This Blog is for the Lender or Special Servicer who wants to do the best job possible preserving the value of the distressed hotel asset. I have enjoyed working for such hotel asset managers for my entire career and since this time around looks to be particularly challenging, I want to offer up my thoughts on how we can all survive together.
For those of you who have not been through one of these cycles or who have done workouts but not the peculiar asset class known as hotels, I hope to share some real world experiences. And hey, since this IS the hospitality business, I will be telling some fun stories and a lively sense of humor is mandatory.
Just a few important basics and then off we go:
1. Hotels are more of an operating business than they are a class of real estate. If there were only three commercial real estate classes, office buildings would be the third little pig’s house of bricks and hotels would be the house made of straw.
2. Hotel values go up faster and come down faster than other real estate. Hotels have 24 hour leases and this has deep consequences for value change. (Will someone dispute this and is it true?)
3. It’s all about the operator stupid. (sense of humor please)
4. THIS time around most hotels will have to be fed cash to keep the door open- even without any debt service.
5. Hotels will sustain more percentage losses than any other asset class except malls. (Will someone dispute this and is it true?)
This is the nightmare call hotel lenders never want to get. But get ready. I predict that each major lender and Special Servicer will get this call within the next 90 days. Why? The fundamentals of the hotel operating business have not changed but the current rate of income decline is catastrophic. Forget debt service coverage ratios, or debt service in general for that matter, or any other deferrable problems. Payroll is the nuclear bomb problem in hotel operations. It absolutely must be made.
Here’s a rough formula of the problem. Income (revpar) declines 0-15% and causes coverage problems; income declines 15-30 % and debt service isn’t paid; income declines more than 30% and the hotel can’t stay open without a cash infusion. And in today’s world that cash will have to come from the lender!
Many markets today suffer more than a 30% decline so far this year versus last- New York; San Francisco; Phoenix. And that is the average. Many individual hotels dropped 40%. Additionally ALL luxury hotels nationwide dropped an average of over 30% and they have notoriously rigid cost structures which don’t flex as well as other types.
Compounding the problem is that the majority of hotel owners today have lost the equity they had in their hotels and either will not or cannot feed them. Cause – all those 70-85% loans with 1.0 interest only coverage made in ‘06 and ‘07. Don’t count on the borrowers to contribute a dollar they know they will never see again and don’t count on much notice. This precipitous drop caught everyone by surprise and the shock of having to come out of pocket for payroll for a hotel with no equity left will make keys fly out of pockets towards lenders at a speed never seen before. Get ready.
For the first time in hotel history the majority of owners aren’t the true economic owners of their hotels. They just think they are. The true owners at today’s values are the lenders. And in this I don’t include mez lenders, as most of their economic interest is phantom too. If you are a lender, asset manager or cmbs special servicer with a loan originated since 2006 get ready for a default. Not only were the ‘06 and ‘07 loans underwritten with increasingly lax standards- about 75% of the loans were interest or partial interest only and coverages got down to 1.0 of FUTURE revenues (come on!)- but most markets today are producing less income than they were in 2006! Go ahead and read that again. YTD of the top 25 hotel markets half have less income than they did in 2004…many are down 30 plus percent.
Maybe this explains why brokers aren’t able to sell any hotels these days- they are not representing the true owners.
The biggest change in asset managing foreclosed hotels this downturn may be the use of a heretofore forbidden option- closing down the hotel until market conditions improve. Today’s horrific market conditions and the bleak prospect for a speedy recovery make consideration of that option prudent. Hotel revenues in many markets have fallen so far so fast- 30% plus year to date- that some hotels will not be able to stay open without cash infusions. (And lenders forget debt service which ended this year too)
Each lender should weigh the costs of feeding the hotel to keep it open for say three years versus the actual cost of mothballing the property for three years. If there is a difference of more than 50% I would seriously consider closure.
To all of you CMBS Special Servicers whose job is to ”maximize net present value to the Trust” this should be a fairly simple exercise. You merely have to be able to determine what the value of the hotel will be in three years. And since no one especially appraisers can determine what values are today who is going to question your number.
In the last six months Prism has closed two hotels for lenders. It’s not rocket science but it does take experience. We anticipate using this downturn weapon with some frequency this time around the foreclosure track.
The last leg of the stool supporting hotel values just fell off. Hotels can’t sell without loans. The CMBS pool dried up late 07 and the banks stopped in 08. Recently several major life companies announced they were not making real estate loans for the foreseeable future… Hotel buyers are now like the animal herds who gathered around the ever shrinking water hole during a drought and now it just evaporated .(illiquidity?) Where are they going to go? To be brutal they either bury themselves in the mud and hibernate or die of thirst. Which sadly may be an apt image of where the hotel transaction herd is these days.
Since hotel values are dependant on hotel sales and hotel sales are dependant on hotel loans and hotel loans are nonexistent…then hotel values are …well let’s just say they are very uncertain. One dim ray of hope that could turn into some sunshine is happening in of all places Congress. I am not talking about any capital infusion- this one is free (yes it is) and just requires changes in a few clauses of the IRS Code governing REMIC Trusts.
And the mystery good fairy is…changing the rules governing CMBS which currently force Special Servicers to extinguish loans when the hotel becomes REO. The proposal would allow Special Servicers to take back hotels and keep the loan in place and then sell the hotels with a modified loan in place- SELLER FINANCING! This financing allowed hundreds of hotel financings in the RTC days and would be a huge source of liquidity for today’s bone dry loan market. Brokers and owners and lenders should call their Congress person and support this arcane measure. Since none of you will do that at least offer a sacrifice to the hotel gods and hope they listen.