By Irvin W.
June 1, 2010
As the meltdown/recovery cycle grinds away, opportunities remain relatively
scarce, but they do exist. Buyers can seek out “the hotel restructuring
opportunity.” They can also seek to buy hotel assets out of bankruptcy.
What is the context for these opportunities, what are they about, and how
can they be captured?
Context: Where Are We Now in
the Meltdown and Restructuring Process?
From 2004 to 2007, hotel industry development rode the coattails of
a booming residential real estate market. We and others warned against
projects that depended too heavily on demand for residential products,
rather than hotel fundamentals. See Link: “When
a Condo Hotel Implosion Appears Imminent, What Can Be Done?” By 2008,
the real estate bubble burst, and the hotel industry felt the impact. At
the industry’s NYU conference in June 2008, STR and others forecasted that
the economy and the hotel industry would slow—STR, for example, projected
that 2009 RevPAR growth would slow to 2.8%. That forecast proved optimistic.
None of us predicted that the real estate market collapse would nearly
destroy the country’s financial industry. The risk became widely known
in September of 2008, and the stock market plummeted. Industry analysts
slowly began to realize the gravity of the trouble for the hotel industry.
In November 2008, PwC, revised its forecasts, predicting a 2009 RevPAR
decrease of 5.8%. See Link: “PwC
Forecasts a Substantial Reduction in Hotel RevPAR in 2009.” As the
months passed, forecasters continued their downward revisions. When 2009
was over, the industry faced the stunning results: a 2009 industry-wide
RevPAR decrease of 16.7%.
The bleeding has stemmed in 2010. Industry RevPAR decreased by 0.6 percent
through April. Many believe a new floor has been established. If another
financial crisis (in Europe, for example) can be avoided, we are on the
road to recovery. But the road will be slow and bumpy. The Federal Reserve
and Treasury pumped historic levels of liquidity into the economy. As the
economy recovers, the Fed will have to squeeze out this liquidity to prevent
inflation. This tough job will temper the recovery.
The Consequences for Hotel Values and Hotel Financial Structures.
The RevPAR decreases translated into 40-60% decreases in NOI. These
combined with increases in Cap Rates to cause hotel values to decline by
Usually, a hotel’s debt structure is based on a 60% loan-to-value ratio
and debt coverage ratio of 1.3. If hotel values and NOI have dropped by
40-60%, then the industry’s debt structure is seriously out of balance.
What Has to Happen to Bring Hotel Financial Structures Back Into
Take an example: A hotel was worth $30 million in 2007. It currently
carries debt of $20 million. The hotel’s post-meltdown value is $15 million.
Under these facts, the Owner has lost $10 million and the lender has lost
To bring the financial structure back into balance, the owner needs
to admit a loss of $10 million, the lender has to take a $5 million haircut,
and the owner has to come up with new equity to pay the loan down by $7
million. Result: a $15 million hotel, owner equity of $7 million, and a
debt load $8 million—the financial structure is in balance.
This restructuring must happen throughout the hotel industry. But it
hasn’t yet occurred.
Why Hasn’t the Restructuring Happened?
For the last year, reality has been avoided and little has been done
to bring the industry’s financial structures back into balance. Two factors
have assisted this continuing state of denial:
Where We Are Now—the Rock Through the Snake.
The interest rate on many of the industry’s loans is artificially low.
For example, many loans are tied to the one-month LIBOR—often the rate
is set at LIBOR plus 2 or 3. LIBOR is at historic lows—currently 0.35%.
Meanwhile, market interest rates are between 7% and 9%. Artificially low
interest rates are allowing underwater hotels to squeak by and avoid monetary
defaults. In our example, above, the owner can possibly scrape together
enough money to pay the low monthly debt service and continue to avoid
confronting the uncomfortable fact that the owner has already lost all
of its equity.
Lenders don’t want to recognize their losses, either. If a borrower is
avoiding monetary default, the lenders can pretend that everything is fine.
In our example, above, the lender can avoid the fact that the value of
the lender’s loan is only $15 million, at most. As a result, the lender
might avoid taking a $5 million loss (at least for now)—the loss would
hit the lender’s balance sheet and could affect the lender’s conversation
with its regulators.
We are at the very beginning of the financial restructuring that must
occur. Three forces will continue to intrude on the current state of denial
and push forward the industry’s restructuring:
Owners will eventually tire of working on their underwater hotels. In our
example, above, it will take years for the hotel to claw back from a value
of $15 million and get past the debt of $20 million. In the meantime, all
value improvement from the owner’s work will benefit the lender—the owner
is working for free. If the loan is nonrecourse, then the owner will begin
to wonder why he is doing so.
