Download In this and previous economic downturns, hotel investments showed

In this and previous economic downturns, hotel investments showed signs of distress
early on, as occupancy and then rates declined with the economy. In the past, hotel debt was
worked out much later, well into the recovery phase of the economic cycle. The extended
period of distress that preceded the final workout found owners and lenders engaged in serial
interim modifications, formal and informal extensions, and usually inconclusive
restructurings. Delaying the final resolution made litigation, bankruptcy, restructures and
dispositions visible only in the last stages of the downturn.
This article begins with addressing the business cycle itself. We focus on that as the
basis of our analysis because many of the legal and documentation problems of the current
cycle clearly arise in a failure to understand and anticipate the business realities of the
industry. We discuss, first, the historic or theoretical cycle, and then how the present cycle
has departed from the historic model. Second, we address the impediments to resolution and
the issues which have contributed to the environment of “extend and pretend” without
effective longer term strategies. As part of this, we address specific impediments in CMBS
lending, special servicing and choices made in documenting transactions. We conclude with
comments on what is developing as the “New Normal”, and issues that the industry and its
advisers need to address going forward.
Where We Have Been – Extend and Pretend
The Pattern of a Downturn
Occupancy rates of hotels react quickly, sometimes within days, to adverse news
about the economy, international events, and other developments that impact travel. The
volume of individual discretionary travel declines first, then the volume of corporate travel.
Hotel operators at first attempt to maintain rates, often signaling to competitors that they will
not lower rates. Even while making such statements, they will begin to cut prices indirectly,
through special promotions and incentives, in order to compete for declining demand.
Eventually, even advertised rates will fall. Pre-negotiated rates for business travel will
continue to apply for a time, but corporate travel departments will soon bypass the negotiated
rates or force renegotiations. Occupancy overall will continue to decline, and rates will
follow. Some stronger segments may seem to continue, as pre-booked group business under
multi-year contracts may finish out contracts subject to large cancellation fees. Conventions,
trade shows, and similar events will then shrink and may be adjourned or cancelled. What
group business continues usually is booked on short notice at highly competitive pricing,
making cash flow unpredictable. The lower occupancy and lower rates ultimately combine to
result in an accelerated decline in the most important reported metric of hotel revenue called
“RevPAR” or “Revenue Per Available Room”.1
1
RevPAR is technically defined as rooms revenue (excluding discounts and services like food and
beverages) divided by the number of available room nights in the relevant financial period. It can also be
calculated as the Average Daily Rate multiplied by the Occupancy Percentage for Rooms in the financial
period. The industry standard for these definitions was historically set by Smith Travel Research, a
standard source for industry statistics. The company has moved into a series of ventures and other
relationships, in particular with Deloitte as STR Global. Whether it will be viewed as remaining
independent and authoritative is unclear and competition to provide statistical information is increasing.
As discussed below, the quality of information available to lenders and investors is an expanding
concern.
Relative to other types of real estate, hotels operate with a higher level of fixed costs,
meaning that a substantial part of their operating costs must be paid regardless of the level of
occupancy. As a result, the cost of operating a hotel is rarely reduced at the same percentage
as RevPAR falls. A material decline in RevPAR, therefore, results in a disproportionately
larger decline in cash available to the owner. The point at which RevPAR decline actually
wipes out all net cash flow and the hotel becomes insolvent depends on the specific type of
hotel, its cost structure, the ratio of fixed and variable costs, brand-associated costs, and other
factors.
Over the last two decades, not only the level, but the percentage of costs that are fixed
in hotel operations has risen. As a result, the percentage of hotel gross revenue that reaches
the bottom line as cash flow available to the owner or as net operating income margin in a
typical managed or franchised hotel has generally declined. This change magnifies the
impact that a decrease in RevPAR will have on cash flow available to pay debt service.
Compared to prior cycles, hotels entered this cycle far more vulnerable to failure in a
downturn because they had much higher fixed costs. They would inevitably become cash
flow insolvent at higher RevPAR declines.
One practical consequence of material declines in RevPAR is the creation of direct
competition between hotels normally not thought of as competitors. A hotel with a room
rate of $400 in a strong market may reduce its rate to $200 in a weak market to maintain
some level of occupancy. Because its profit margin per room, measured in dollars, is large, it
can absorb the reduction.2 A second hotel normally at a $200 room rate cannot compete with
the superior quality hotel at that price level. The second hotel has no choice but to also drop
its rate to a level that allows it to attract occupancy, although in dollar terms it has less of a
profit margin to absorb the reduction. The second hotel’s reduction pushes it into
competition with a third hotel still lower in the rate and quality tiers. The second hotel cannot
afford to cut its rate as much as the first hotel, and the third hotel has even less margin to cut
its rate. This domino-like effect of rate reductions takes all the hotels out of their intended
market position and pushes them in closer competition for the duration of the downturn. This
phenomenon is referred to as “compression” of hotel rates. In a falling market, the
compression effect hinders any ability to judge the long term value of all hotels and makes it
difficult to underwrite lending and restructuring options.
The longer the rates remain
depressed or appear likely to continue low, the more likely an investor or lender (who
typically bases valuations on the prior three years of income statements) will be to judge the
hotel to have suffered a long term or even permanent loss of value.
Projections and long term budget plans for hotels used in feasibility studies and
underwriting by CMBS lenders and rating agencies rarely include any suggestion of or
provision for future downturns. In fact, downward fluctuation in hotel profitability is a
recurring phenomenon well known to experienced investors and lenders. As a consequence,
well understood techniques were developed among experienced hotel investors and lenders
for responding to sudden downturns. After 9/11, investors and lenders immediately worked
together to deal with the abrupt interruption of travel and sharply reduced demand. Staffing
reductions were implemented, partial closures instituted, and capital reserves were made
2
While the gross revenue per room is greater, the gross margin for a higher room rate hotel may not be
higher given staffing levels and amenities’ costs.
2
available to owners for shortfall funding. Credit lines for operations were provided by some
lenders, particularly for resorts that were severely affected by reduced air traffic. Some loans
were put on interest-only status to preserve cash for what was feared likely to be an indefinite
period of uncertainty and travel interruption. As discussed below, the 9/11 induced recession
proved to be relatively limited in depth and length.3
The Recovery Phase
By the time the economy begins to recover, individual travelers will have been lured
back to hotels by heavy discounts and promotions. Business travel will have increased, but
with rates still being negotiated downward by corporate travel managers. Group bookings
will begin to rebuild slowly, but the larger groups will continue to seek multi-year contracts
at prices reflecting the oversupply of rooms relative to demand in the market. Occupancy
will increase, but rate competition may continue for a sustained period. Hotel operators
typically begin to raise rates and reduce concessions and promotions they have used to build
business only when occupancy reaches a much higher level, at which rate competition can
safely resume. The phenomenon of hotels beginning to raise rates as demand and occupancy
rise is also referred to as “compression”, but, in a rising market, the term means that higher
occupancy is creating the possibility of competition and therefore an accelerating increase in
RevPAR. Hotels, then, can begin differentiating among themselves by rate or quality tier.
As occupancy stabilizes at higher levels RevPAR rises somewhat, but when room rates and
occupancy levels both are able to increase, RevPAR will rise geometrically. At that point,
cash will become available for debt service again.
Once this rising trend in RevPar becomes established, investors and lenders will look
for indications of new stabilized market conditions, trying to determine when the conditions
will be achieved and what will be the new stabilized cash flows. While RevPAR is an
important indicator of ultimate cash flow, the critical issue in underwriting is not RevPAR
but net cash available for debt service and other needs, including for use in raising new equity
and determining collateral value and coverage for new loans.
Stabilized cash flow is the critical issue for underwriting hotel investment and
financing. Hotels are typically valued by applying a capitalization rate (reflecting the
perceived risk of the investment) to stabilized cash flows projected for future periods. 4
Whether the calculated value shows untapped equity is often critical in the recovery phase of
the cycle. Hotels at the end of a recessionary cycle are likely to face many problems: (i)
deferred maintenance and years of minimal capital spending; (ii) competition from newer
hotels, which will have continued to open; (iii) demands for increased spending by brand
managers or franchisors; and (iv) higher costs of operation than before the cycle. These
require funding in the short term, and are likely to require new cash to be injected by
borrowing (if the value will support it) or by new equity (meaning replacement or dilution of
3
The trend to greater default levels in securitized hotel loans was however already evident in that cycle.
