The Smart Car folks in LA are celebrating because the hotel business has recovered ….REVPAR up 8% last year and maybe 4% this year. And no meaningful new supply. Optimism abounds and operators are pushing the accelerator to the floor… RECOVERY! Best time since the collapse of Rome to invest in hotels. And I studiously believe all that is true.

But unnoticed coming towards the one way bridge is the Suburban described at the CMBS loan conference. Listen to them…”CMBS maturities remain a massive, massive, massive, massive problem. (yes he said massive four times)”…”This is a long slow slog and there is no easy way out of this”…”The proceeds shortfall this year in commercial real estate loans coming due between face value and likely replacement loans is $600,000,000,000.00 (I wrote out the zeros to make a point) and the gap in 2016 will be $1,600,000,000,000.00 (stop counting that’s one trillion six hundred billion dollars and no cents).

So the Truth for hotels in 2012 is that the financial mass (not mess) of the very real hotel recovery just won’t be nearly powerful enough to overcome the huge financial mass (and mess) of hundreds of billions of loans coming due without any hope of replacement proceeds.

So if you can buy a hotel do it! If you can hang on to a hotel loan do it! If you are in the Smart Car with heavy loans due….jump!!!

The fortunate few (25%?) who didn’t over leverage their hotels and those who buy now will be real winners in a few years.

Some details:

1. Hotel income growth has averaged about 3% annually for 40 years and all predictions for 2012 are between 3.5% to 8% (the latter by Dr. Pangloss). It is directly correlated with GDP growth.
2. Supply growth historically averages 2% but now is less than .5% and will stay that way for years (go try to get a hotel construction loan).
3. The US economy still leads the world in innovation and productivity and the coming applications in Nano technology, robotics, gene therapy, artificial intelligence, etc. will make us thrive.
4. Inflation has always benefited hotels on the recovery side. Unlike office and retail with long term leases, hotels can now raise their rates hourly. Buy a hotel at less than replacement cost, get a fixed rate loan and sit back and watch that appreciation fly.

So hotel defaults will continue to grow because of the maturity proceeds shortfall and PIP demands from franchisors but buying now makes perfect sense.

For future reference it is an axiom (and even true) in the hotel economy that the single best predictor of revenue growth is GDP. Say what?

P.S. I told my children it was rude to say I told you so.

For RevPAR growth in 2012 to support replacement loans for the Billions in notes coming due, growth would have to be more than 64% (no there is no decimal between the 6 and 4 – I have the math if anyone would like to see it).  The single greatest misconception made in the hotel loan industry is that robust annual income growth of 7 plus percent will make everything ok in 2012. Wrong! Despite strong growth the past two years income is still not at the level of 2007.  (Remember how hard it was to recover from that 1.5 GPA in your freshman year?) And that is not adjusted for inflation.  Without regurgitating the PROCEEDS problem it is clear that today’s downward forecast makes for a messy future.

Will this slow down the industry standard Extend and Pretend game? No. Just make it even more unlikely to succeed. Receiver posses mount your horses.

Current CMBS hotel delinquency rates are around 15%.  So how will we get to 50% in 2012?  Well if we just take the lipstick off the pig we have been kissing we will see that defaults are ALREADY over 50%. Over 2/3 of the loans that were due this year and last have been extended or they would have defaulted. Let’s call them functional defaults. And the functionally underwater credit kidding loans are being extended to what will be the worst year to refinance imaginable- 2012.

Simple addition- 2007 plus 5 equals 2012. Does anyone remember the quality of loans made in 2007?  The beauties were 85% to 97.5% leverage with no amortization and coverage projected to GROW in 2008 and 2009 to 1.25. Next year the pig in the python will be triplets.

So? …its all about PROCEEDS- billions needed to replace the five year 2009 and 2010 loans extended into 2012 and added to all those 2007 emaciated loans coming due then. During the three year period of 2005-2007 approximately $14B in CMBS hotel loans with 5 year terms were originated.  And almost each and every replacement loan will be way short of proceeds. Where in today’s hotel loan market will $14B in new capital come from?  Proceeds shortfall will be 25%  to 50% because IF one can find them current new loans are 55-60%, based on trailing 12 results, with lower property NOI than when originated and finally will require major additional capital for the PIPs (to be discussed) Marriott, Hilton, Starwood et al are forcefully demanding.

The combination of stacking all those functionally defaulted loans onto the biggest year ever for loans coming due in what will be a very restrictive hotel lending market and with most hotels needing capital for renovation will make vultures happy and bondholders sad.

Topics 2-5 will come out daily beginning tomorrow.

Franchisors’ patience, like carpet on hotel floors, has worn thin from years of neglect. The hospitality business is recovering rapidly so they are declaring an end to the truce and putting owners on notice that PIPs (required Product Improvement Plans ) MUST be adhered to. If not the flag goes away. Terminal cancer for a hotel’s value.

