How preferred equity, mezz financing have changed in the capital stack

Hotel Investment Today is writing a series featuring interviews with hospitality experts about the current state of the hotel refinance market. Today, we interviewed Carlos Rodriguez, founder, chairman and CEO of Driftwood Capital. For Part 1 with JLL’s Kevin Davis, click here. For Part 2 with Peachtree Group’s Jared Schlosser, click here. For Part 3 with Berkadia’s Michael Weinberg, click here. For Part 4 with CBRE’s Michael Straw, click here. For Part 5 with Arriba Capital’s Ryan Bosch, click here.

NATIONAL REPORT — Carlos Rodriguez is seeing a difference in the role preferred equity and mezzanine financing are playing in the capital stack for hotel refinancing.

Rodriguez, founder, chairman and CEO of Miami-based Driftwood Capital, said preferred equity or mezzanine was previously used to get the loan-to-value percentage (after the senior loan) in the 70% to 85% loan-to-value space.

Now, Rodriguez says that financing is used to get loans above 50%. “I’m seeing more borrowers willing to do [preferred equity] than before,” he said. “[Borrowers] used just to be happy for a senior loan that got up to 70%, and then it would be equity from there, but since they’re now only getting to 50%, and they need to bridge the gap, that’s when we’re seeing more mezz or preferred equity than we used to see.”

Driftwood is a vertically integrated commercial real estate firm with investment, development, lending and management platforms. For hotel refinance deals, it works primarily in the mezzanine funding space (or preferred equity) and will also assist in finding a senior lender when it does provide that financing.

Rodriguez said that because financial institutions are offering fewer loans, there’s “bigger room for us to come in with a nice spread for ourselves and our investors.” He said Driftwood is working with a higher-quality borrower now.

Construction has dwindled to a minimum, and I don’t see it having an uptick for the next five years. I see construction being very little around across the board.

Carlos Rodriguez, Sr.

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“What I’m seeing is really good quality operators and sponsorship groups in need of [financing}, and it provides a great opportunity for us to grow and have exposure in groups that we probably wouldn’t have seen,” he said. “The people coming to us now are a result of the financial institutional shutting off the spigot.”

Driftwood is doing a higher number of refinance deals than it has in the past few years. Rodriguez said the company’s sweet spot is in the $15 to $25 million range, but it will go as high as $50 million.

Slowdown in construction

Where there is a slowdown, Rodriguez said, is in financing for new construction. He said he thinks that trend is going to stick around.

“Construction has dwindled to a minimum, and I don’t see it having an uptick for the next five years,” he said. “I see construction being very little around across the board... Before, we used to build 2% a year supply growth; now I don’t know if we will reach 0.5%.”

It’s because deals aren’t penciling, Rodriguez said, and he doesn’t think the Federal Reserve lowering interest rates will be a quick fix, either. “While I believe that a rate cut will stimulate construction, that still might not be enough to make the deals pencil,” he said.

Rodriguez said it’s a different case for Driftwood as the company has changed its strategy. The firm has adopted a “white knight” strategy with investors who have been developing for several years but are having trouble getting capital. “We come in, inject the capital they need or help them get the loan they need… So, we’re bringing the capital, and we will help them develop the hotel.”  

Because of that strategy shift, Driftwood currently has about $1 billion in its pipeline.

State of the market

Borrowers are getting more creative in this market, Rodriguez said. “Before, it used to be a higher loan to value that you would get. Nowadays, you’re willing to get the same interest rate for a much smaller loan in  the capital stack.”

Driftwood Capital provided mezzanine financing on the refinancing of the Sheraton Dallas Hotel earlier this year.

It’s still a competitive market for senior loans, Rodriguez said, with banks being substituted in part by debt funds. While debt funds are easier to work with, there’s a catch. “It’s just more costly in general,” he said. “But they are a lot faster, a lot easier and a lot more efficient in getting it executed." 

The acquisition market is also much slower for Driftwood too. Rodriguez said the firm would typically buy five to eight hotels yearly, but it’s only bought a few in the past two years. 

Another area where Driftwood is increasing its activity is in EB-5 investments. Rodriguez said it requires a lot of work. “For the project, it’s a cheaper source of capital. It takes time to develop it,” he said. “In certain ways, it’s not only cheaper, but it’s easier on the project for debt servicing.”

Rodriguez said that type of financing requires patience because of the time it requires plus the uncertainty. “If I go to market on a loan, typically, you negotiate terms, you do due diligence, and you’re able to close in 30 to 60 days,” he said. “On EB-5 [financing], you can be raising the money for three to six months or even a year without certainty that you’ll be able to raise it at all.”