The relative rate of defaults and the inherently higher risk of failure was an issue in one of the first
bankruptcies to test the handling of hotel debt in special servicing. See, e.g., In re Shilo Inn, Diamond
Bar, LLC No. 02-03180-elp. (Bankr.D. Or.).
4
More detailed multi-year discounted cash flows are also used in underwriting.
3
existing investors or even the lender). Thus, the capitalization rates applicable to hotels in
the recovery phase are critically important to what restructuring changes will be necessary to
keep the hotel competitive and to its collateral or investment value.
Hotels do not suffer downturn cycles only because of downturns in the wider
economy. They seem to be magnets for irrationally exuberant investment in the late phases
of most real estate bubbles. Due to the time necessary to complete development, developers
continue to open new “built-to-fail” projects well into the downturn and recovery cycles.
Coming out of those cycles, capitalization rates are reset based on recent loss experience and
oversupply. Since hotels have greater variability and risk, they suffer disproportionately from
adjustment of capitalization rates and, thus, downward revaluation.
A reduction in the availability of third party hotel financing and a lack of cheap
equity after a downturn often occur and continue into a recovery, as they did in the economic
cycles in the 1980s and 1990s. Those shortfalls drove up interest and capitalization rates. 5
Lenders active before the downturn tended to focus on dealing with continuing portfolio
problems and were less interested in new projects. Some lenders did not return to the market
at all because they had failed and were being liquidated or merged. This scarcity of supply
drove up interest and capitalization rates and drove down the size and loan-to-value ratios
offered by the few remaining lenders. These higher rates eventually began to attract more
opportunistic and aggressive lenders that would provide loans at higher loan-to-value ratios,
but the cost of such financing remained high and continued to climb. Some of the lenders
and deals would be “loan to own” where the lender anticipated loan failure, and planed to
foreclose to obtain ownership of the asset. Among these opportunistic lenders in past cycles
have been brand managers and franchisors who become active as sources of financing,
providing direct loans, mezzanine financing, or credit enhancement, investing directly, and/or
offering concessions to owners and lenders for ownership shares or more lucrative contract
terms. Very often several of these funding sources – secured lender, mezzanine lender, and
brand-affiliated financing source – needed to come together to achieve a longer term
restructuring. In the past, the extended periods of uncertainty resulted in interim
restructurings and long periods in Real Estate Owned (“REO”) status or “bad bank”
portfolios before distressed hotels were worked out with any degree of finality. Typically,
some hotels were worked out only at a very late phase of the recovery cycle. Other hotels
were “worked out” but subsequently failed because the exit financing was not sustainable.
5
A consequence of this has been the eagerness of hotel developers to engage with higher cost financing if
it is made available to them - as in the case of CMBS lending in the last cycle and syndications in
previous cycles - even when the lending structures are in fact not compatible with the business of hotels.
4
This Time: Recession, Downturn, More Downturn and Recovery
Recession
Differing degrees of stress result from differing reductions in RevPAR. As an
indication of the order of magnitude of the stress in the current cycle, a branded full service
hotel in the 2008 or 2009 market was likely to suffer a cumulative 35% drop in RevPAR
compared to 2007, the recent year for peak performance. That level of stress would indicate
a drop in net cash flow to negative cash flow even before debt service. In other words, if a
hotel’s RevPAR falls 35% over that period, it would typically have no operating profit to pay
debt service and maybe even operating costs. When the decline reaches 25% below 2007’s
RevPAR, a typical leveraged hotel would have insufficient cash flow to pay the full amount
of debt service from operating income, making the hotel cash flow insolvent. If a hotel
suffered a 20% RevPAR decline between 2007 and 2008 (which was not unusual), only a
small additional decline between 2008 and 2009 would be necessary to tip it into negative
cash flow.
By early 2008, the downward trend was visible within the industry, although
unrealistic performance projections still were being reported. Many in the hotel industry
debated whether the industry faced a “V”, “U” or “W” downturn. The hoped-for pattern was
a “V” cycle, meaning RevPAR would turn down severely and quickly, but would also sharply
and quickly climb back to pre-recessionary levels. The post-9/11 downturn had been a
classic “V” recession for the hotel industry, with little perceived long term impact on the
industry and few hotel insolvencies or reported debt failures. If the “V” pattern were to
apply, 2008 would be the brief period of lowest cash flow with recovery evident in late 2008
or early 2009. That cycle would call for short term measures similar to the period after 9/11.
However, the mounting evidence through 2008 suggested that the cycle would be slow and
any recovery gradual, so that the “V” could widen into a “U” or even “L” cycle with a
sustained period of low performance and greater stress. This would force hotels into longer
term cash-savings methods and would increase debt service shortfalls. A further possibility is
that cash flow could improve for a short period and then be followed by another sharp decline
and later recovery, forming a “W” cycle. This would make survival dependent on both
longer term measures and the ability to infuse new cash.
Downturn
The hotel industry came into this cycle with the most comprehensive ability to
forecast economic conditions and hotel results that it had ever had. It is highly unlikely that
the major management groups did not appreciate what the industry faced. The risk of a “U”
or “L” cycle was very evident by late 2008, as was an already-incurred 25% drop in RevPAR
in many markets. The evidence of a long-term problem continued to accumulate through
2009 and into the beginning of 2010. Cash flow was so diminished in most markets by 2009
that many investors were concluding that hotels would require substantial new money to be
injected, by debt reduction or equity dilution. Some investors analyzed the combined effect
of current cash shortfall, competition from new projects, and capital needs, and announced
publicly and clearly that their hotel investment dollars would be better spent on acquiring
5
other hotels at current prices. They ceased feeding many existing hotels and tendered them
back to lenders.6
Realistic judgment was not, however, universal. Servicers and lenders appeared to
cling to the idea that the recovery of the wider economy would resolve all issues, and thus the
current conditions required minimal or no special accommodation to borrowers and no or
only small adjustments to reserves. Many concluded that a period of short term distress in
hotel loans offered opportunities for new fee income and rate increases in exchange for short
term extensions or suspension of contributions to reserves or amortization, similar to what
was being done with other categories of commercial real estate.
However, even in 2008, debt maturities required lender action. The average
maturities of hotel debt have shortened over the last two decades. In past cycles, many hotels
eluded distress simply by having longer term financing that they could service without having
to face a debt maturity at the wrong point in the cycle. But, in this cycle, an increasing
percentage of hotels faced imminent debt maturities in any one year. The meant that debt
maturities were and continue to be an inescapable problem. If full debt service was being or
could be paid currently in 2008, borrowers could generally obtain a short adjournment of the
maturity date in exchange for an extension fee and interest rate adjustment. If cash flow
coverage was otherwise marginal, a borrower might be allowed changes or concessions, such
as reductions of current reserve contributions, deferral of capital plans, or even release of
funds in capital or equipment reserves for coverage of shortfalls, payment of extension fees,
and higher interest rates. The cash made available from these arrangements was often
expected to be paid as a fee to the servicer or lender. These changes were not regarded as
materially altering the loan terms or impairing repayment, to the extent that they called for
material reevaluation of collateral. With few comparable transactions and much doubt about
prevailing pricing and appraisals, valuations were informal, highly optimistic or avoided
altogether.
Because hotels typically had substantial funded reserves, the reserves were
tapped and debt service continued to be reported as paid and the loans not in default. The
level of actual cash impairment and the draining of cash from reserves and capital projects
appear to have been widely underreported.
After the last quarter of 2008, the magnitude of the RevPAR decline became obvious
in even the strongest markets. Year-to-date annual declines of RevPAR in the range of 30%
or more were discernable, although higher “adjusted” numbers were presented in many
internal budgets and industry market reports.7 The published reports continued to understate
6
The logic and negotiation process were made public by REITs subject to SEC reporting obligations and
also REITs which sought to maintain investor confidence by laying out the basis for the decision to walk
away from properties. See, e.g., Press Release, Sunstone Hotel Investors, Sunstone Hotel Investors
Provides Business Update Jan. 7, 2010 (filed with SEC as a report of material event on Form 8-K). This
lays out the decision to end negotiations with lenders on three properties and put the hotels back to the
lenders.