Here’s what will happen. Joe Ego purchased a branded hotel in his hometown in 2007 for $60M and borrowed $50M. Now the hotel is worth $40M (sorry folks). Extend and Pretend has worked because the borrower and the lender have a common interest — they need time for value to recover. So far so good. But the critical third party, the Franchisor, has a conflicting interest. It has customers who are loyal because of the consistent quality of their hotels, i.e. a brand. And the brand’s competitors are remodeling and updating. To keep its customer base loyal the Franchisor must demand that its hotels are remodeled also. So the Franchisor notices Joe that a $5M PIP is due. Joe has no dough, or if he does, he will not contribute it to a hotel in which he currently has no economic value. So although the loan was extended two years with a token pay down, the asset value on which the loan is based will fall below the loan amount as soon as the property is deflagged.

What can lenders do? First of all make absolutely sure that the notice requirements the Franchisor agreed to in the loan documents are current and valid. Alert Master Servicers to your need for this information. Do whatever you can to preserve the flag. First tack is to work with the Borrower. If that fails, the next step depends on the loan — balance sheet lenders can foreclose and either sell, JV or do the PIP themselves (with professional assistance). Special Servicers are limited by REMIC rules and the Pooling and Servicing Agreement’s limitations on advancing and may find it difficult to do the PIP within the Trust so foreclosing or finding a new capital source to team up the Borrower may be the only alternatives.

If you would like to learn more, we are planning a seminar on PIP Costing, Negotiation and Implementation so send me an email and I will get an invite out.

As the tourists from the ice bound North head South to the warmer climate and the high season begins in Florida and Arizona, lenders should be extra careful to consider the seasonal cash flow when making decisions about whether or not to foreclose or appoint a receiver. A good half step is to get a Cash Management Receiver  appointed just to watch cash and approve all checks. This relatively inexpensive action can be a prudent measure in preserving the asset (and just so you don’t think this is all self promotion, Bill Hoffman with Trigild out of San Diego is a great  Receiver company also).

Some hotels make ALL their cash flow during their local season of three months and require feeding the other nine months. So get your antenna up when the high season for your distressed hotel loan is coming… be it Spring, Summer, Fall or Winter.

More tricks are coming.

]]> http://www.prismhotels.com/blog//2011/01/27/hotel-loan-bubble/feed/ 1 http://www.prismhotels.com/blog//2011/01/20/bubbles-lower-originator-iq/ http://www.prismhotels.com/blog//2011/01/20/bubbles-lower-originator-iq/#comments Thu, 20 Jan 2011 16:38:27 +0000 Steve Van http://prismhotels.com/blog/?p=239 A 2008 Herverd Business School study concluded that the cyclical advent of frothy capital markets lowers originator IQ. For each percent point increase in total originator bonus tied to loan volume (not quality) underwriting IQ was found to be lowered by one point.

For example in 2002, $35B in CMBS loans were originated with hotels underwritten at 1.75 coverage on trailing 12 and 20 year amortization. This was assumed to be 100 IQ. By 2007 there were $228B in loans originated (over 600% increase) with hotels underwritten at 1.15 coverage on projected 2008 revenue with zero amortization and no reserves.

The studies’ authors were initially surprised by this correlation and its resulting mathematical conclusion that originators with less than 0 IQ were originating loans in 2007. However a follow-up study was performed in late 2010 which confirmed the formulas’ accuracy. Bubble had burst and originator IQ had risen.

The same Herverd Business School authors are planning a new study for the coming bubble in 2014 but have decided to partner with the Yerkes Primate Lab to use as their base group chimpanzees.

An additional series of studies is contemplated to apply this same formula to owners, lenders, appraisers and blog writers.

Stay tuned.

It’s the Proceeds Stupid!

A $50M ‘06 origination at best will get $25-30M in new loan proceeds. And the hotel is probably worth no more than $34M today. So borrowers won’t pony up the shortfall to pay off the loan but will turn the pony in and go buy another discounted hotel (after they have looked up the meaning of non-recourse in Webster’s).

It’s the PIP Stupid!

PIP is not the protagonist of Great Expectations but Property Improvement Plan. It’s the tax franchisors put on hotels so their brand will stay on top of the heap. All the best ones- Marriott, Hilton, Starwood, Hyatt… will be coming down much harder on renovations now that a “recovery” is under way. So an owner who has a $50M hotel loan performing at say LIBOR plus 150 will be faced with an $8M PIP on a hotel worth $34M and will make the economic decision to take the $8M elsewhere and buy a foreclosed hotel and give his or her hotel back…

It’s the FDIC Stupid!

There is some talk in the corridors of the Mother of All Extend and Pretend — the Fed — that with all the subsidized profits banks are making they should start cleaning up their bad loans and hotels stink more than most. They may require banks to clean up 20% a year for five years and that will be a lot of turkeys coming.

The problems above will only get worse if the economy falters or if God forbid LIBOR goes up but let’s bury our heads in the sands on those possibilities. Special Servicers and Asset Managers staff up!!! Distressed Buyers… lick your chops and all you Lawyers, Brokers and Appraisers get ready for a good year finally.