the $50 million remaining to be paid and the 10% interest on the $50 million, or $5 million worth of interest. Now let's create some bonds based on these mortgages. We're going to have three classes of bonds. These are known in the industry as tranches based on the French word tranche, meaning slice. Slicing these mortgages into different classes of bonds, we have class A, which are the highest- rated bonds. They have the least risk. Next, we have class B, which are the riskier bonds. Finally there is an interest- only or IO- class. The interest- only class is created from whatever interest is left over after we pay the A- and the B- classes. Here is how it works. In our example, the A- class bonds are paid before anybody else; the A- class is created from $75 million of the $100 million pool. The subordination level for the A- class bond holders is 25%, which means that 25% of the bonds in the pool have to default 18

19 before the owners of the A- class face potential losses. The B- class is the remaining $25 million of the $100 million pool, or 25% of the $100 million. The B- class holds the bonds that face the losses first, should borrowers default. The A- class owners tell the investment bank that in exchange for getting paid first, they're willing to own these bonds at an 8% yield on their investment. Thus, they get an 8% coupon. However, in exchange for getting paid second, the B- class bond owners want a 12% yield. They get a 10% coupon, however, meaning that their payment is based on a 10% return on the par value of the bonds, or 10% of $25 million. So how do you get a 12% yield with a 10% coupon? The price of the bonds adjusts down so that the bonds yield 12%. Those B- class bond holders pay $24.15 million for the rights to a 10% coupon on $25 million worth of bonds. So they buy the bonds at what's known as a discount to their par value in order to achieve their yield of 12%. In the same way, the interest- only class wants a 14% return due to their risk, because they get paid last. All in, we have our par value at $100 million worth of bonds, but the value as mortgage- backed securities is $ million. So we're able to sell $100 million worth of mortgages for $ million. In other words, we're able to make $850,000 through the securitization process. We create 0.85% of value. Now let's take a look at how these investors are paid. In year 1, the A- class investors get all of the principal that's being paid, $50 million. They get an 8% return on the $75 million worth of bonds in the class, which is $6 million of interest. The B- class doesn't get any principal because there is nothing to be paid. Remember, the A- class bond holders get all of the principal that's being paid until they get their $75 million back. But the B- class bond holders do get interest of $2.5 million. Recall that while they bought their bonds for $24.15 million, they get a 10% coupon on the $25 million par value, or $2.5 million. If we look at the interest paid in the first year, we were expecting $10 million worth of interest. We paid $6 million to the A- class bond holders, which is an 8% coupon to them. We paid $2.5 million to the B- class bond holders, which was a 10% coupon to them. We have $1.5 million left over, and this remainder goes to the IO- class. They get $1.5 million of interest. 19

20 So, now let's take a look at the second year. The A- class bond holders got $50 million last year, and they get the remaining $25 million this year. They also get the 8% coupon on the $25 million owed to them, which is an additional $2 million. Our B- class bond owners now get their $25 million. They get a 10% coupon on that, or an additional $2.5 million. We were expecting, however, $5 million of total interest. $2 million went to the A- class, and $2.5 million went to the B- class, so there is $0.5 million left over that goes to the IO- class bond holders. Note that the IO- class bond holders' cash flows were $1.5 million in the first year and half a million in the second year. They paid exactly $1.7 million in year 0 for those bonds, and thus their yield is 14%. So, now let's take a look at how our credit enhancement works. Why are the A- class bond holders willing to take an 8% coupon on a pool that yields 10%? Say there is a default on one of the mortgages in year 2. You collect only $5 million on that mortgage instead of $11 million the $10 million principal expected, plus the million dollars of interest that was owed. Let's see what happens. In year 1, all of the cash flows look exactly the same. But let's look at year 2. Instead of $50 million in principal and $5 million in interest, we have $45 million in principal and $4 million in interest. The A- class gets paid they get their $25 million worth of principal, plus their $2 million worth of interest. But what happens to the B- class? They were expecting the $25 million, but because of the default, they only collect $20 million. They were expecting $2.5 million in interest, but they only get $2 million. So, they suffer a loss. And the IO- class gets nothing. 20

21 So, how did this influence the yield to the various investors? The A- class was expecting 8% and they actually got 8%. The B- class was expecting 12%, but they actually achieved only a 0.8% return on their investment. The IO- class was expecting a 14% return, but they got a negative 11.8% return, so they suffered the biggest loss. Overall, we were expecting a 10% return from the mortgage pool, but with that one default the actual yield was 6.2%. Notice how two classes of bond holders got hurt badly and one class of bond holders got exactly what they were expecting. Thus, the ability to financially engineer the cash flows has protected one set of bond holders at the expense of the other two. If this had been a pass- through certificate where everybody received an equal share of the cash flows, everyone would have been hurt a little bit. But that's a very different security than the credit- enhanced security we've just illustrated. To finish, let's take a graphical view of a very stylized deal, something that would be typical in a well- functioning mortgage- backed securities market. Generally, these pools are billion- dollar- plus pools of mortgages. A billion dollar pool, would yield $850 million worth of investment- grade bonds, $100 million worth of non- investment- grade bonds, about $25 million worth of interest- only bonds, and about $50 million worth of unrated or junk bonds. We'll obtain billion dollars worth of securities, from $1 billion worth of mortgages. We just told a story where the IO- class got hurt the most. The more typical story is that the IO- class is superior to the unrated bonds. What we've illustrated here is a first loss piece that is $50 million. So, $50 21

22 million, or a 5% default rate, would have to occur before any of the other bond holders get hurt. For the investment grade bond holders, 17.5% of the pool would have to default before they faced any losses. Transcript: Duration: Augmenting Your Real Estate Tool Kit How do the length of the investment, and the structure of the cash flows within the investment, effect the return to equity? To answer this question, we turn to a measure called "duration." Recall our three hotels. We have already calculated an IRR and an FMRR for each. Calculating the duration will allow us to better differentiate their three cash profiles. Let's look at how we calculate duration, step by step. We'll use Hotel A as our example. First, we calculate the IRR of the cash flows. We have already done this; the IRR is 15%. Second, for each cash flow, we calculate the present value, using the IRR as the discount rate. For year 1: we take the cash flow of $180,000, divide it by 1.15, and arrive at a present value of $156,