Owners will run out of money and will default. Even though interest rates
are artificially low, many hotels still have insufficient revenues to cover
debt service. Many owners have been funding the deficits by using reserves
or contributing money from other sources. Eventually, these sources will
be exhausted, or owners will tire of throwing good money after bad. When
a monetary default occurs, most lenders will have to reevaluate the loan
and take a loss. Then the lenders wake up and act. See Link: FDIC
Guidance on Prudent Commercial Real Estate Loan Workouts.
Owners will run out of time and will default. Many loans are coming due.
When market values and market interest rates are confronted, the hotel
owner will be unable to refinance. Although an “extend and pretend” mentality
has persisted, reality will take hold, either because lenders will employ
sound valuation and accounting methods or bank regulators will require
them to do so.
The restructuring of the industry will proceed like a pig through a python,
but far less nourishing—perhaps more like a rock through a snake. The industry
is at the first stage of digestion now. As more loans go into default,
more “workout” discussions will occur. Lenders will approach their borrowers
and demand more equity. The borrowers may temporize, find new equity, or
offer the lenders the keys. Some may try their luck with a bankruptcy filing.
Next, for those loans that aren’t brought back into balance in the first
stage, the lender may begin foreclosure, move to appoint a receiver, change
managers, get into possession, and ultimately find out what it’s like to
be a hotelier. We may expect the industry to be well into this second stage
of digestion by the first quarter of next year.
In the third and final stage of digestion, the lenders who have become
hoteliers will want to sell the hotels. We may expect the industry to be
at this stage by the middle and end of next year.
Given that we are largely in the first stage of digestion now, where
are the opportunities? Two are described below.
The “Hotel Restructuring Opportunity.”
In the current, first stage of digestion—the “workout” stage—lenders
and borrowers talk to each other about bringing loans into balance. This
stage is usually dysfunctional:
Most good owners have not been in this situation before and don’t know
what to do. Owners who are confronted with circumstances like those in
our example, above, typically have trouble accepting that they have lost
$10 million in equity. They may be embarrassed and keep the problems to
themselves, or they may be in denial, unreasonably optimistic that full
recovery will occur any day now. They may avoid discussions with their
lenders. If they do discuss the situation, they may not know what to say.
Many simply ask for extensions.
Lenders typically take a “black and white” approach—they threaten to foreclose
unless the borrower comes up with more equity, additional collateral, or
guaranties. Most lenders think of hotels as simply commercial real estate—they
don’t know how difficult it is to foreclose on hotel collateral. See Link:
Hotel Loans In Trouble – Pointers for Lenders.
What’s wrong with this picture? In our example, an owner would be unwise
to put up more equity if the lender won’t take a $5 million haircut. Doing
so would throw good money after bad. Similarly, new equity investors would
be unwise to invest if, in addition to the lender’s haircut, the owner
isn’t willing to recognize that its equity is gone. Neither the owner nor
the lender has the courage to do so. And even if they do, they aren’t sure
what can be done about the situation. As a result, typically, the loan
isn’t brought into balance. Instead, the parties march toward foreclosure,
sometimes by way of bankruptcy court. Eventually, in the second and third
stages of digestion, the financial rebalancing will occur. But it will
come with much waste in time and expense, and with unnecessary loss in
This dysfunction creates the “hotel restructuring opportunity” for the
well-advised, proactive buyer. In essence, the buyer serves as a catalyst
to cause the necessary financial restructuring early, thereby benefiting
all parties. Here’s how it works:
The buyer—a savvy hotel equity investor or fund with ready capital—first
decides on the type of hotel product and geographic region that will best
meet its investment criteria.
The buyer then identifies these properties (once the criteria are established,
it’s not hard to locate all the hotels in the desired region that meet
Using real property records and industry contacts, the buyer finds out
which of these hotels are financially out of balance—the situations like
our example, above.
The buyer approaches the borrower and lender, openly, with a straightforward
proposition. Using our example, again, the proposition is: (a) the lender
and owner accept that the hotel is worth $15 million; (b) the lender therefore
acknowledges that its loan is worth $15 million, at most, and must be written
down to that amount, resulting in a $5 million haircut, (c) from there,
the buyer, using a new ownership structure, contributes $7 million, which
pays down the loan from $15 million to $8 million and resets the loan’s
terms at market, and (d) the buyer allows the owner to participate in the
new ownership structure by giving the owner a promote—a share of the upside
after the buyer receives its expected return.
