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Capital Improvements Without The Capital Take a look at these cool alternative financing methods to help you operate more smoothly. Tuesday, September 04, 2012 Kevin A Goldstein

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Introduction

Over the course of ownership for a particular asset, hotel owners and managers are oftentimes faced with conflicting priorities for investment of working capital – either into front of the house renovations to drive revenue, or back of the house projects to curtail costs. In the case of REITs and other public companies, managers must also reserve adequate capital for future acquisitions and maintain portfolio balance sheets that are attractive to investors. With diverging priorities and limited funds, where does a hotel owner or manager begin?

The good news is that some relief may be in sight in the form of a range of alternative financing methods for utility efficiency projects, which can help hotel owners reserve their capital and available credit for uses other than back of the house projects. Several of these alternative financing models have been developed in recent years by entrepreneurial investors, while other methods have been used for decades in publicly-owned buildings and commercial real estate.

What is Alternative Financing?

Traditional debt in the form of loans is a mature and widespread financing vehicle; however, hotel owners are oftentimes reluctant to use available lines of credit for utility efficiency projects. Originating in the public sector but expanding into privately-owned buildings, a number of alternative methods of financing equipment retrofits have become increasingly popular. These approaches include financing based upon participation in the savings resulting from project implementation, financing directly from utility companies, onsite power purchase agreements, equipment leasing, and other novel mechanisms.

Alternative financing can be attractive to hotel owners because a third-party investor is willing to share in the project risk and returns, creating a joint incentive between the investor and the building owner for the success of the project and sometimes negating the requirement for owner-contributed capital. Several methods of alternative financing are transferable with a change in ownership, allowing owners to consider projects with lengthier payback periods (e.g. large-scale plant retrofits). Under certain circumstances, alternative financing can also be structured as off-balance sheet financing – although pending changes to standards in lease accounting under consideration by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) may impact the balance sheet treatment of several of these funding methods under U.S. GAAP and IFRS.

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Why Consider Alternative Financing?

So, why should hotel owners and managers consider alternative means of financing for utility retrofit projects?  Several motivating factors include:

Conservation of Capital. With most of the methods of alternative financing discussed in this article, established lines of credit are not used to purchase capital assets.

Better Managed Cash Flow.  The lower operating costs of modern, efficient equipment (along with decreased repair and maintenance costs) can provide for an immediately positive cash flow.

Tax Advantages.  Several of these alternative financing mechanisms may qualify as off-balance sheet financing pursuant to GAAP and IFRS / IAS.

Potential for Higher Capitalized Property Valuation. The installation of more efficient energy equipment can significantly reduce operating expenses, which in turn provides for greater gross operating profitability and capitalized property valuation.

Enhanced Facility Management. Nonconventional financing can make a more holistic project possible – thereby eliminating the need for ongoing maintenance expenses and/or numerous smaller projects, and enhancing the guest experience.

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What Alternative Financing Approaches Are Available?
Multiple approaches of alternative financing are available for consideration, although each method has its own advantages and limitations. Several of these existing and emerging financing methods are described below.

Guaranteed Savings Financing. In a guaranteed savings agreement, an Energy Services Company (ESCO) guarantees that the savings resulting from an energy efficiency project will repay the cost of financing over the term of the contract. Financing is typically provided via a third-party company, which can be either a conventional lender or a specialized energy finance company. Since the annual savings are greater than the required payments over the contract term, a positive cash flow is anticipated, and the lender is assured a lower risk of default. ESCO projects can be favorable for owners with deferred capital improvements, in geographies with high commodity prices, and in situations where outside project design and management expertise is needed. ESCO projects have been successfully completed at hotel properties in the U.S. as well as a number of other countries, although historically the hospitality sector has not provided a large market for ESCO transactions.

Tax-Lien Financing. Under tax-lien financing (also referred to as “Property-Assessed Clean Energy”, or PACE financing), property owners are able to borrow money from municipal agencies to implement a variety of energy efficiency projects. The PACE model affixes the loan to the property rather than the owner via an incremental line item in annual property tax assessments – thereby encouraging equipment retrofits where payback periods may be longer than ownership horizons. PACE financing can include both the soft and hard costs of energy efficiency projects, with loan repayments over 5 – 20 years. Although PACE has been in development for a number of years and the enabling legislation exists in roughly half of the U.S. states, actual commercial projects financed under PACE have been limited to select municipalities in California and Colorado (in addition to small-scale residential loans in New York) due to transactional issues which are currently being reviewed.

On-Bill Financing. In the On-Bill Financing model (also referred to as “Meter Loans” or “Tariff Improvement Programs”), a utility will invest its own capital or rate payer funds into equipment upgrade projects at its customers’ properties. The equipment purchase loan is repaid over time as a component of future utility bills. When structured and funded correctly, and with the appropriate marketing, these programs have been successful in their limited deployment. From a property ownership standpoint, however, on-bill financing can limit projects to improvements relating solely to the commodity that the utility distributes (e.g. electricity, natural gas, etc.). These programs are established at utilities in approximately fifteen U.S. states.