7
The quality of reported results seems to have been significantly impacted by reporting practices
facilitated by the Uniform System of Accounts for the Lodging Industry, Tenth Edition. This edition
gave strong support to the reporting of “phantom” revenues, or revenues deemed to exist as a result of
barter transactions, provision of complimentary or discount services, redemption of award certificates and
other non-cash transactions. These undercut the usefulness of RevPAR and related statistics in
(Footnote continued on next page)
6
the problem well into 2009. With the focus on reporting RevPAR, the scale of the impact on
cash flow was not well reported and seemed poorly grasped by analysts. No one seemed to
connect the impact of possible inflated or optimistic valuation with a growing likelihood of
insufficient lender reserves.8
The erosion of operating cash flow became apparent to more investors and brought
them into greater conflict with management companies. Many owners had already observed
serious failures to contain cost, with operating expenses for some of hotels actually rising
during 2008. Charges related to transactions with affiliates of management companies
climbed relentlessly.9 Some owners also observed that reported RevPAR increased but gross
cash receipts from the hotel were flat or decreased.10 Promotional programs, such as triple
miles awards, increased costs to the owners and fees to management companies, but were of
dubious value to the hotel, and often damaged net income. As reserves were tapped, hotels
faced greater capital expenditure deficits. Yet owners continued to receive proposed capital
plans and capital calls from brand groups and management companies for brand upgrades.
More Downturn
For many owners, the decisive and pivotal phase was the period in which budgets for
2009 were developed and revised. Many operators’ budgets originally proposed in the last
months of 2008 and 2009 proved unattainable shortly after being sent to owners and lenders.
The 2009 proposed budgets were revised downward when actual performance in the final
months of 2008 continued to deteriorate. Further downward revisions followed as
information on sales and operation indicated continued deterioration into 2009. Four or five
budget revisions were not unusual. Repeated revisions downward on the basis of assertedly
“new” information fed the fears of investors and lenders. It is unknowable whether the 2009
budgets were first issued with the knowledge that they were “optimistic” but also with a
(Footnote continued from prior page)
forecasting the ability to meet debts, as well as increasing expenditures and fees (such as franchise and
management fees) linked to reported “Revenues”
8
A widely reported study issued in mid-2010 described massive increases in projected losses on hotel
loans as a result of reappraisals. The study examined changes in appraised values of hotels reported in
filings for CMBS portfolios in the first part of 2010. The typical hotel loan examined by the study
involved a LTV of over 120% after reappraisal. See, e.g., (Matt Valley, Loan-to-Value Ratios Spike
Following Wave of Reappraisals), Nat Real Estate Inv., July 21, 2010 ( reporting the study by Trepp
LLC) available at http://nerionline.com/distressedinventory/loan-to-value_ratios_spike_0721/index.html..
9
The impact of hotel brand management practices seems likely to be a recurring theme in litigation coming
out of this economic cycle. One case focusing on this was filed by an owner facing foreclosure. The
owner asserted that the hotel manager had breached its contractual obligations and contributed to the
hotel’s financial problems by, among other things, costs imposed by the management group’s selfinsurance program, labor practices and frequent traveler program. A motion by the management
company to dismiss the claims for breach of contract and for breach of good faith and fair dealing was
denied. Madison 92d St. Assocs., LLC v. Courtyard Mgmt. Corp., Index No. 602762/09 (Sup. Ct. N.Y.
County July 17, 2010).
10
As an example, a room sold with a breakfast could be booked under the Uniform System for $200 plus
$25 for a breakfast. The internet vendor would pay $150 to the hotel and $50 could be written off as
marketing and the $25 free breakfast written off as a promotion.
7
misplaced belief that it was best to manage expectations of owners and lenders in this way.
(The “optimistic” information had the practical and perhaps foreseeable benefit of
encouraging owners to continue to come out of pocket to pay lenders and fund additional
shortfalls.) Instead, the continuing downward revisions conveyed a business deterioration
that was either uncontrollable or out of the control of the professional managers.
Restructurings became more and more difficult to complete.
As 2009 progressed into its first quarter, cash flow for many hotels was effectively
wiped out by revenue declines and the failure to achieve sufficient cost reductions by the
management companies. Most hotels experienced at least multi-month periods in 2009 in
which cash flow was insufficient to meet debt service. With their reserves having been
already exhausted, or in some cases seized by servicers, or unavailable by reason of preexisting contractual agreement, investors confronted the question of whether to pay in more
capital. Some owners, like Sunstone REIT, firmly and publicly decided against advancing
further equity to certain of their SPE affiliates who owned hotels. Others chose to pay off
mortgage debt on core properties immediately.11 When these investors next sat down with
lenders and servicers, the investors were not there to talk about further short term fixes or
tapping into additional reserves; they wanted more fundamental changes. Without more
comprehensive and immediate restructuring being offered, the investors had determined that
they were prepared to abandon their investments.
Lenders and servicers were not well prepared to respond in many of these cases.
Until early 2009, most lenders and servicers had seemed to act on the assumption that their
borrowers’ hotels would be able to meet operating costs and pay at least currently accruing
interest until the cycle turned up. The assumption seemed to rest in part on the belief that
hotels were not directly but incidentally affected by the recession and that residential real
estate and related financial markets were the core problem. Once these financial markets
stabilized, so too would general demand in the economy and thus in hotel business. The
solution of the core problems and the markets’ recovery would drive resolution of all other
issues. Using this logic, the core problems were not the responsibility of hotel lenders.
Holders of hotel debt could not do much more to help themselves in this situation than
extract payments and concessions from hotel borrowers in exchange for short term
extensions. After all, hotels had seemed to be relatively stable through the middle months of
2008 with public expressions of optimism about 2009. This attitude on the part of lenders
and servicers discouraged careful review of loan collateral, reassessment of the original
valuation analysis, updating of loan underwriting, or any significant (and highly unwelcome)
increase in loan loss reserves. The assumptions were largely unchallenged into early 2009,
with virtually no publicly reported loan sales or arms length hotel dispositions. Value in the
market place with few transactions was nearly impossible to gauge. Financial indicators of
loan distress were ignored in reporting performance and reserves, as were many technical
defaults.
11
Host Hotels’ decision to pay off the mortgage in regard to the Westin Kierland is indicative both of the
elimination of mortgage risk and the strategic deployment by REITs of their capital resources. In fact,
all-equity acquisitions are a very high percentage of current transactions and convey the degree to which
the hotel lending market is currently viewed as dysfunctional or too expensively priced.
8
Last year, 2009, proved to be a year of unpleasant realizations for hotel lenders, as
hotels and unfinished hotel projects valued at hundreds of millions of dollars were effectively
handed back to lenders outright or in minimally opposed foreclosures. These projects were
usually cases in which the borrower had not abandoned the assets without serious discussion
or offers to attempt a longer term solution. Unfortunately, the discussions were largely
unsuccessful.
Lenders and servicers presented with hotels in payment default through 2009 also
faced a market with few active hotel buyers. Of these buyers, even fewer offered prices
sufficient to repay substantially all of the mortgage principal. Information about loss levels
on dispositions early in the cycle was not easily available, but emerged gradually to indicate
unanticipated high levels of loss, in the range of 40% of the principal, based on a small
sampling of mortgages. One of the first published statements about this appeared in the first
report on progress under the TARP program.12 This loss experience and the obvious lack of
buyers discouraged acceptance of deeds in lieu or similar prompt resolutions. To the
contrary, conditions and regulatory concerns encouraged lenders to pursue slow motion
foreclosures, reporting minimally acceptable action with some delay in loss recognition and
staving off immediate additions to loss reserves. There was also substantial ambiguity about
assumptions and virtually no comparables to be used in appraisals, making it easier to deemphasize or defer reappraisals. When the strategy was criticized, the response was that the
approach was temporary, just pending the revival of CMBS lending for hotels; that CMBS
rating agencies had pulled back from hotels well before the recession was overlooked.
Recovery
Hotel opportunity funds, however, continued to be visible in raising capital, and
privately negotiated transactions began to be reported. A few institutions allocated new funds
to their hotel lending groups, and those specialized groups announced new deals, however
conservative the deals were in size and rate. Some RevPAR improvement was reported along
with incremental “green shoots” improvement in the wider economy. This encouraged some
lenders to take more forceful action toward foreclosure in the belief that there would be more
active buyers at the end of the process. At the same time, borrowers became less interested in
retaining ownership and regulators were pushing for more action.
By early 2010, there were indications that bank regulators were coming to grips with
the reevaluation of hotel loan collateral and inadequate reserves. Monetary defaults, as in
failing to make current loan payments, normally trigger substantial additional contributions to
loss reserves. There were indications in 2009 that lenders had not reserved realistically or
had evaded the issue of reserves by pointing to the ambiguity of current valuation standards.