This approach results in a three-way win: the lender gets full value now,
and avoids waste of time, money, and hotel value; the owner ends up with
something, rather than nothing; and the buyer places its money in a good
hotel investment during a time when good deals are scarce.
Here are three tips to consider when pursuing the “hotel restructuring
Buying Hotels Out of Bankruptcy
The buyer needs advisors that can access the property records and help
identify the opportunities.
Many owners, and even lenders, don’t fully understand what lies ahead in
the second and third “stages of digestion.” The buyer’s team needs to be
experienced and knowledgeable in hotels and bankruptcies. If so, then the
buyer can approach the owner and lender with the credibility needed to
help them read their cards and see the unpleasant future that will occur
if a restructure doesn’t happen now.
Tact is at a premium. Focus on the win-win-win. Be ready to address the
benefits of the transaction—without motivation, inertia will cause the
lender to blindly proceed down the well-worn path of foreclosure and, meanwhile,
for the owner to maintain a state of denial or unreasonable optimism.
In the current, first stage of digestion, sometimes the workout discussion
takes a wrong turn and the owner elects to commence a Chapter 11 bankruptcy
A Chapter 11 is almost always the result of the owner and lender failing
to look ahead and read their cards correctly and objectively. Bankruptcy
is, in essence, a forced restructuring. It is very expensive. And it almost
always results in loss of hotel value, simply because it’s much harder
to market the hotel, maintain yield, and keep employees happy when the
hotel is in bankruptcy and operating under court supervision.
Nevertheless, a resort in Chapter 11 presents a unique opportunity for
the savvy buyer. Here are some considerations and tips for pursuing and
capturing this complex opportunity:
Chapter 11 is like its own planet with unusual inhabitants. They operate
according to complex legal and social rules. If the buyer doesn’t understand
the terrain, the language and the rules, the buyer will inevitably take
wrong turns, make the inhabitants (including the bankruptcy judge) angry,
and end up misaligned with the people who are needed to get the deal done.
In approaching the opportunity, the strategy should be established as the
very first step. The bankruptcy process is a legal process. Good legal
counselors who are experienced in bankruptcy (so they understand the terrain,
language and rules) and in hotels (so they understand your language) are
essential to serve as trusted guides to get you to your objective and avoid
A fruitful approach is often to attempt to become a “stalking horse bidder.”
Outside of the bankruptcy environment, the term “stalking horse” has a
derogatory connotation. Inside bankruptcy, however, the stalking horse
fulfills a respectable purpose. In essence, the stalking horse is a prospective
buyer chosen by the debtor (who runs the Chapter 11 bankruptcy estate subject
to court supervision). The stalking horse enters into a sale agreement
with the debtor and undertakes the due diligence and documentation that
credible buyers of the asset would normally be expected to undertake. In
bankruptcy, sales are expected to be open and fair, and auctions are often
preferred. Accordingly, the stalking horse must allow its bid to be presented
openly, and other bidders must be allowed to outbid the stalking horse.
If the stalking horse is outbid, then the stalking horse is normally protected
with a “breakup fee”—a fee paid to the stalking horse to cover its time
and expenses. The stalking horse is intended to set the floor price for
the assets and encourage other prospective bidders to come forward. Because
of the advantages given to the stalking horse, the stalking horse bidder
frequently becomes the successful bidder.
The prospects of becoming the stalking horse are improved if you and your
professionals maintain a position that is “pure as the driven snow.” Try
to identify the parties and lawyers in the case that hold the most leverage,
and try to establish good relationships with them (and, for that matter,
everyone else in the case). Maintain the position that you simply want
to present a good, fair price for the assets.
In all events, you must avoid any appearance of bid rigging or manipulation
of the process. In bankruptcy, these can be crimes.
The “rock through the snake” will continue in the months ahead. At each
step of the way, buyers will have opportunities. Currently, savvy, well-advised
buyers will be able to capture the hotel restructuring opportunity or the
opportunity to acquire hotel assets out of bankruptcy. If these opportunities
are not seized, they will evaporate, but others will arise as we proceed
through the second and third stages of digestion. Eventually, the financial
structures in the industry will be brought into balance. Then, business
as usual will return to the industry.