COVER STORY, MAY 2010

THE INN THING IN INVESTMENT
Investors should move now or miss the opportunity in the West's hotel and lodging sector.
Karen Johnson and Thomas Morone

Johnson

Step One is to buy low. Hotels may be operating businesses, but profitable hotel investment depends on what you paid at acquisition and what you put in your pocket when you sell it. The window is beginning to open so you can execute on the first part of the formula. While not abundant yet, there are deals out there, even if the anticipated “steals” have not yet materialized.

Flat is the New Up

The most commonly used yardstick relative to health of the business, revenue per available room (RevPAR), is still down, but the rate of decline has abated greatly and hotel revenues are near or at the bottom. The downward RevPAR trend that continued into the first quarter of the year was caused by declines in average daily rates (ADRs), which are the effective rent earned per night after all forms discounting. In spite of continued job losses in most western states, demand for hotel rooms, expressed as occupancy, is increasing. Strengthening demand is a harbinger of rent increases, and rent increases are critical to restoring operating profits. How fast ADRs recover will be determined by the strength of the recovery. While no one expects the ADR run-up to be as fast as the decline, most expect a rally in ADRs to commence with the summer vacation season.

Morone

New supply is negligible and consists of projects that were under construction before October 2008. The only notable exceptions are the mountain resort markets and Las Vegas, where numerous delayed openings indicate that the pain and associated fiscal trauma will continue into 2011.

Visibility Improves

Unlike this time last year, there are a number of transactions that can be used as guideposts for today’s hotel investor. This first wave of sales is of the most over-leveraged properties, many of which were given up without a fight. The median discount for these sales, listings and notes is 45 percent as compared to their previous price, cost or mortgage balance; this is consistent with anecdotes of 50+ percent discounts from peak-to-trough.

The level of interest at these prices is high and getting higher. More money has been raised for distressed hotels than there are properties available to buy. One venture capital firm has abandoned plans to purchase distressed hotels and their debt due to the rates at which prices are being bid up on high-quality assets. There is too much capital looking for a home for this 45 percent level of discounting to hold through year’s end.

What Happened to the Steals?

Limelight Lodge in Aspen, Colorado

Lender denial has morphed into lender discipline. Foreclosure continues to be treated as a last resort. For example, a CMBS special servicer declined to foreclose on the Arizona Grand Resort; instead CW Capital re-split the $190 million CMBS mortgage into a $100 million senior piece that can be serviced by cash flows and a junior piece that will not be resolved until the debt matures in 2016. The borrower was required to put in $5.8 million.

The propensity to foreclosure varies by geography. In California, for example, Atlas Hospitality reports that there were 79 hotels in foreclosure as of March 31st as compared to 327 in default. Between fourth quarter 2009 and first quarter 2010, the number of California hotels entering default increased only 6.5 percent, breaking a 4- quarter string of double-digit increases. In an average year, approximately 250 California hotels change hands. Dallas hotels, which enjoyed a temporary reprieve due the high oil prices at the beginning of the recession, may dwarf California’s statewide total. Foreclosure Listing Service reports that foreclosure proceedings were filed in the Dallas metro area on 43 hotels in first quarter as compared to 41 for all of 2009. Brokerage firms specializing in hotel transactions expect an increase in foreclosure-driven transaction volume, but not a flood.

Even after foreclosure, lenders may wait for business to improve before disposal. Barclay’s Bank has been in control of both the Orchid on the Big Island of Hawaii and the Stanford Court in San Francisco for more than a year and is in no hurry to sell either. Bruce Habig, a director at Barclay’s Capital, sees no reason to liquidate now when asset values could rise by 10 percent or more by year’s end.

Any New Debt out There?

One big difference between this cycle and the Resolution Trust Corporation (RTC) days is the lack of seller-financing for the foreclosed properties. By and large when the lenders or special servicers have decided to liquidate, they want out completely. There are exceptions like the $12.3 million February sale of the Sheraton Pleasanton (Calif.), which was sold and financed by its lender Mesa West Real Estate; however, in exchange for the financing, the sales price was $100,000 above Mesa’s outstanding mortgage balance.

Aspen Skiing Co. purchased the Limelight Lodge in Aspen, Colorado, in April.

Financing is becoming more readily available from insurance companies, REITs and private equity funds, but at relatively low loan-to-value (LTV) in the 50 to 60 percent range. While these are low, they are much closer to the long-term averages that prevailed during the bubble years. When investment firm Abacus Lodging Investors purchased The Tuscan Inn Fisherman’s Wharf in February, its purchase was facilitated by a loan from a specialty REIT at a 55 percent LTV ratio. An $18 million loan on a beachfront hotel in Laguna Beach, California, was among the $108 million in new mortgages originated by Barry Sternlicht’s new entity in January. The first mortgages were originated with an average LTV of 61.5 percent and the funds were expecting at a weighted average LTV and have an average term of 3.5 years. The REIT expects a yield of 11.3 percent on the loans, inclusive of fees.

Biggest Losers

The greatest distress — and future opportunity — is in condo-hotels. In an ironic twist, the laws that were intended to protect consumers enabled buyers to delude themselves. Here in the United States, laws stipulate that by providing income forecasts, a real estate investment becomes a security and must be registered with the SEC. Thus, buyers were provided with hotel occupancy and ADR for the market and were turned loose to do their own underwriting. The rapid declines in the underlying unit values accelerated the reckoning nationally. Lawsuits are pending on virtually every condo-hotel project that was sold during the heyday of double-digit appreciation. In the mountain destinations, there is more pain to come, as buyers renege on pre-development contracts and sue for their deposits. There will be big opportunities in these resorts for experienced, deep-pocketed investors that can withstand the carrying costs. These deals, however, are not for the faint of heart.

Eyes Wide Open

Most hotel assets in the western states have the advantages of “legs.” These leisure destinations are proven and, for the most part, family-friendly. Relative to national averages, western population centers and economies are growing. There is great hope among investors that the distress will be bountiful and the deals will flow. Just remember the old real estate axiom: “You don’t make money when you sell a hotel, you make it when you buy it.” Do your homework, underwrite conservatively and be prepared to be in it for the long haul.

Karen Johnson is a consultant with and Thomas Morone is a principal of Warnick + Company in Los Angeles.

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