As this article was being prepared, information became available about a wave of
reappraisals, which had rolled across hotel loan portfolios in early 2010. 13 Relying upon a
much larger sampling of hotels than previously studied, the information showed hotel loans
12
Fin. Stability Oversight Board, First Quarterly Report to Congress pursuant to Section 104(g) of the
Emergency Economic Stabilization Act of 2008 for the Quarter Ending Dec. 31, 2008, available at
http://www. Financial Stability.gov/latest/reportsanddocs.html.
13
Supra, note 8.
9
incurring very substantial write-downs based on material loss of collateral value. In the same
period, a rating agency reported the continuing acceleration of the rate of monetary defaults
in the hotel loans pooled in CMBS securities rated by the agency. The report forecast a
continued acceleration of defaults up to a rate of more than 20% of loans in monetary default,
giving hotel loans the highest default rate and most rapidly accelerating rate of default among
categories of real estate tracked by the rating agency.14 While these developments were
reported as new and significant news, there was in fact little new going on. Rather, what was
underway was a clearing away of misinformation. To a limited degree, the hotel industry
was coming to grips with where the players stood in regard to their rights and responsibilities,
and their strengths and vulnerability in restructuring discussions.
Where We Are Today
Barriers to Successful Restructuring.
In light of the current state of play in the hotel space described above, many hotels are
now the subjects of the foreclosure or bankruptcy process, negotiations to restructure disputes
with management companies over cost control, and searches for new money. The
consequences of reappraisal and new information on values have brought lenders to the table
with borrowers and management companies. For some lenders, this is the first time in this
cycle that they have squarely confronted the issues of a permanent or at least longer term
restructuring. They are also facing up to the tools, or lack of them, to support their exit
strategies. We discuss below some of the impediments to restructuring that have emerged
and how they are being addressed in current negotiations.
Who Will Restructure
For much of this downturn, borrowers have had great difficulty finding lenders and
servicers willing to enter into restructuring negotiations. In significant part, this has been due
to the position and motivation of the servicers and to a lesser degree, the actual lenders.
Many hotel loans now in default are in commercial mortgage backed security
(“CMBS”) pools, which require hotel owners to deal through special servicers in any attempt
to restructure. These pools are a compilation of various commercial property mortgages
pooled into trusts. The trust sells bonds secured by interests in the cash flow from the pooled
mortgages. These bonds are issued in “tranches” or classes of notes that pay returns in
inverse proportion to the risk of repayment of that class. For example, the senior tranche is
repaid from the first dollars available for distribution from the pool, but have the lowest yield
because they provide the least risk of non-payment. The yield increases for the lower tranches
repaid from remaining dollars, if any, available for distribution after the senior tranche.
CMBS pools are administered day-to-day by master servicers who collect monthly
payments and other cash coming from the borrowers. The master servicers apply the cash to
expenses pursuant to their servicing agreements and then pass the net cash along to the
14
See Carrie Bay, CMBS Delinquencies Slowed ‘Temporarily’ in June, Fitch Says, DSNews.com, July 12,
2010, available at http://dsnews.com/articles/cmbs.delinquencies-slowed-temporarily-in-june-fitch-says2010-07-12.
10
investors, also pursuant to provisions in these agreements. Servicers have little power to
modify the loan. If there is a significant risk of default by a borrower, the master servicers
are entitled and in most cases obligated to turn the loan to a “special” servicer. The special
servicer, whose actions are also governed by a pooling and servicing agreement (“servicing
agreement”), has different responsibilities, powers and compensation arrangements.
Notwithstanding the duty to administer distressed hotel loans in CMBS pools, special
servicers lack the contractual and legal authority and also the practical ability to fund the one
thing most hotels need most, substantial new money for capital improvements, repair and
maintenance. Hotels need to focus constant attention to these matters to maintain collateral
value in a highly competitive market. Due to the heavy usage by guests and visitors and the
need to meet the quality brand standards imposed by the brand management companies, lack
of current funding can be extremely damaging.
Also, as discussed above, highly distressed hotels will not generate cash flow to meet
debt service payments needed to keep debt service current. The impact of reduced cash flow
becomes even more complex in many of the highly structured “capital stacks” so often used
from 2003 to 2007. For example, when there are multiple levels of notes secured by a single
hotel, it is difficult to keep the senior secured bondholders (the “A Note” holders) current
much less the subordinate bondholders (the “B Note” holders). In these complex structures
the special servicer obligated to administer the loan documents may be placed under
conflicting demands by the multiple note holders, to the point of litigation over what actions
should be taken and when. Appraisal, which is key to determining which holders control
decisions, is a major area of dispute. Under virtually all pooling and servicing agreements,
key decisions rest with the “controlling class”, usually defined as the holders of the most
junior notes or interests outstanding in a CMBS pool, provided that the notes or interests
retain at least 25% of their face value determined pursuant to an appraisal procedure.
Important actions by special servicers require approval of the controlling class, subject to a
dispute mechanism between the controlling class and the special servicer that is rarely used.
When the securitized debt becomes the “A Note” and there are multiple levels of other
secured debt, there is normally an Intercreditor Agreement that similarly controls who
approves the actions of the special servicer among the various classes of notes (A Note, B
Note, etc.).
The paralyzing tension which can arise between the holders of different tranches of
bonds has become known as “tranche warfare”. Not only can “tranche warfare” take place
between the A Note and B Note, but also within the securitized A Note, where the pooling
and servicing agreement determines who approves actions on behalf of the A Note as
discussed above. A typical dispute finds the A Note bondholders desiring to foreclose, even
at a deep discount at today’s values; the B Note bondholders oppose prompt or any
foreclosure. This is because the funds from the foreclosure will flow first to the A Note
bondholders, and they will be repaid in substantial part, if not in full. The B Note
bondholders face immediate and total loss, and would like to extend if possible and for as
long as possible in hopes that values will rise, and they will get at least partial payment. Even
if the future loss is a total loss, the B Note bondholders may still delay recognition of the loss
(and additions to loan loss reserves if they are financial institutions) to that future date.
This tension among tranches of bondholders creates uncertainty for the special
servicers when determining the authority in their governing documents to restructure. The
conflict also creates well-founded fear of bondholder suits for any action the special servicers
11
take. Special servicers have their own financial exposures arising from the need to make
advances, pay costs of foreclosure, and incur other expenses which they did not fully
anticipate. The process of special servicing and the terms for pooling CMBS hotel loans have
repeatedly undercut restructuring and consensual workouts. With regard to hotels, the level
of frustration has become extremely high. It is probably fair to say that new money coming
into the market today looking for distressed hotels has special concerns in determining
whether CMBS and complex capital stack hotel loans are worth pursuing.
Institutional and conventional lenders have only come reluctantly to the table for long
term restructuring discussions in this downturn. Their main and sometimes only concern has
been whether the borrower can produce additional capital or an additional source of
repayment to assure full performance of debt service and funding obligations for the duration
of the negotiations. In the absence of such an assurance or more funds, there is immediate
action toward foreclosure even during negotiations. Even if the assurances are produced, the
negotiations are overwhelmingly unproductive.
Recently, with the perceived stabilization of values, institutional and conventional
lenders have become more approachable. But as those lenders turn their attention to their
hotel portfolios for serious restructuring discussions, they too discover additional problems.
Discussed below are several issues which we have seen arise in recent restructurings.
Because these result in part or whole from decisions made in creating and documenting hotel
loans, we deal with them on the assumption that these impediments to recovery of value and
resolution were not intended.
The Laws of Unintended Consequences
CMBS loan documentation of hotel loans grew out of the adaptation of
documentation used for more generic commercial real estate lending, often without use of an
actual loan agreement and without significant focus on remedies other than acceleration and
quick seizure of collateral. This was different from the documentation used by major hotel
lenders in the past, which provided for continuous monitoring, interim remedies and control
through operating and financial covenants, to the point that some loan agreements read like
sophisticated joint venture termsheets. For reasons beyond the scope of this article, lenders
and their counsel declined or failed to draw on those precedents.
Lenders
In this cycle, lenders making hotel loans that were not securitized and facing strong
competition and ever increasing prices relaxed the detail and rigor of their loan
documentation. In part this was inexperience of the lenders and their advisers, but it was also
due to competition from CMBS originators and other lenders chasing hotel deals. It was not
unusual for a borrower to take one lender’s draft document and require a competing lender to
agree to that document as well as to lower pricing or higher LTV and a cap on loan costs.
The lenders’ competition to provide low cost capital to buyers created a feeding frenzy that
pushed lenders to relax or forego risk management and underwriting standards; such
adjustments were perceived as necessary just to stay in the game. The lenders pointed to
CMBS practices as “safe” and to the CMBS market as an easy and assured exit for the lender
should the lender need to unload the asset. To a significant extent, complex hotel loans
originating with non-bank and Wall Street lenders embraced and took to new depths the
deterioration of underwriting in the securitization market.
