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Article

Hotel Loans In Trouble - Pointers For Lenders

By Irvin W. Sandman and Russell C. Savrann
April 3, 2009

Lenders who understand the unique and complex aspects of hotel collateral can avoid costly missteps and resulting losses. The “recession-turned-meltdown” has put intense pressure on the hotel industry. As the pressure continues to build, many hotel loans are in default or soon will be.

Beginning last fall, consumers, seeing their net worth and savings evaporate, cancelled vacations and travel plans. Entering the winter, businesses began layoffs to respond to shrinking demand, and travel continued to decline. Congress then piled on, claiming that business meetings and conferences were mostly boondoggles taken at taxpayer expense. Companies cancelled all “nonessential travel,” and group and transient business dried up. Hotel industry analysts, as recently as last June, had predicted a 2.8% RevPAR increase for 2009. Now they predict a 2009 decline of between 10% and 30%, depending on the region and segment, with the upscale segment taking the biggest hit. These RevPAR decreases convert to NOI decreases of 20% to 60% and, with increasing cap rates, a loss of hotel value of 50% or more.

Many—if not most—upscale hotels that have been financed within the last five years are now in loan covenant default. This year, so far, relatively few hotel loans have fallen into monetary default, as owners use up their reserves to meet debt service. This cannot last. By June, hotel lenders will see increasing monetary defaults.

What should lenders with hotel collateral do? Below are some obvious—and not-so-obvious—pointers specifically for hotel lenders.

The Obvious

Find out if you have any hotel loans. Because hotel loans typically are interspersed among a bank’s other commercial real estate loans, the first task is to find out if your commercial loan portfolios include any hotel loans. If they do, then you can begin to make reasonable choices about them.
Recognize that any hotel loan is at risk. If you have hotel loans that were funded in the last five years, expect that they are in trouble, even if there is no current monetary default. Most upscale hotels that are leveraged at 60% or more are using up and running out of reserves. The time to evaluate your alternatives is now, before you face a loan default or operational deficits that will require the bank’s cash just to keep the hotel open.
Understand that hotels are not like other collateral. Hotels are not like other commercial real estate. Although hotels are often housed in a box that looks deceivingly similar to an office building, they are complex, operating businesses within that box. A typical upscale hotel includes restaurant businesses, cocktail lounges, retail outlets, landlord operations, spa operations, laundry and housekeeping operations, recreational facilities, parking operations, and, of course, nightly rooms rental, all run by 100 or more on-site employees. The legal structures are complex, usually involving a national brand under a franchise agreement or a “branded hotel management contract”—a complex, industry-specific contractual relationship. Equity structures are often multi-layered. Residential components or even “condo hotel units” can be intertwined with reciprocal easements and other rights that impact the value of the hotel and its flexibility.
Line up reputable, industry-knowledgeable legal and business advisors. The hotel industry is a tight-knit community, and hotel skill sets are specific, specialized, and held by people and companies dedicated to the industry for years or decades. Without access to industry knowledge and experience, you have little hope of achieving satisfactory results. To adequately exert control and then stabilize, manage, and market these complex assets, you will need the assistance of legal and other advisors who know the hotel industry, are experienced with all aspects of hotels, and can apply this industry, legal, and business knowledge for best advantage.

