You Need to Reset Your Exit Strategy

Last year I posted a blog to remind hotel owners that they needed to have an exit strategy that embraces the circumstances and probable timetable under which they plan to exit their hotel investment. Since then, major and dramatic – some say seismic changes have occurred in the domestic and international economy and in the hotel capital markets. It is appropriate and advisable to revisit the exit strategy and revise it to reflect the current environment and foreseeable circumstances.

First the good news:

The hotel industry is and remains cyclical and demand is closely correlated with GDP. So when the national economy becomes strong again – some are already calling an end to the recession; the demand for hotel rooms will improve.
Supply growth has been sharply constrained by changes in the financial markets so little new product has entered most markets and not much is foreseeable for a while. So when demand strengthens, an existing hotel that has been well-maintained and well-operated through the down cycle will be likely to benefit.
A property whose capital stack was put in place before the high-leverage, low cap rate era should, with aggressive asset management in place to tighten costs, be able to survive until the upturn.

Now the bad news:

Average daily rates are going to take a while to come back. We saw this after the September 11th event and this time around it may take even longer for hotels to regain enough pricing power to achieve the rates that were in effect in mid-2008.
Between tightened underwriting standards and increased interest rates, most five-year term loans that come due this year, or in 2010 or 2011, will not be able to be fully rolled over. The hotel’s value is going to have to be reset and, in most cases, additional equity injected. The “experts” are forecasting “haircuts” ranging from 25-60% of 2005 – 2007 value. And a number of vulture capital funds are waiting patiently for weak owners who fall by the wayside.
Let us review and update some of the circumstances that indicate that it is time to leave a hotel investment:


• You are out of money [“the well is dry!”]
Either the hotel isn’t doing well or financing to replace outstanding debt that is maturing isn’t available. The hotel needs an infusion of equity and you don’t have it, cannot get a return sufficient to warrant investing it or cannot raise it. This is what the bankers call a troubled asset and brokers refer to as “a distress sale.” The selling price is going to be favorable only for the new owner.
• The picture isn’t pretty [“it soon will be raining on my parade!”]
A new competitor is coming in – the brand is out of favor – the location is no longer prime – demand is declining -- the property is older and needs much upgrading and refurbishment – a union agreement (or the threat of one) or a legislative mandate such as a “living wage” or retroactively applied building code change has changed the economics – and so on. For whatever reason or reasons, a large outflow and/or a small inflow of cash are foreseeable. Clearly, this hotel will not produce the desired return on investment in the near or medium-term future.
• My ship has come in [“here’s my pot of gold!”]
There are at least two versions of this: One is the “Greater Fool Theory” where a prospective buyer wants the hotel so badly, for whatever reason, that he is willing to overpay for it, giving you a handsome profit.
The second is where the land the hotel occupies has become so valuable that it makes economic sense to buy the property, tear the building down, and replace it with a different, more profitable use –shopping center, mixed-use development, offices, condos and the like.
Believe it or not, these “ships” will be sailing again in the future. But presently they are far out at sea, or perhaps even in dry-dock. The challenge is to forecast how long it will take, and how much additional cash outlay will be required before they arrive at the pier.
• The time is right (again) [“timing is everything!”]
The bulk of the tax benefit has been realized – Opportunities considered more attractive (or safer) are available – cash is needed for other purposes -- estate planning (or estate settlement) needs dictate a sale – the partners are arguing about objectives or future strategies. These are just a few examples.
If a potential or planned exit strategy is thought out, it can be modeled in a pro forma and the effects of various strategies considered and refined. The forecast and an asset management approach can then be utilized by the owner to increase his total return on the investment by:
Managing the outflow of capital expenses (and maintenance costs) appropriately.
Structuring financing and lease versus buy decisions for greatest benefit.
Making short-term decisions on a host of other items, including service contracts, booking agreements, sales & marketing activities.
Creating an audit trail of exceptional expenses to make a case to a prospective buyer as to why the net operating income (NOI) should have been higher.
Several hotel owning companies periodically do an exercise called a “re-buy analysis” on the hotels they already own. Considering present property and market conditions, availability of financing, new opportunities or potential threats that have arisen, capital needs, return on investment objectives and alternate opportunities available, would they buy that hotel asset today? Would they now revise their strategies from what was originally put in effect? This is a great asset management discipline that should be applied by any hotel owner on an individual asset basis.
If you model the likely income and realistically project the amount of debt that can be supported for at least the next five years, you will quickly pinpoint opportunities and roadblocks. If the hotel was highly-leveraged and its debt is maturing in the next few years, this would be a very good time to reset your exit strategy. Will it be on your terms or someone else’s? If you plan to stay in the hotel, you will need to restructure your capital stack. If you can come up with strategies to add value, perhaps you can convince the lender to write down the loan by less than he would be facing if he put the property into foreclosure and sold it to a new owner at market rates. Even though the loan decision is likely to be made on the basis of trailing twelve-month’s earnings, and not the proforma, if the future scenario is presented carefully and thoughtfully, it can enhance the prospects for a favorable outcome.
If the conclusion is to exit the investment, you need to become knowledgeable about today’s cap rates and the amount of financing potentially available to a buyer. Couple that knowledge with a current cash flow forecast and you can easily determine how long you can hold out, and what a realistic value is for your equity.
A sound exit strategy, put in place and then reset to current conditions, will greatly increase the likelihood that when you exit your hotel investment it will be on the most favorable terms available, and that your return during the holding period will be optimum for the circumstances.