12
Many of these loans, however, remain with the originating lenders, or the successors
who bought their failed portfolios. In these loan portfolios we now see lenders who accepted
non-recourse notes from single purpose bankruptcy remote entities (“SPE”) or their SPE
corporate parents. We see loans that mimicked CMBS documents in relying on “bad boy”
carve outs from the non-recourse provisions to prevent borrower bankruptcy. What we do
not see are tools to work with borrowers and to incentivize them to work with lenders.
Traditional hotel lending had learned that having an experienced, motivated borrower
working with the lender was the best route to value recovery; closure and/or foreclosure were
the worst.
Lenders in the last decade and CMBS originators focused on structuring their loan
documents for a quick resolution of defaulting loans. In the rating model, the length of time
from default to liquidation of the collateral was important. Because lenders had suffered
during the previous real estate downdraft in the early 1990’s through lengthy and expensive
litigation and borrower bankruptcy, they sought to penalize and discourage borrowers as
thoroughly as possible. Lenders saw speed as an absolute good and believed that they were
best served by a quick resolution--a deed in lieu of foreclosure or foreclosure itself. To avoid
protracted bankruptcy and bankruptcy defenses, loan documents required borrowers to be
SPEs and to accept very substantial penalties, such as carve outs from non-recourse
provisions and springing sponsor guaranties, if the borrower filed or was declared bankrupt.
Lockbox and other cash management protections were put in place to prevent the borrower
from using cash from the hotel. Lenders and their counsel appeared to compete for the most
draconian, immediate and absolute provisions for seizure of revenues and other assets. Few
lenders gave attention to what was actually necessary to maintaining collateral value and
operating a hotel business in distress conditions. Borrowers were not equally blind to the
risks. Rather, they made a more calculated assessment of the exposures, and treated the hotel
projects as closed end investments. If the market deteriorated, they understood that there
would be a point at which they would, and could, walk away, losing only their equity.
CMBS-style documentation has in fact encouraged and facilitated borrowers in
walking away from hotel loans. Borrowers are applying their knowledge and skills to their
own assets to conclude that there is no incentive to participate in any strategy that risks
breaching a “bad boy” covenant triggering full recourse. They also have no incentive to
invest more time, energy or capital if the investment fails to assure them a reasonable
recovery or compensation for staying the course. Why, given the continuing threat of full
recourse and open-ended demands for more collateral and absorption of shortfalls, would a
borrower with resources possibly want to find a new sponsor guaranty or put up new money
to fund debt service or operating shortfalls and recapitalize the borrower? It is much easier to
walk away, and buy a similar hotel asset in a new SPE without those complications. Both in
their original documentation and at the table in negotiation, lenders did not address this.
Equally, very few invested in increasing the number and quality of asset management staff to
the level necessary to administer the provisions of the loan documents that the lender would
need to do to deal with distressed hotels.
Lenders also appear to have misjudged the impact on hotel values in the most recent
downturn. Hotel workouts require patience, and an exit strategy. Banking and insurance
regulators require banks to increase their reserves and capital if they hold non-performing
loans. Lenders are strongly discouraged from retaining any failed loans that take substantial
time to resolve or require additional advances. Thus, lenders are not incentivized to work
13
with non-performing hotel loans unless they already have prudent reserves for hotel loans and
have adequate control over further shortfall funding obligations. For some time slow-motion
foreclosure rather than a real workout looked like a good option. But this strategy required
that the hotels generate cash flow to cover operations during foreclosure, and that at the end
of the process there would be a buyer prepared to pay a price equal at least to the loan’s face
value net of reserves. In the face of growing evidence that hotels had negative cash flow and
that such buyers did not exist for the majority of hotels being foreclosed, slow-motion
foreclosures could not, even in the short term, stave off write-downs and demands for more
reserves.
The result of this disintegration of values over the last two years has been that lenders
have become more motivated in more situations to sell loans quickly and at a substantial
discount to investors who will deal with their resolution. This makes the loss a one-time
event rather than a prolonged burden of increasing reserve requirements, which may attract
more criticism. Of course, rapid sale of non-performing loans brings greater notice of the
high volume of distressed hotels. Loans in default, with the risk, cost and delay of resolution
yet to come, also sell well below the anticipated future value of the same collateral after a
workout or foreclosure. The effect of this, and the high volume of loan defaults now
understood to be in the pipeline, is that loan purchasers cherry pick and require very deep
discounts from par to cover the uncertainties and expected profit. It is not surprising that
60% or greater losses are being reported for some classes of hotel loans which have been sold
or liquidated into REO.15 Into early 2010, this pricing had not been acceptable to many
lenders holding such loans. As more time goes by without resolution, with regulators and
investors increasingly questioning the adequacy of lender reserves, and as the economy
recovers slowly, the bid/ask pricing spread for distressed hotel loans will narrow. In fact that
trend is visible and accelerating as this article is being prepared.
Resolution of distressed hotel loans has also been adversely affected by some lenders’
decisions to entrench management companies through their loan documentation. This
entrenchment usually comes from agreements (usually tri-party agreements among the
borrower/owner, the lender, and the management company16) containing assurances that the
hotel management company would not be removed as manager of the hotel or the
management contract terminated in the event of a loan default or a sale of the hotel outright
or in a foreclosure transfer. Some provisions affirmatively obligate the lender to act to ensure
continuity of management and to provide funds to the management company. Other
provisions are worded as negative covenants undertaken by the lender which require the
lender to bind its successors, even if by foreclosure. Why non-disturbance provisions were
entered into or thought beneficial is often inexplicable. It may be that they were thought to
be simply a cost of the deal, being payment to the management companies for their informal
15
See supra, note 12; see also Reports for Quarters Ending Mar. 31, 2009; June 30, 2009, Sept. 30, 2009;
Dec. 31, 2009 and Mar. 31, 2010.
16
Other vehicles of entrenchment include, without limitation, self-operative terms in the management
agreement conditioning any grant of a mortgage, recordation of the management agreement or a memo
thereof in the land records, language in a collateral assignment of contracts, language in consents to
collateral pledges of agreements or personal property, estoppel certificates from the management
company, or untitled side letters. Entrenchment may also arise under state law by use of quiet enjoyment
language in the management agreement or agreements for operation.
14
support for the selection of the lender, or for the formal credit enhancement from the
management group to the lender. Whatever the reasons, hotel management companies were
allowed into the capital stack and guaranteed a pivotal position in any distress situation. This
had implications for the future that the loan originators did not recognize or chose to ignore.
The agreements entrenching management companies with non-disturbance
protections have proved especially troublesome. A management company indifferent to the
consequences of debt default is not strongly motivated to cut costs or modify operations to
preserve cash flow. In fact, such actions to limit expenditure often conflict with the
management group’s own interest in its own profitability. When this profitability is
threatened by the general economic downturn, the management company is motivated to
charge more costs to the hotel and more, not less, for the goods and services that it controls.
Management companies, like some servicers, may also see distress as a fee opportunity or a
chance to improve its positions vis à vis the owner. Thus, at the depth of the recession, we
continued to see capital calls, lavish new capital projects, and new brand standard demands,
with simultaneous offers to extend loans, waive standards, release reserves or make short
term concessions in exchange for material extensions of the term of management agreements,
waivers of unfavorable contract terms, and other benefits for management companies.
Entrenchment of management companies has made selling hotel or hotel loans more
difficult. The use of incentive fees to motivate and align the conduct of managers has turned
out to be illusory. The base fee is a percentage of total revenue, and the incentive fee is a
percentage of net operating income after debt service.17 However, since the manager gets
reimbursed for out of pocket expenses and an allocation of marketing costs and other services
provided to all the hotels it manages, the management company can make an acceptable
profit without any incentive fee paid. Thus, the management company is incentivized to have
as many hotels under management even if the owners are not getting an acceptable return on
investment. If the hotel is foreclosed or transferred, the manager stays on for the next owner
due to the non-disturbance provisions. The management companies have no incentive to
walk away or grant concessions; they just wait for the new owner and someone else (the
owner or lender) takes the loss.
If an asset comes with a management company in place, the basic cost structure may
be impossible to alter without drastic steps. The field of buyers will be much reduced,
leaving only those that will work with that management company and will accept its methods
and costs of operation, which have demonstrably produced a hotel unable to pay its debts.