The Not-So-Obvious

When a hotel goes dark, its value takes a nose-dive. If a borrower’s business is losing money, the lender’s ultimate recourse usually is to sweep the accounts, collect accounts receivable, force a liquidating “going-out-of-business” sale, and then sell any remaining real estate. This approach works with hotel collateral only if the hotel is such a poor performer that the property should just be scraped. If this is not the case, then the hotel facilities are usually worth money only as a hotel—hotel facilities are so specialized that they typically are worth very little for any other purpose. Then, your choice usually is either to sell the hotel as an operating hotel or as a “dark” hotel. Of these two choices, the second is almost always disastrous. The reason is that, when a hotel goes dark, two large capital investments are lost. The first is the capital outlay required to open the hotel after it is built—this is the cost of locating and hiring a capable work force and of outfitting the hotel with liquor, food, etc. The second is the large chunk of capital required to get through, typically, three years of deficits, while the hotel establishes its customer base, becomes efficient in its operations, and reaches “stabilization.” If a hotel is allowed to go dark, these capital investments vaporize. Any buyer of the hotel will then need to take into account the cost of making these investments again, as well as the risk that stabilization will not be achieved as planned. To avoid this impact on collateral value, you absolutely must be proactive. You must see any operational deficits coming well in advance and decide how to fund them, if necessary, to prevent the hotel from going dark.
Consider receivership. Working with a cooperative, honest, and capable borrower to achieve a satisfactory resolution can be a sensible strategy. Other times, you may feel that the borrower is out of rope, especially if additional funds are required to avoid a hotel closure. Receiverships can provide a way to fund operations and run the hotel without leaving the borrower in control. Receivership laws vary from state to state, but most work very well for hotel assets. A key in using receivership laws is to successfully identify and put in place a receiver that knows hotels. Many reputable management companies are very interested in serving as a receiver, and some see receivership as an opportunity to “manage to own.” But conflicts of interest can arise. You need experienced counsel to help select the right receiver, formulate the receivership order, and establish the strategy for using the receivership to stabilize and dispose of the hotel.
Rethink whether you have priority over unsecured creditors. It is true that secured lenders have priority over unsecured creditors, such as trade vendors and managers. Accordingly, you have the power to foreclose and not pay vendors, payroll, etc. As indicated above, however, a hotel’s value is largely dependent on the hotel’s operation. If you foreclose in a traditional way, the value of the operation will be so damaged that you typically will lose, many times over, any savings from foreclosing out unsecured creditors. As a result, rethink whether you can practically take priority over the hotel’s unsecured creditors.
Determine whether the SNDA should be enforced. The “Subordination and Nondisturbance Agreement,” between the lender and the hotel’s management company, is an important document. If the management company was asleep at the wheel, you may have what appears to be the holy grail of SNDA’s—it may state that you can sweep the operating accounts and leave the hotel management company to fund payroll and operating expenses. These rights often cannot be exercised, however, without seriously damaging the operation and the value of the collateral. Before you use these rights, take a well-considered look at the actual impact of doing so.
Think like a hotelier. Your recovery will depend on how you preserve or improve the value of the hotel operation. This means that, like it or not, you have to begin to think like a hotelier. How is the hotel positioned? Is the hotel management company doing a good job? Is it the right company for the property? What can be done to improve the hotel’s value as you exercise your rights? Obviously, you need advisors that can help with these choices, as well as legal counsel with industry contacts that can help you get to the right resources and steer clear of pretenders.
Know the condition of the hotel. Many hotel owners are neglecting facility maintenance and putting off necessary repairs. Will you be inheriting assets with mold, façade issues, ineffective or dated HVAC, ADA or structural issues? Are there extraordinary liabilities that should be considered or handled before you move toward control or foreclosure? Require a Maintenance Enforcement Program survey (“MEP”) before embarking on your realization strategy.
Review obligations to the brand. Most hotel assets will have a brand or flag. Does the brand hurt or help the hotel’s value? If the brand impairs value, evaluate your legal rights to shed the brand, under the SNDA or otherwise. If the brand enhances value, review and understand the commitments made to the brand. For example, the brand may be engaged in repositioning efforts (for example IHG is in the midst of a brand repositioning for all Holiday Inn hotels and is requiring expensive signage changes and other upgrades). Or the hotel may be currently required by the brand to perform a major upgrade of the facility (known in hotel parlance as a “PIP”). Triage may be required to prevent the brand from imposing penalties or even terminating the right to fly the flag.
Evaluate the leverage over the borrower. Because hotel collateral is fragile and dependent on the hotel’s operation, there is considerable value in your ability to motivate the borrower to assist you in reaching your objectives. Do you have personal recourse against the borrower? Is the borrower facing a big tax bill if the borrower gives you a deed in lieu? Be up front with the borrower and his needs. A cooperative, well-motivated borrower can lead to enhanced collateral value and a successfully executed realization plan.
Understand and anticipate special problems, such as liquor licenses. Every upscale hotel has liquor licenses that are essential for revenue. If a lender has a receiver appointed, takes a deed in lieu, or forecloses, the liquor license must be transferred. The transfer often requires several weeks and many detailed disclosures from the new licensee. Think ahead—being forced to close down the hotel’s bars can be extremely costly. Make sure your counsel’s team includes experienced liquor license attorneys that can address these issues.
Beware of multi-faceted hotel assets. All hotels are complicated assets, but some are “over-the-top” for the uninitiated. A hot segment over the last six years is the “condo hotel.” Assets such as these present a myriad of complications See Troubled Condo Hotel Workouts. For example, if a foreclosing lender sells a condo hotel unit without following specific, well-considered procedures, the foreclosing lender may inadvertently violate federal or state securities laws.