Surviving the Coming Hotel Deleveraging Storm

If the grimmest of the prognosticators turn out to be correct, the old fundamentals probably are not going to work for a while. Scarce availability of financing, reduced loan to value requirements, tighter loan terms and higher interest rates are combining to substantially reduce hotel values. Using the mortgage/equity approach to underwriting, as pioneered by Steve Rushmore and associates at HVS, it is not difficult to predict that, if everything else stays the same, a hotel that was financed with 75% debt a few years back may qualify for perhaps 60% of the original loan amount when the note comes due. Then factor in a drop in NOI because of market conditions and it is easy to understand why some experts are forecasting reduction in hotel values of up to 50%.

As CMBS and other term notes come due in 2010, 2011 and 2012, hotel owners and hotel lenders could face a host of disagreeable choices:

The Hotel Owner may need to consider:

· Raising more equity

· Replacing a part of the debt with high-cost mezzanine financing

· Renegotiating and substantially reducing the amount of debt

· Entering bankruptcy, either voluntarily or involuntarily

· Providing the lender with a deed in lieu of foreclosure

· Other alternatives

The Hotel Lender, who could be facing major losses, would look to mitigate them. His options may include:

· Restructure the loan and leave the facility and debtor in place

· Foreclose on the loan and eventually sell the property. Before the sale:

o Keep existing management and brand

o Secure appointment of a receiver

o Replace management and or rebrand

o Demolish or market the land value

o Convert to alternate use

· Pursue other actions

In choosing the course to pursue, the lender needs to consider several variables, most of which he will not be an expert in. These include:

· Property condition

· Market potentials and hotel competitive position

o Location is a major factor here

· Highest and best use determination

· If the best use remains a hotel, then:

o What immediate actions should be undertaken to limit losses by increasing revenue and/or reducing costs?

o What are the opportunities to add value?

The workout of a troubled hotel loan needs careful study and analysis. A strategic review must cover all the bases, as a miss could lead to invalidation of the determined action plan. The assessment needs to encompass the following major areas:

Financial Review:

This is straightforward, and includes a summary of the loan terms, any payments past due, the resources available to the borrower and an updated proforma, based on a current business reforecast, not the annual budget, to decide the debtor’s ability to repay.

Property Condition Review:

This phase consists of three elements. The first, perhaps best performed by one of the engineering firms that specialize in this area, consists of a physical inspection and evaluation to assure that no uncorrected building violations exist and that the building systems (HVAC, plumbing, electrical) and major mechanical equipment are all in satisfactory condition. Roofs should be included here, as should compliance with the Americans with Disabilities Act requirements. The purpose is to be certain that there are no immediate problems that need to be corrected and that any near-term fixes necessary are identified and costed.

The second phase is compliance with brand standards and a review of the most recent property inspection report should help. The consultant will also need to determine the status of work on any property improvement plans that have been agreed to.

The final phase is an assessment of the appearance and condition of the guest rooms and public areas of the property compared to its direct competitors. If the subject hotel is inferior, the occupancy level and rates it can command are likely to be substandard as well.

