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.