Entrenchment leaves management companies with few or no incentives to contribute to any
restructuring. Having an existing management agreement in place makes repositioning the
hotel almost impossible, even if repositioning is the only way to restructure or raise new
investment for the asset. Buyers also fear the future implications of a continuing nondisturbance obligation. Although rating agencies apparently did not discount valuations on
hotels subject to non-disturbance obligations, current appraisals are clearly viewing such
obligations as a reason to discount value. Current appraisals appear to put a premium on the
legal ability to sell free and clear. Thus, by having the management company or its affiliate
17
It is often paid after a certain owner’s priority payment. In any case, in the recent downturn incentive
fees were deeply reduced from the intermediate term and managers turned elsewhere to increase their
revenues.
15
entrenched above the lender’s position in the capital stack, there are now three parties in
interest to appease; each with different priorities and goals. At least one – the management
company – may feel it has nothing to lose by refusing to agree.
Along with a lack of hands-on asset management staff with advanced hotel workout
expertise, lenders are suffering from a failure to have monitored their collateral and
compliance with the non-monetary terms of their loan documents. A surprising number of
lenders cannot locate revenues or bank accounts or had pledge provisions that did not track
the reality on the ground. These lenders seem not to have learned the basic principle of
checking the location and status of collateral before moving to enforce liens. Some lenders
and servicers left collateral in the hands of competing creditors, including the management
company, who now are disinclined to release it. We have seen problems with deficient
insurance coverage, or coverage premised on a mistake in who owns what.
One of the recurrent problems in enforcement seems to be the collision between what
the servicers assume they can do and what the local law requires an owner or employer to do
in regard to employees and vendors. This collision goes to the essential nature of a hotel as
an operating business, subject to labor laws, ERISA, WARN Act, collective bargaining
agreements, tax withholding and reporting, liens for goods and services used in operation,
and a host of other issues unfamiliar to generic real estate servicing. Some servicers are
now re-learning why experienced hotel lenders were careful not to sweep funds coming into
hotels or to take pledges of payroll accounts. None of these problems present novel or
unforeseeable issues. Lien and collateral defects should be fully indentified by servicers and
their attorneys before enforcement is confronted. As is usually the case, fresh eyes on a loan
file is a best practice, but a strikingly rare practice in this cycle for hotel loans.
Both lenders and management companies have been surprised to learn the utility and
sometimes the necessity of bankruptcy in working out hotel loans. The brand management
companies had focused on “buying” long term management contracts by their involvement in
development of hotels. The management companies invested money, made mezzanine loans
or gave credit support for financing to get management agreement concessions. These
concessions include the aforementioned non-disturbance provisions and protection against
termination by a test for low performance as the sole termination right of the owner/lender
exercisable only after a 3-5 year stabilization period. These performance tests were further
diluted by being two-pronged tests based on performance against budget and competitive set,
requiring failure of both prongs for consecutive years, and allowing multiple cure rights. All
of these conditions and limitations contributed to making the performance test virtually
impossible to fail. The brand management companies also required entrenchment for the
brand and required that the owner invest money in maintaining the hotel at the brand
standard. As competition among the brands increases, these requirements will lead to massive
requests for project improvement plans and ever increasing brand standard upgrades that
appear likely to outpace a slow recovery.
Management Companies
The unintended consequence for the brand management companies has been that,
notwithstanding the non-disturbance language in the tri-party agreements and favorable
language in their hotel management agreements, the managers have become viewed as major
impediments to workouts, restructures, and recapitalizations. Owners and lenders have
become painfully aware that the concessions granted to brand management companies during
16
boom times, have had disastrous unintended consequences in today’s major real estate
recession. Lenders and owners have used and are continuing to develop techniques to negate
the entrenchment of management agreements or to gain sufficient leverage to renegotiate
them. The brand management companies have responded with continuing efforts to enhance
and defend their entrenchment, such as by seeking to remove fiduciary and agency
obligations from their agreements and to grant broad rights of self-dealing and ability to
profit from their control of hotels.18
Beginning in the 1980’s, the line of Woolley19 and Woodley Road20 cases invoked
agency and fiduciary principles to terminate long term management agreements at will, and
then used evidence of breach of contract and fiduciary duty to establish that no termination
damages were payable. The use of bankruptcy to reject management agreements as
executory contracts does not require proof of agency, but bankruptcy relies upon the same
types of breaches to show that no rejection damages are owed. This continues to allow
borrowers who obtain the lenders’ waivers of the “bad boy” covenants to declare bankruptcy,
reject management agreements and restructure, sell or transfer the hotel free and clear of the
encumbrance of the management agreement. Breaches of obligations by a management
company can justify low or no compensation for the management company that has managed
a hotel that entered insolvency. The potential of bankruptcy to terminate management
contracts and facilitate restructuring leads lenders and borrowers to consider the use of semiprepackaged bankruptcy as the forum for restructuring. However, bankruptcy is a formidable
step for lenders, and many lenders fear a loss of control in bankruptcy, so lenders tend to
exhaust all options before looking seriously at granting the waivers necessary for a borrower
to undertake it. Management companies have also threatened claims against lenders for
efforts to work around non-disturbance provisions. Recourse to bankruptcy also leads to
increased public litigation of claims against management companies, because rejection
carries with it a need to litigate the estimated damages for early termination. Lenders may
not welcome such disputes. Long before a lender brings itself to make the decision to grant
waivers, the lender may have exhausted the willingness of a borrower to cooperate, or may
have convinced the borrower that the lender is not prepared to see the hotel through what can
be a challenging process. As a result, some hotel workouts are currently paused so that the
bankruptcy scenario can be explored more fully. Not all will proceed into bankruptcy.
In previous cycles, many lenders ultimately failed to move forward with bankruptcy
strategies. They instead sold their hotel loans to vulture investors prepared to partner with
borrowers in a bankruptcy strategy. The appearance of such investors in the hotel market
and their participation with borrowers generally indicates that we have entered into the
endgame of the restructuring cycle. Another indication of this stage is the apparently
18
This has gone as far as statutory enactments under state law. See, e.g., Md. Code Ann., Com. Law §23101 et seq.
19
See, e.g., Wooley v. Embassy Suites, Inc., 227 Cal. App.3d 1520, 278 Cal Rptr. 710 (Cal. Dist Ct. App.
1991); See also Pac. Landmark Hotel, Ltd. v. Marriott Hotels, Inc., 19 Cal. App 4th 615, 23 Cal. Rptr 2d
555 (Cal. Dist Ct. App. 1993); Gov’t Curr. Fund of the Republic of Finland v. Hyatt Corp., 95 F.3d 291
(3d Cir. 1996).
20
2660 Woodley Rd. Joint Venture v. ITT Sheraton Corp., No. Civ. A. 97-450 JJF, 1998 WL 1469541 (D.
Del. Feb. 4, 1998).
17
negotiated departure of management companies that had agreements entrenching them. The
acceptance of termination and departure by these management companies may indicate that
the potential consequences to the management companies of borrowers entering bankruptcy
have been brought out in negotiation.
Owners are also applying pressure to management companies to facilitate
restructuring. Owners are putting the manager’s actions under a microscope looking for
breaches of fiduciary duty and the duty of good faith and fair dealing. These claims may
focus on how the manager treats the hotel against all other hotels managed by manager or its
affiliates in steering reservations, allocating chain services and marketing, treatment of
employees and union contracts, and providing purchasing services.
Owners
Owners also find themselves having created impediments to resolving their own
problems by their own documentation decisions. Some owners focused on taking advantage
of cheap and plentiful credit to leverage up their portfolios. Even though they were paying
high prices for hotels based on very low cap rates and little or no due diligence, capital for
hotel investment was cheap and plentiful, especially for CMBS SPE borrowers, public hotel
companies and public hotel REIT’s. With lax lender underwriting, leverage was readily
available and bidding for hotels was fierce. An unsupportable price, highly leveraged with a
CMBS first lien followed by multiple tiers of secured and mezzanine debt, was the typical
structure of the overburdened hotel capital stack during the bubble. Some thought that to be a
player in the game you had to take on these risks. Also, speculative owners traditionally left
the management of their hotels to the “experts” with a short term horizon, also known as
pumping revenues for resale. Asset supervision was lax by many owners and lenders, and
even analysis by rating agencies was short term, unnuanced and model driven. These owners
falsely believed that using nominal incentive fees structures aligned the economic interests of
the brand manager and the owner sufficiently to provide the protections given up by diligent
or any supervision of management. Still, out in the market are the long-term owners who
made none these errors, and they are now quietly and rapidly accumulating new properties.
