By Irvin W. Sandman and Russell C. Savrann
January, 2011

The Post-Meltdown world continues to be a strange, changing place for the hotel industry. Where are we now? What unusual attributes of our situation are we now discovering? And how can we use our knowledge and understanding to achieve success as hotel owners and buyers?

The Recovery—Where Are We Now?

We last took stock in our June article, "Meltdown Opportunities for Hotel Buyers," in which we summarized the meltdown, the consequences for hotel financial structures, and the expected process for bringing the industry’s financial structures back into balance.

As we expected, the recovery continues at a slow pace. Here are some current macro statistics (going from the broader indicators to more industry-specific ones), as well as some of our reflections on them:

• Growth in Real GDP

Growth in real GDP was -0.4% in 2008, -3.3% in 2009, and +1.7% 2010. The 2011 forecast is +1.9%. See link: World Bank Country Forecasts.

Industry analysts have for some time told us that there is a direct correlation between GDP and RevPAR. The correlation diminished, however, in the post-9/11 period—the industry was hit extra hard by 9/11 and the aftermath because of their drastic effects on travel. Similarly, the Meltdown hit our industry extra hard because companies and individuals clamped down earlier and more severely on business and leisure travel.

Perhaps as a silver lining, the Meltdown has virtually eliminated new hotel development. As a result, supply will continue to be constrained for several years. Also, people do love their vacations, and companies do need to gather together to talk face-to-face—demand has possibly been “pent-up.” The bounce-back of demand is therefore expected to be stronger than the recovery and growth in overall GDP. The industry analysts’ predictions of strong RevPAR growth in 2011 and beyond reflect these factors (see below).

• The Dow Jones Industrial Average

Is there a correlation between upscale travel and the Dow? The upper middle class, more than ever, is invested in the market through their 401(k)’s and other vehicles. When the market plummets, one may not feel like living the high life. But when the market soars, a high-end trip is one of the first things that come to mind.

The Dow hit its high-water mark on October 12, 2007 when it reached 14,093. On March 6, 2009, it hit its trough at 6,626 (remember how that felt?). Currently, as of January 14, 2011, the Dow is at 11,787.38. One way to look at it is that we’ve had almost a 100% gain since the low-point. Another way to look at it is that we are still 16.4% below the highpoint in October 2007.

Our nation’s companies have done a remarkable job at reacting to the Meltdown, right-sizing to the new reality, and quickly becoming profitable again. The Dow reflects this success. Our stock portfolios do, as well. In the process, however, we’ve had extensive job losses in the middle class, and many of those jobs (especially family-wage manufacturing and blue collar jobs) may be permanently lost. Perhaps this suggests that the short- and long-term will be proportionately better for upscale hotels.

• RevPAR and NOI

The broader economic indicators, above, provide some background to the industry’s key statistics.

Nationwide RevPAR growth in 2009 was -16.7 percent. The current 2010 estimates show RevPAR growth at +5.6%. Recent forecasts for 2011 predict +5.6 See link: PKF Consulting US. Taken together, the 2009-10 two-year RevPAR change was -12.03%. If the forecast for 2011 is correct, the three-year change will be -7.0%. In other words, nationwide RevPAR in 2011 is expected to be 7% below RevPAR in 2008.

The RevPAR decline converted to an average hotel NOI decline of 37.8 percent from 2007 through 2009. See link: PKF article. Current estimates show 2010 NOI growth of +5.6%. See link: PKF Consulting US. Recent forecasts for 2011 predict NOI growth of +11.1%. Taken together, the 2007-10 three-year NOI growth is therefore expected to be -34.3%. If the 2011 NOI forecast is correct, then the four-year growth will be -27.02%. In other words, nationwide hotel NOI in 2011 is expected to be 27.02% below NOI in 2007.

So we continue to climb out of the recession’s crater, but we’re definitely still in the hole. Progress is relatively slow for now, as we expected.

These figures do not take inflation into account, but the impact of inflation has been negligible. In 2009, inflation was at -0.4%, and in 2010 it was +1.6%. See link: US Inflation Calculator. The Fed and the Treasury continue to pump historic levels of liquidity into the economy to maintain the recovery and prevent a double dip or deflation. If, as the economy heats up, they don’t diligently squeeze this liquidity back out of the economy, inflation could become a significant factor impacting real RevPAR growth in 2012 and beyond.

There is a risk that Congress will move to politicize the Fed. If it does so, then we’d predict a much greater chance of inflation, because squeezing the money supply during the recovery will not be politically popular.

