Meltdown Opportunities for Hotel Buyers: The Hotel Restructuring and the Acquisition Out of Bankruptcy / Irvin W. Sandman and Russell C. Savrann / June 2010

By Irvin W. Sandman and Russell C. Savrann
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?

The Meltdown.

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 40-60%.

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 Balance?

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 $5 million.

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:

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.

Where We Are Now�the Rock Through the Snake.

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 hotel value.

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 the criteria).
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 opportunity�:

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.

Buying Hotels Out of Bankruptcy

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 case.

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 pitfalls.
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.

Conclusion

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.