Lack and Poor Quality of Information
One surprising trend in this cycle has been the apparent deterioration of the basic
information about the market (especially future bookings) used by those in the market, at
least in their public statements. Restructuring discussions have been derailed repeatedly by
the parties’ receipt of new and different information, generally reporting downward changes
in projections, rate compression and news of new cash shortfalls. This has led some in the
market to the impression that the management company and those responsible for marketing
for the brand management companies did not have a good grasp on what was really going on
in the market or in their own hotels.
That impression would be wrong. In fact, there seem to have been very few surprises
for operators. The quantity and quality of information available inside the management
companies has been far greater in amount and better in quality than in past cycles. The real
causes for misleading market information seem to have included the intentionally slow
release of negative information, especially the failure to project forward known decreases in
rates and occupancy and the use of upwardly “adjusted” numbers in reporting to keep owners
and others “optimistic”. There has proven to be quite an eager audience for bad information
18
which conceals negative news and excuses the failure to make hard decisions. Reliable
information however is key to maximizing recovery and minimizing losses in restructuring.
The fact that hotels are being hard hit by reappraisals is part of this collision between a period
of pretence and the imposition of discipline, together with the uncertainties of
macroeconomics and its negative impact on corporate business.
Many hotel loans have been in or are now approaching default or loan maturity with
little attention from lenders and with little lender support for asset management efforts of
owners. In contrast to past cycles, lenders have much less capacity for internal assessment
and planning for complex strategies to recover value. Institutional and conventional lenders
who concentrated in hotel lending in past cycles made substantial investments in continuing
asset management. Many of these lenders were also investors in the same or similar projects.
They generally thought like owners and entered restructuring discussions able to comprehend
the owner’s position. Today’s lenders are only beginning to think like owners.
The bubble euphoria is over and the hangover is here for lenders. Owners are left
with hotels that are valued at less than the debt in place and with cash flow that is not
sufficient to meet operating expenses (especially after the escalating costs of brand standards)
and debt service. Some of the brand management companies have been or have been forced
to become understanding of the recession and their own risks. They have worked with
owners on capital expenditures, repair and maintenance and operations as owners seek to cut
costs to make ends meet. But the drop in revenues and values has been too much for too
long. Management companies, owners and lenders all wonder if the extend and pretend
mindset has run it course, but the conclusion would have different consequences and
significance to each of them.
Results of Unintended Consequences
The results from the unintended consequences of the actions of the lenders, owners
and managers leave us where we are today. Lenders do not want to foreclose and do not
want to advance new money to a hotel managed by a receiver. However, in many cases, their
loan documents are weak, and they do not have many options: either have a receiver
appointed to protect the asset while they try to work out the loan or make up their mind as to
a course of action (while the hotel continues to lose value), foreclose and deal with the hotel
and its manager and clean it up for sale, or sell the note and let someone else deal with the
problems. That some lenders describe themselves as waiting for the revival of CMBS
lending to hotels is not encouraging.
CMBS servicers are facing tranche warfare and the threat of bondholder suits if they
take action. They face the same dilemma as the lenders in deciding to extend the loan or
foreclose, but may have less flexibility in the actions they can take. CMBS special servicers
also face another limit that greatly exacerbates their problem. Even if an owner is willing and
able to advance additional funds, the CMBS lender for tax reasons is absolutely unable to
increase the loan - the one thing most likely to help.
Brand management companies have been pulled into the middle of these negotiations
because they may be seen as pivotal in completing or holding up a resolution. By seeking to
hold on to and benefit from the concessions they bargained for in the initial document
negotiations, brand managers are having their actions and documents carefully scrutinized in
hope for an owner/lender discovery that will lead to termination or leverage for renegotiation.
19
The management companies also risk making themselves targets for bankruptcy rejection and
having the pendulum swing back in favor of the owner/lender in document negotiation over
the longer term.
Owners are finding it very difficult to get long term relief or meaningful restructuring
accomplished without putting in new money or credit enhancement to recapitalize the
borrower. They have little contractual leverage with the brand management companies on
brand standards or management practices. The lax loan documentation and non-recourse
nature of many of the current hotel loans have allowed owners of hotels with loans in default
to consider giving the hotel back to the lender and stop paying operating shortfalls, but the
documentation does little to help them keep some ownership or recover their equity from the
hotels.
The New Normal in Hotel Transactions.
The “New Normal” in documenting new hotel transactions (including
recapitalizations, restructures, and workouts of legacy loans) will be the result of the interplay
of the decisions, actions and unintended consequences discussed above. Logically, lenders
will have the upper hand so long as there are relatively few new loans being made to hotel
owners, and lenders have many easier loans to make. At this time it is unclear if and when
there will be a significant resumption of CMBS lending to hotels.21 The argument against
applying the old CMBS rating models developed for real estate to what are essentially
complex operating businesses was strong even when the hotel loans were first being made
and pooled. The clear loss record of these loans should chill any resumption of the market
until structural changes are made and institutionalized.
Some of the New Normal will be temporary. Lenders who have required new money
or credit support to sit down and negotiate meaningful extensions or refinancings may need to
concede that they need negotiated modifications to recover value in the medium term.
Lenders who have required strong sponsors with good track records before beginning to
underwrite new loans may now have to become more comfortable with only the reassurance
of very low loan-to-value ratios. Management companies, which are no longer receiving the
concessions and entrenchment protections to which they had become accustomed, are
working to make the concessions extracted from them as short in duration and weak in
substance as possible. Some are using their group balance sheets as a weapon in fighting to
retain leverage in negotiation. And even in this market, there are hungry lenders who
continue to lend aggressively in making new loans and have a profound ability to convince
themselves and their advisers that old-style concessions make business sense. Some even
continue to use CMBS-style documentation as a “market standard”, and both lenders and
investors continue to see concessions to management companies as key to getting access to
deals.
More prudent lenders are scrubbing and plugging leaks in their documents, either as a
condition to any workout or in new papers for refinancings or new loans. Lenders are
21
Retail CMBS loans have an even higher default and loss ratio; however, that is caused by a dramatic over
supply of retail outlets, together with an Internet led change in buying habits. Hotels, for the most part,
have had less supply problems.
20
tightening financial covenants, such as loan to value and debt service coverage ratios. Many
lenders have withdrawn temporarily from the hotel sector. They are in some cases asking for
more frequent and thorough reporting from managers. We have only in limited instances seen
comprehensive rethinking of documentation and underwriting.
If I Had Only Known
At the end of each downturn in the hotel industry, lenders have returned to the
financing market thinking much more like hotel owners, which many lenders have become
involuntarily. Some investors will become lenders by choice, by their purchase of bad loans
with the specific intent to become owners in the future. Other investors will use market
conditions to acquire properties and will avoid previous errors. They are all operating on
their intuition and experience about what mistakes were made and what will help them better
achieve their goals going forward.
In our view, one of the most significant developments for the industry that could
come out of this recession would be a comprehensive statistical study of loss patterns and
identification of factors contributing to loss levels among hotel loans.
Such “failure
analysis” or “deep dive” reviews have long been routine among investment fund managers
and institutional investors, and are important decision-making tools. Such studies are much
needed for the hotel industry to return to a firm investment foundation. Ratings agencies
have proven themselves unable or unwilling to conduct such analyses, perhaps because the
studies would illuminate the dangerous lapses of past underwriting. We have described
below some changes which are now becoming visible in the hotel industry. Whether they are
the right changes or will be long term in their adoption remains to be determined.
More Equity and More Recourse Demanded from Borrowers
As in prior downturns, lenders with relatively expensive and conservatively
underwritten loans have continued in, or come back into, the market in the recovery cycle.
There has been an unprecedented level of all-equity hotel transactions in this recession, but
new loans have also been made. The typical new loan has been for a low loan-to-value ratio
(perhaps 50%) using a conservative valuation. The typical borrower has been a REIT
subsidiary with recourse payment guarantees or credit enhancement from the REIT parent.
The properties have generally been well-established and in stable markets without a history
of rapid price escalation or overdevelopment in the last decade. Many REITs continue to
have access to relatively inexpensive equity and little parent-level debt, making the low loanto-value ratio acceptable to them and in line with their normal investment pattern.
