Tax-exempt hotel financing: A primer for finance officers.

• Author: Hazinski, Thomas

Because of the limited availability of conventional financing for full-service convention center headquarters hotels, many governments are turning to the tax-exempt bond market to finance their projects.

Convention centers stimulate local economic activity by attracting visitors to the community. In an increasingly competitive convention market, success in attracting new visitors depends on having hotels proximate to the convention center. Recognizing hotel proximity as an important competitive factor, many cities are pursuing development of quality, full-service hotels adjacent to their convention centers. These hotels, which serve as headquarters for convention attendees, are called "headquarters hotels."

Conventional financing for headquarters hotel properties presents great challenges, with only a handful of institutional lenders financing hotels in the current economic environment. The financing that is available imposes a 50 to 60 percent loan-to-value limit and prices loans at 3 to 4 percent over London InterBank Offering Rate. Equity investors in hotel financings require 20 to 30 percent returns in a three- to seven-year holding period. Because of the high cost of conventional financing and the high construction cost of quality, full-service properties, few proposals generate the forecasted cash flow necessary to attract financing.

Over the last five years, most of the headquarters hotel projects that have been completed or that are under construction have used some form of public-sector incentives. Absent these incentives, headquarters hotel proposals tend to languish. Public-sector incentives and funding support for a convention center hotel can come from a variety of sources: contributions of land, infrastructure, and parking facilities; direct subsidy payments; and contingent pledges of financial support, to name just a few. In particular, tax-exempt bond financing can significantly change the financial calculus of a project's feasibility. Tax-exempt bond financing and other forms of public support dramatically reduce interest rates and equity requirements.

Over the last 18 months, several cities have used tax-exempt bonds to finance new convention headquarters hotels. Recently financed properties include headquarters hotels in Austin, Texas; Overland Park, Kansas; and Myrtle Beach, South Carolina. A privately owned project currently under construction in an empowerment zone in St. Louis also is being partially financed by tax-exempt bonds. Exhibit 1 provides a profile of some recently completed tax-exempt hotel financings.

For many proposals, tax-exempt bonds can provide the majority of the overall financing needs. This article reviews the basic features and structure of tax-exempt hotel financings. These are highly negotiated transactions whose successful completion requires a significant investment of time, focused attention, and experience.

The Ownership Entity

To use tax-exempt financing, the hotel owner generally must be a public-sector entity. In some cases, privately owned hotel projects located in a federal empowerment zone also can use tax-exempt financing. State law typically determines the appropriate structure of the ownership entity, whether a public-benefit corporation, a not-for-profit corporation, or an entity within a department of government. Where a newly formed public-benefit corporation is appropriate, it is typically a single-purpose entity created to develop, finance, and own the hotel. The purpose of a public-benefit corporation is to isolate hotel operations from a government's other assets and revenues. Creating a new entity clearly delineates a government's responsibilities and limits its obligations and liabilities.

Important Credit Features

Several factors influence an investor's decision to purchase the bonds for a hotel project. These factors include the following:

* Rationale for the project

* Reliability and credibility of projections

* Construction risk

* Evaluation of uncertain revenue streams

* Hotel operator and performance incentives

* Qualifications and experience of the development team

Reviewing these factors will provide a better understanding of the public support needed to successfully finance headquarters hotel developments. The bond financing must be tailored to shield bond investors from various risks inherent in a single-project financing.

Rationale for the Project

A vital factor that bond investors evaluate is the rationale for public investment and support of the convention center hotel and the convention center industry. Investors evaluate this factor by applying the concept of "essential public purpose;" that is, in times of...