• Hotel Values

It’s tricky to convert nationwide RevPAR and NOI statistics into nationwide figures and forecasts about hotel values. One has to take into account (among other things) the amount of capital chasing hotel deals, equity return expectations, the supply of hotel assets for sale, and closed sale price statistics. HVS has been willing to do so.

A three-year NOI growth of -34% was bound to create large losses in hotel values, and HVS’s calculations confirm this. From 2007 through 2009, HVS calculates a total national, industry-wide value growth of -41%. See link: Hospitality Net (HVS Report). See link: Hospitality Net (HVS Report). HVS estimates the 2010 value growth will be +16.1%. If this estimate is confirmed, the total three-year value growth from 2007 to 2010 will be -34.2%. And if HVS’s optimistic forecast of +27.7% for 2011 proves correct, the total four-year value growth from 2007 to 2011 will still be -17.2%.

If these value statistics and estimates are accurate, the average hotel is currently worth 34% less than it was in 2007.

Strange Worlds and Unusual Consequences.

In the process of navigating these unprecedented times, we’ve confronted some “black swans”— circumstances, events, and situations we didn’t anticipate. Here are some of them and their possible consequences:

• REMICs and their strange behavior.

Since 2003, much of the industry (roughly one in three hotels in the nation) took financing from the REMIC world. These loans seemed like normal loans, and few borrowers “looked under the hood” to find out how REMICs might behave in times of trouble.

Our industry has learned quite a bit about the REMIC world over the last two years. A REMIC holds a pool of mortgage loans. Investors buy “bonds” in the pool (i.e., Commercial Mortgage-Backed Securities, or “CMBS”). The bonds are often in multiples classes (“tranches”). The relationship between the tranches is much like that of junior and senior lienholder.

Each REMIC is run by a Master Servicer under a Pooling and Servicing Agreement (“PSA”). Under the typical PSA, a Master Servicer can’t do much to modify a loan held by the REMIC. If there is a default, a maturity, or “an imminent risk of an event of default,” then the Master Servicer transfers the loan to the Special Servicer. The Special Servicer then has the authority to restructure the loan, do a workout, foreclose, etc.

Here are some key points about the REMIC world:

• The Master Servicer is paid fees for its work. If a loan isn’t yet in actual default, the Master Servicer has a certain amount of discretion to decide whether a loan is in “imminent risk of default.” Is it possible that the Master Servicer might be less inclined to find an “imminent risk of default” because the Master Servicer will lose fees when it turns over the loan to the Special Servicer?
• The Special Servicer is normally directed by the PSA to maximize the net recovery, on a net present value basis, for the collective benefit of all the tranches of bondholders. This standard would suggest that the Special Servicer will read his cards well and make good, prompt business decisions in a workout, including taking a haircut if doing so will result in a quick, beneficial recovery.
• However, the Special Servicer is usually selected by the most junior tranche of bond holders that is “in the money.” Also, this junior tranche must consent to any significant restructuring action the Special Servicer proposes. As a result, the Special Servicer may not be as motivated (or permitted by the controlling tranche) to quickly rebalance the loan if doing so would establish a loss for the junior tranche. The Special Servicer may be more motivated to “extend and pretend” or to foreclose, hold, and sell in a year or two, if doing so might help keep the junior tranche alive.
• The Special Servicer is paid fees for its work. Is it possible that the Special Servicer may be less likely to enter into a quick, beneficial workout and sale because the Special Servicer will lose fees if it does?
• Much has been said about the IRS rule changes that allow servicers more flexibility to modify loans without fear of REMIC tax penalties. To the extent that tax concerns were preventing workouts, these rule changes did help. However, the contractual restrictions and structures of the PSA, described above, remain.

The above points suggest why the workout process in the REMIC world has been so slow and dysfunctional. But activity has begun to occur and will become more prevalent. Currently, roughly $66 billion in REMIC hotel debt exists. Of that, over $17 billion (about 25%) is now with Special Servicers, and about $13 billion (19%) is listed as over 60 days delinquent in debt service payments. The Special Servicers will act. However, it appears that they will continue to behave more conservatively and act more slowly than typical lenders. Perhaps they will be more inclined, ultimately, to foreclose, hold the foreclosed property for a while, and then sell, rather than allow the borrower to restructure and rebalance the hotel’s debt with new equity or through a short sale.