Managed Energy Service Agreement. The Managed Energy Service Agreement (MESA) is a financing model based on the concept of building owners paying a fixed rate for utility services in exchange for implementation of energy efficiency projects at their properties. Under a typical MESA agreement, a third-party investor finances the design, construction, and installation of energy efficiency improvements at a property, and then sells energy back to the property owner at rates equivalent to historical energy usage. The cost of the MESA project is repaid to the investor over the term of the energy provisioning contract, which can extend up to ten years depending on the scale of the project and financial returns to the MESA investor. During the contract term, the MESA investor owns the installed equipment, which is ultimately transferred  to the building owner at the end of the contract term. 

Efficiency Services Agreement. Under an Efficiency Services Agreement (ESA), a third-party investor finances turn-key energy efficiency projects at a host property. During the term of an ESA, the hard and soft costs of the turn-key project are repaid to the investor in the form of a service charge that is based upon a cost per unit of energy saved. The building owner continues to pay its utility bills directly. A typical ESA agreement includes all design, construction, and installation of an energy efficiency project. The ESA financier owns the equipment during the contract term (typically between five and ten years), and at the contract end date, customers have an option to purchase the project equipment at fair market value or extend the contract to include new energy efficiency investments.

Sale of Energy Arrangement. With a Sale of Energy arrangement (also commonly referred to as a “Power Purchase Agreement” or PPA), a utility service provider owns, installs, and operates utility equipment at its customer’s property. This approach is commonly used in solar energy, although it has potential applicability to other methods of onsite utility generation (for example, wind energy, geothermal energy, co-generation of heat and hot water, generation of potable water, waste to energy, etc.). The utility service provider typically benefits from the many tax credits and other financial incentives associated with renewable energy facilities – which in conjunction with the sale of the commodity can provide a reasonable return on investment over time.

Equipment Leasing. Leasing effectively separates the ownership of an asset from the use of an asset. Leasing companies are different than conventional lenders in that they have a specific knowledge of an asset (and industry) and are lending based on the ability of an asset to generate a cash flow (or to reduce operating costs, in the case of utility equipment). Under a finance lease, the risk and benefits of ownership are assumed by the lessee, while under an operating lease the economic ownership and all related rights and responsibilities remain with the lessor. The operating lease structure can have distinct tax advantages for the lessee, in that it has historically been deemed as off-balance sheet financing under current accounting standards. However, significant changes to lease accounting rules currently under consideration by FASB and IASB would effectively eliminate operating lease accounting treatment.

Other Factors that Impact Project Financing. In addition to the alternative financing methods described above, a number of incentives and subsidies for utility efficiency projects are available from vendors, utilities and governmental entities that may reduce capital requirements to the level where conventional or alternative financing is more manageable or in some cases not required at all. These incentives and subsidies tend to vary significantly over various municipalities and utility company regions, but are worth exploring in depth since they can significantly improve project ROI and minimize owner/investor risk.

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Why Isn’t Alternative Financing Used More Widely in Hospitality?

Although nonconventional financing methods can be attractive, there are nevertheless significant challenges in applying these models effectively at a large number of hotel properties worldwide which include:

Demonstrating that Alternative Financing Methods Are Viable for Hotels. Although alternative financing methods have been used successfully for decades in the public sector, a critical mass of projects has not moved forward at hospitality properties to date.

Transaction Complexities and Costs. Alternative methods of financing can be complex from a financial, legal, tax, and risk perspective. Because these methods are largely unfamiliar to hospitality owners, the due diligence required can be both expensive and daunting.

Sharing of Financial Gains from Projects. Hotel ownership entities that are well capitalized and have long-term investment goals for their properties may be better served by self-funding utility efficiency projects or negotiating for as much of the savings as possible - to optimize returns resulting from the improvements.

Availability and Cost of Traditional Debt Financing. Although the hotel owner may not be directly exposed to traditional debt markets as a component of participating in these alternative funding scenarios, the initial capital outlay for alternative financing of utility retrofits is oftentimes still conventional debt – which can impact project design and pro forma returns based on debt lending conditions.

Lack of Universal Approach. The availability of the alternative financing methods described in this paper is very different in many locations based on geography, utility company structure, commodity rates, regulatory regime, and other localized factors. Therefore, the research and due diligence required is likely to be very different in individualized locations.

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Conclusion
Each of the alternative financing methods discussed in this article have potential applicability to the hospitality sector. Given the high diversity in hotel building types, ownership goals, and general availability of each of these financing methods, HVS suggests that “one size does not fit all.” A variety of approaches will need to be explored to best meet the business needs of individual owners and properties.

HVS Sustainability Services monitors conventional and alternative financing methods for utility efficiency projects and collaborates with hotel owners and managers to implement projects that align with strategic business goals and ownership objectives.  We wish to acknowledge and thank the National Association of Energy Service Companies (NAESCO), SCIenergy, Metrus Energy, and the Carbon War Room for their contributions to this article.

For a full version of this article (with additional detail regarding these financing methods), please visit our website: http://www.hvs.com/Services/SustainabilityServices/?v=ar or contact Kevin Goldstein at kgoldstein@hvs.com.