Market Potentials and Hotel Competitive Position Review:

Almost anyone with access to Smith Travel Research Data can prepare a hotel market study. But one of the firms with experience and a track record in this field is needed to assure that 1) the competitive set for the subject hotel is really the right competitive set; 2) that the property’s performance within that set, as expressed in penetration of occupancy, average rate and RevPAR levels, accurately reflects its position in the market and 3) that potential growth in area demand generators and competitive supply is weighed against the location and the strengths and weaknesses of the hotel to develop the most likely forecast of potential market position of the property in the market. Expected annual occupancy and average rate should be set forth for at least the next five years.

Highest and Best Use Determination:

Should the property remain a hotel, and if so, should it keep its current brand? Part of the answer to these questions will be clear when the property condition and market reviews are finished. But it may be necessary to bring in appraiser or to talk with the local economic development or planning agency. A proforma showing expected hotel net operating income, after normal and any extraordinary capital replacements should be compared to the cash flow foreseeable from other potential uses to make this determination.

The recent announcement that the Century Plaza Hotel in Los Angeles is to be razed to make way for two high-rise condominium towers proves that the highest and best use may not always be a hotel, even in the 2009 economy. In prior cycles, hotels have been demolished to be replaced by shopping centers, condominium developments, mixed-use projects and even newer, larger and more vertical hotels.

If the hotel’s location is no longer strong; if the market it is competing in is weak or if physical property issues are too severe, alternative uses may need to be considered. If the brand affiliation is not adding value, rebranding may be appropriate. Or, it may be workable for the hotel to become unbranded. If the existing flag is no longer a good fit with the property and its market potential, a new, either down or up market brand may produce more revenue. Keep in mind that large changeover costs may be incurred; besides new signage, logo items and property management system, most franchisors will look for liquidated damages if the license is surrendered before the end of the franchise term.

Immediate Actions to Reduce Losses

In perhaps most cases, the highest and best use will continue to be a hotel and the brand and management company now in place will be considered suitable for the future. If so, immediate actions to reduce losses should be undertaken. A host of these have been identified from past cycles, and recent developments have provided other opportunities. In considering areas where costs can be cut, it is important to remember that the hotel guest experience should not be noticeably reduced. For other hotels in the market, whether troubled or not, are aggressively competing for their business. So if service is greatly cut or property physical condition is allowed to deteriorate, those customers are likely to go elsewhere and 100% of the revenue formerly produced by their business will be lost.

Happy hotel staff is a key to customer satisfaction, and preserving a favorable environment in times of a sharp reduction in business levels is a major challenge for the general manager. Reorganization and layoffs are unavoidable, but these should be completed with as much openness and as much decisiveness as possible. Ongoing communication with the staff is critical and actions to celebrate success, when achieved, are important. With the specter of Employee Free Choice Act legislation, which would make easier hotel unionization, managers need to be especially careful to keep a positive work environment. If they do not, Unite HERE organizers could soon be in the hotel executive office with a fistful of signed union cards.

Opportunities to Add Value

A physical property inspection, combined with a P & L review and interviews with key managers will usually disclose several opportunities to add value. Some possibilities will require capital investment, and will need to be evaluated on the expected ROI within the planned holding period. But others can be carried out at little or no cost. The low-cost, quick payback items should be put into effect at the same time as critical loss reduction measures.

Why Cayuga?

Some of the most able experts available to assist owners and lenders with a troubled hotel may be found at an organization I am a part of, Cayuga Hospitality Advisors. Its web site is: Cayuga Hospitality Advisors. Cayuga is the world’s largest and most experienced network of hospitality consultants. Its more than 150 members have an average of 25 to 35 years of hands-on experience; as former senior executives and entrepreneurs they have “been there, done that” through multiple earlier down cycles. They know hotel operations, financial strategies, markets and brands. Cayuga consultants can step into any size hotel or resort anywhere in the United States, or throughout the world, and in a short time assess a property’s financial performance and opportunities for revenue enhancement and cost savings. They can recommend on capital deployment to achieve the best use of funds. They can also help sort through differences in objectives between the lender, the owner and the brand, and assist the stakeholders in arriving at the best possible solution. Cayuga consultants are available to serve as interim managers or asset managers while a strategy for a troubled hotel is developed and executed.