See links for sources and resources: IRS Revenue Procedure 2009-45; IRS Modifications to the Principally Secured Test (TD 9463); Wells Fargo Paper, Master Servicers: Who’s Who and What’s What; CMSA White Pater on Clarifications and Changes to the REMIC Rules; Conduit Loans (Loans.com); Midland Bank Analysis of New REMIC Rules; HVS Article on Tidal Wave of Hotel Mortgage Loan Defaults.

• Traditional Lenders have also been plodding, but activity is increasing.

When the repayment of a loan in a bank’s portfolio is in doubt, the bank must reserve for the loss. This hit is taken on the bank’s balance sheet which, in turn, limits the amount of new loans the bank can make. If reserves or losses mount, the FDIC may determine that the bank is in trouble and take regulatory action.

Bank lenders who hold commercial real estate loans have obviously been under stress for over two years. Because the Meltdown affected virtually all real estate, the banks have been slow to take action that might recognize their losses. And the FDIC has been slow to require them to do so. However, monetary defaults have become more frequent, and a monetary default requires the bank to reevaluate the loan and reserve or take a loss. Then the bank is motivated to rebalance the loan or foreclose and sell. This activity is increasing.

• Brokers have been out of the game.

Take an “average hotel” that was leveraged at 70% in 2007. It’s worth 34% less today than it was in 2007, and so the hotel is financially out of balance.

To use tangible numbers, say the hotel was worth $40 million in 2007. At 70% leverage, the loan balance would be $28 million. As an “average hotel,” today it is worth roundly $26 million. In other words, the owner currently has no equity in the hotel and the lender is underwater by $2 million. LTV loan covenants are in default. And if, as an “average hotel,” NOI is down by 34%, then it’s likely that the hotel is in payment default on the loan.

As we indicated in our last article, what has to happen is clear. The lender needs to take a $2 million haircut, and new equity has to come in with about $13 million. Result: hotel value of $26 million, equity of $13 million, and debt of $13 million. The financial structure of the hotel is back in balance.

This situation is currently widespread in the industry, and yet the financial restructuring process is going very slowly. The motivations of lenders (discussed above) and other reasons (discussed in our last article) are behind much of this sluggishness. But one interesting contributor is the fact that the brokerage community has been out of the game.

Brokers are essential to transactions. They are how we market properties and put sellers and buyers together. In the last two years, however, brokers have not been bringing us the usual steady flow of opportunities. The reason is that the brokerage business doesn’t really work in the current context.

The brokerage business relies on the “exclusive seller listing.” This is a staple of the business because it gives the broker such a high probability of a commission. The broker is hired by the seller as the exclusive agent, and all that the broker needs to do is sell the hotel—at any price—to obtain the commission.

But in the above hypothetical example, no one can give the broker an exclusive listing. Because the value is less than the amount of the debt, the owner has no authority to list the hotel for sale at its current value. And the lender isn’t the owner (yet), and so the lender can’t list the hotel for sale. One way around this predicament would be for the owner to obtain the lender’s consent to a short sale. But REMIC servicers have been slow to do this, and so have bank lenders, for the reasons set forth above.

The result is that our entire brokerage community has been virtually unengaged for the last two years. Given this, it is little wonder that good deals have been hard to find.

• “Distressed Buyers.”

A significant number of REITs and other funds have been poised to take advantage of distressed hotels. These funds often work on a “use it or lose it” basis—if they don’t acquire assets, they loose access to the funds. Also, in the current low interest environment, REITs have been attracting a large amount of money from investors with very low income return expectations. These REITS face pressure to make hotel investments with expected returns of as little as 6-8%. See, e.g., links: Hotel News Article—REITs Preparing for Potential Flood of Hotel Foreclosures; NREI Article—Vulture Funds Lie Low as REITs Move In. Hotel News Article—REITs Preparing for Potential Flood of Hotel Foreclosures; NREI Article—Vulture Funds Lie Low as REITs Move In.

These trends, combined with the fact that hotel opportunities have been scarce, have created a new phenomenon. Rather than seeing the expected flood of distressed sellers, we’ve been seeing what we call “distressed buyers”—buyers that are so anxious to buy that they bid assets to prices that don’t seem to reflect current circumstances or risk, at least in the eyes of traditional private hotel investors. See also, link: DAI Article—Is There a New Bubble?

