The first phase of the United States Army lodging privatisation programme takes the template of the army's housing privatisation deals and applies it to short-term lodging facilities at army bases. The deal, sponsored by Actus Lend Lease, had to be adapted to take into account changes to the way the army operates the programme, as well as the challenges of applying it to hotel-type assets.

More importantly, debt market conditions forced a rethinking of the sponsor's financing approach, leading Actus to put in place a small initial debt facility with the flexibility to refinance it when bond market conditions improve. The sponsors are doing this within a contractual framework, and on a set of assets, at least as robust as those on the housing programme.

The situation in the aftermath of the crunch is similar to the conditions faced by sponsors of housing privatisations early in the last decade. While bond insurers and ratings agencies took time to learn the economics of the army housing system, sponsors were frequently forced into principal finance deals with single investors that locked in high initial interest rates and reduced the cash available to fund renovation work.

The army, using its existing authority covering the housing programme, issued a request for qualifications on a first group of lodging privatisations – group A – in December 2005, and awarded the group to the Actus-led consortium in September 2006. Actus brought in InterContinental Hotel Group to be the operator of the facilities, which will be branded in a similar fashion to a fully-commercial hotel.

The privatisation covers on-base lodging at a number of army bases: Fort Rucker, Alabama, Forts Leavenworth and Riley in Kansas, Fort Polk, Louisiana, Fort Sill, Oklahoma, Forts Hood and Sam Houston in Texas, Yuma Proving Ground, Arizona, Fort Myer, Virginia, and Fort Shafter's Tripler Army Medical Center in Hawaii. The 3,200 rooms will be used for short-term accommodation for army personnel attending training courses, meetings, and other army assignments.

The army provides its personnel with a variable per diem, typically in the region of $70 per night, to be expended on accommodation, an amount below the rates offered by many commercial facilities. Personnel have the option of using lodging wherever they choose, but lodging on bases enjoys considerable advantages of proximity, cost, and facilities over commercial competitors.

The main condition attached to the 50-year ground lease of the lodgings is that rooms be available at 75% of the level of the per diem. To offer such low-cost nightly rates the new operator starts with considerable advantages. It is not paying rent (the ground lease is for a nominal sum), usually not paying real estate taxes, and is paying the same rate the army does for utilities. It is also likely to enjoy much higher occupancy rates (close to 95%) than fully private hotels, and its guests often stay for longer periods, reducing both revenue uncertainty and some operating costs. In many instances the army, rather than guests, will pay for rooms directly. The cost of debt is one of the project's bigger variables.

The borrower, Rest Easy LLC, is set up so that all revenues are distributed in a waterfall, including operating costs, debt service, a fixed rate of return for the sponsor, and the rest of the revenues are then applied to building additional lodging facilities. One big difference from the army housing privatisations, though a common feature with more recent deals, is that the army is no longer a member of the project company. The US Office of Management and Budget prefers that the army not expose itself to potential conflicts from having an interest in the new operator, although the army probably would have preferred to stick to the old system.

The effect of the waterfall is to link the amount of cash available for reinvestment to debt service costs. Locking in high interest rates for a large part of the lease would result in fewer new rooms being constructed, a similar concept to the output-based specifications that have crept into PPP bidding in Europe and Canada. It leaves the project highly vulnerable, however, to debt market conditions.

Like many of 2009's winners, Actus had a 144A bond issue ready to go to market in late 2008. While recent army deals had relied upon bond insurers, these were no longer an option, and the assets had no historical operating data with which to reassure investors or agencies. The principal finance investors offered to provide the debt, though at unattractive rates and with stiff prepayment penalties.

The sponsor's financial adviser, Bank of America Merrill Lynch, stepped in to provide a scaled-down $35 million senior financing, which would allow some early renovation and upgrading work, and leave Actus with the ability to refinance the debt in the bond market when conditions recovered.

The sponsors also raised a $25 million mezzanine loan from commercial real estate investor Behringer Harvard, which reduced the pressure on junior and senior debt without locking the project into a permanent high interest rate. Actus provided $2 million in equity and its affiliate Lend Lease Capital put in $21.5 million in subordinate debt. The financing allowed the sponsors to take over the facilities, and when these can be brought up to the required standards these will be operated under InterContinental-owned brands such as Holiday Inn Express, Staybridge Suites and Candlewood Suites.

The sponsors are now working on a long-term refinancing of the initial debt facilities, a deal that is likely to be four times larger than the first. If bond market conditions continue to be welcoming and the take-over goes smoothly, it should be ready to go later this year. On the horizon, the second two groups of army lodgings should be coming to market, pending Department of Defense approvals, and the Navy and Air Force could offer similar sets of assets to private operators. All told, 16,000 rooms could be up for grabs.

Rest Easy LLC
Status: Closed 15 August 2009
Size: $83.5 million
Location: Army bases across the US
Description: 50-year lease and upgrading of Army lodging facilities
Grantor: United States Army
Sponsor and subordinated debt provider: Actus Lend Lease
Equity: $2 million
Subordinated debt: $21.5 million
Mezzanine debt provider: Behringer Harvard
Mezzanine debt: $25 million
Senior lender and financial adviser: Bank of America Merrill Lynch
Operator: InterContinental Hotel Group
Construction contractor: Actus Lend Lease
Legal advisers: Perkin Coie (Actus), Kutak Rock (Bank of America), Powell Coleman & Arnold (Behringer Harvard) and Lowenstein Sandler (project company).
Market consultants: Carolyn Law & Associates/HVS Global