Strategies for Owners

Our experience over the last two years and our analysis of the current context bring us to the following comments and suggestions for owners who have out-of-balance hotels:

• Start with the end—where you’d like to end up. If you believe the value of the hotel is below the amount of the current debt, don’t give up. There is an opportunity to structure a workout with new equity and maintain a “promote”—an upside if the hotel performs well in the coming years. For example, if your hotel is worth $16 million and the debt is $20 million, the structure needs to be rebalanced as follows: the lender needs to take a $4 million haircut, new equity needs to come in with $8 million, and new debt financing of $8 million should be obtained. If you help structure this deal before foreclosure, you can expect a promote for your efforts. If you’re a management company, you might also have the opportunity to maintain your management of the property, assuming you find the right equity partner. This is the “Restructuring Acquisition Opportunity” (RAO) we described in our last article, "Meltdown Opportunities for Hotel Buyers"
• If your loan is in a REMIC, learn about the REMIC world. Note the observations about the servicers’ motivations, above. Obtain a copy of the Pooling and Services Agreement (PSA) governing the Master Servicer and the Special Servicer for your loan. Learn about the tranches and who controls the Special Servicer. Review your loan documents to identify the consequences of default and transition to the Special Servicer. Also, be careful about the non-recourse carve-outs in your loan documents. Sometimes the language can contain traps. For example, the language might impose recourse if the borrower “admits its inability to pay its debts as they mature.” If so, you need to be careful about what you say to the servicers when you’re trying to get their attention.
• Be realistic. Denial is unlikely to work. A realistic assessment of the situation should present opportunities. Good hotel counsel can help you to make dispassionate and beneficial decisions, develop strategy, and even find debt and equity partners for implementation of the strategy.
• If you’ve guarantied the loan, then consider the situation from the lender’s perspective. How much is your guaranty worth? The value should take into account the lender’s cost of any litigation, execution, and liquidation on your assets. Consider this value as part of the lender’s collateral in determining whether the lender should take a haircut. Also, recognize that most lenders view guaranties primarily as a way to encourage the borrower to deal with the collateral and the lender prudently and respectfully. Typically, lenders only think of pursuing the guaranty if the borrower causes distrust or anger. After you’ve looked at the situation from this perspective, then, once again, start at the end and determine what will be necessary, in new equity and financing, to bring the financial structure back into balance. The result should be the three-way win of the RAO: the lender comes out better than the alternative of receivership, foreclosure and eventual sale; the equity will enjoy a deal in a deal-starved environment; and you will end up with benefits that reflect your deal-making efforts and your position as the current owner.

Strategies for Buyers

Our analysis and experience also brings us to the following comments and suggestions for buyers who are seeking to acquire hotel assets:

• We are still primarily in the “workout” stage of the industry’s restructuring process, as described in our last article. Accordingly, the RAO opportunity still should be a principal strategy. Recognize that, as described above, the brokerage community is largely “out of the game.” To find these RAO opportunities, you need to work with brokers and well-connected counsel in a new way. It is true that buyers in the past never expected to pay a commission or a finder’s fee for deals that were brought to them. That was because the seller always listed the property with a good broker, thereby ensuring that the broker would get a fee from the seller’s side of the transaction. The broker then brought you the opportunities without needing you to pay for their efforts. But that is not happening now. To find and capture an RAO, your advisors have to spend the time to identify the opportunities for you, approach the owner and lender who may be currently in denial or locked into dysfunctional behavior, and bring the parties together to create the three-way win of an RAO. You will need to provide your advisors with economic incentives to motivate their investment of time and effort on your behalf.
• Unless you’re a REIT with low IRR expectations, be patient in your search for well-priced foreclosed properties. These are coming down the pipeline. Right now, however, there are few good properties on the market, and “distressed buyers” are likely to pay more for them than you or your equity partners will want to pay. Note that, after a foreclosure, a lender is likely to engage a capable broker to market the property extensively. It will be hard to get an “inside track” in this context. The better approach will be to wait for more of these assets to come onto the market, so that the additional supply and the law of supply and demand will work to produce more attractive prices.
• Don’t be afraid of bankruptcies. If a property you find desirable is in a bankruptcy, be pro-active with the help of good counsel. Attempt to establish an early position as the “stalking horse,” with good protections if you are outbid. Cash is very important in bankruptcy. If you want to play the game, make sure you establish yourself as a credible, credit-worthy buyer who will be able to follow through if no other buyer bids. A good-sized deposit helps. Protect yourself and your deposit with a due diligence period that starts after the court approves you as the stalking horse.