The lenders now coming into the market are also cherry picking the lending
opportunities for the strongest guarantors and lowest loan-to-value opportunities. The
structures of these loans bypass the problems created by SPE borrowers using relatively high
leverage, but the structure works only for a small number of borrowers. Such loans do not
offer much hope for refinancing of existing loans for borrowers with higher levels of debt or
with a business model that does not support recourse payment guarantees. In other words,
an SPE borrower with a typical pre-recession level of debt will find no comfort in the offer of
such a conservative loan, which would require a significant paydown of the debt to refinance.
Increased capitalization rates make raising equity even less feasible. A major wave of such
hotel loan maturities is imminent and a large number of hotels are coming out of foreclosures,
deeds in lieu and other liquidations of debt; all of these will compete for new loans. If only
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low loan-to-value loans are available with a requirement of recourse to more equity or a
guarantor, hotel values will have to be written down much more. The probable consequence
of the New Normal will be much lower values for hotels compared to their values in 2007.
And that strongly suggests more hotels will become insolvent before the cycle resolves itself.
Market Related Segmentation
This recession has, at least temporarily, opened chasms in hotel pricing and lending
based upon market demographics. Large economically vibrant metropolitan areas have seen
significant increases in demand and some increase in rate. The disparity between the “have”
and “have not” markets looks poised to increase. The economically afflicted markets may
continue to move sideways for years until they regain some measure of increased economic
activity. Some rust belt areas may never fully recover. New hotels and investment will
concentrate in stronger markets. The luxury segment will take a long time to recover due to
rate compression and the ability to buy luxury hotels at a fraction of their replacement cost.
Many luxury hotels may permanently become merely upscale hotels as they lack the ability to
command the higher rates their initial costs and operating expenses required. If a luxury
hotel had a 40-50% effective rate decrease, it requires a 66 2/3% to 100% increase from its
reduced rates to get back to its original projections. That is not foreseeable in the immediate
future and increased fixed costs, as discussed previously, make these luxury hotels an even
greater risk.
Re-Aligning Management and Franchise with Debt Performance and Exit Strategy
Lenders are returning to the market to make new loans that do not include nondisturbance protections for management companies. Elimination of non-disturbance is
intended to re-align the management company’s interest with the lender’s goals by requiring
the hotel to be operated profitably enough to allow refinancing. If debt cannot be refinanced
at maturity, the management company will not be entitled to remain in place. Based on
experiences in this and prior cycles, there are senior lending officers who believe that nondisturbance protections materially increase loan losses. Some of these officers held back
from lending and investment in what they saw as a fundamentally irrational market. They are
now preparing to return to the market if they are able to obtain different underwriting terms.
Investors who have survived the cycle intact or educated by the failures in their portfolios
have also refocused on the alignment or lack of alignment of their interests with the
companies that are managing their properties. Many believe that alignment of interest is key
to any successful outcome.
Our practical experience suggests that these lenders and investors are correct.
Alignment of interest has been enormously important to survival in this cycle. Where
management companies were exposed to risk of termination, much more was done to
minimize the risk of loan default, it was done earlier in the cycle, and what was done was
more effective.
Accounting, Reporting and Transparency
Owners, lenders and their asset managers had concern about the quality and
completeness of financial information from hotels before this downturn, but their complaints
were muted while owners paid and lenders financed record prices for hotel assets. Rating
agencies had developed a bias against rating pools containing large numbers of hotels loans
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before the recession, based on failures to anticipate losses. But that information was not
much noticed as financing was generously available from Lehman (one of the largest holders
of hotel loans and investments) and other non-bank lenders.
Disputes over information seem to have a role in most distressed hotel loans now
drifting into litigation. The slow recovery cycle for hotels tends to push disputes to and past
the last phases of the general real estate recovery. Lawsuits are beginning to emerge from
this cycle, and others are progressing in the background. It is clear even now that we are
going to see many cases in which accounting, failure of audit, and self-dealing by
management companies will be major themes. It is also likely that we will see attacks on
chainwide practices and the effect of escalating efforts to transfer costs from management
companies to hotel owners. We also expect that the investment side of the industry will
bring pressure to bear for changes in accounting standards and audit practices. To the extent
that large final losses are likely to appear in SEC-regulated CMBS lending, securities claims
can be anticipated, although they have been rare to date. Hotel investment has repeatedly
moved into the public markets and become embroiled in securities and investment claims.
These are among the slowest of hotel disputes to work through the courts.22
In deals being made now, we are already seeing much more attention to the basics of
accountability and access to information. This is an area in which we can expect claims
against professional firms and advisors to be made, as well as claims for accounting and
books and records. Life is clearly being breathed back into the implied covenants of good
faith and fair dealing over truthfulness in accounts.
Standard of Obligation of Managers
Owners are coming to understand what their waivers of agency will ultimately cost
them. Owners are being denied access to information, subjected to self-dealing transactions,
and hearing straightforward refusals to act for the profitability of their hotels, all from
management companies who assert that they are not agents or fiduciaries. Some owners
have been unable to obtain information that their loan documents require them to deliver to
their lenders, and have experienced direct refusals by management companies to answer
questions about their business. Management companies have defended these refusals with
some success against owners, but lenders as potential or involuntary owners seem likely to be
much more effective in obtaining answers.
Management agreements that waived agency or fiduciary duty generally failed to
preserve the rights of owners and lenders in many important ways. Their counsel did not add
back the express obligations of access, accountability, loyalty, and communication that
owners assumed that they would retain. Although many management teams have worked and
communicated cooperatively with owners, some notably have not. New loan and
management agreements will need much more attention to these issues, and those drafting
22
One of the longest playing of such disputes involved class actions claims involving syndication of
investments in early pools of Courtyard hotels. Those disputes arose from the use of limited partnerships
to finance and own Courtyard hotels in the 1980’s and continued to be litigated until settlement of
litigation and a tender offer to buy in interests of the plaintiffs were announced by SEC filings in 2000.
Some of the issues raised in those cases continue to arise in new hotel investments.
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and negotiating the documents will need a broader acquaintance with the issues than they
appear to have brought to existing agreements.
In regard to this issue of accountability, there has developed particular resistance
among sophisticated investors and their legal counsel to the selection of the law of Maryland.
Maryland law by special enactments has special provisions uniquely favorable to hotel
management companies.23 We expect to see Maryland more systematically rejected as a
choice of law or the further development of the term “good faith and fair dealing” under the
recent Maryland law changes. There are so many opportunities for self dealing in hotels -including in union agreements, reimbursements for workers’ compensation, handling of
insurance claims, purchasing discounts or creating benefits solely for the management
company and loading of manager overhead into reimbursements, and courts need to at least
permit discovery in these areas. This is critically true of international management
companies which can easily and intentionally obfuscate the actual implementation of
systematic changes under both management and franchise agreements.
It may be that there will be a reemphasis on the selection of New York law. New
York’s senior trial court, known as the Commercial Part of the New York Supreme Court,
has become a frequent and convenient forum for hotel contract disputes. The federal
bankruptcy court in New York’s Southern District has also developed an experienced bench
for hotel insolvencies. Another jurisdiction likely to continue to develop hotel law is
California, due to the sheer volume of hotel failures there.
Arbitration
Litigation counsel for owners are becoming passionate in their distaste for arbitration.
Owners, and lenders who have become owners, are experiencing the practical application of
arbitration clauses in management agreements which they signed or which they accepted as
collateral. Their experience has not been positive in regard to speed, process and outcome of
arbitration. The outcome has been particularly negative in regard to disputes over timesensitive issues of cost reduction and budgetary problems likely to lead to debt default.
In practice, arbitration has also discouraged good faith engagement by management
companies in practical resolution of disputes by negotiation. Arbitration has instead
encouraged management companies to push disputes to the point of breakdown, in the
apparent belief by them that arbitration is likely to be an ineffective forum for the owner and
will protect the management companies from public observation and the risk of unfavorable
precedent. As investors and lenders come into new deals, we expect the more experienced
among them to insist on retaining the remedies of litigation to avoid repetition of their bad
experiences. So long as the lenders and buyers are in a position to pick and choose, and
perhaps longer if underwriting criteria become more formalized, arbitration may be a litmus
test for which management agreements will and will not be acceptable.
23
Supra, note 18.
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Performance-Based Termination Standard
Performance tests which require both a minimum cash flow and a comparison of
performance to a competitive set of other hotels have proven extremely difficult to enforce.
This is part of why so-called “two prong” tests are ineffective in practice to control
management companies and to remove those who are not working to meet debt service
requirements and maximize profits for the owner. Such performance tests, when combined
with non-disturbance provisions, are disincentives and work against profitability. Owners
and lenders are also discovering that, contrary to their assumptions, not “everyone” agreed to
such standards. Those owners and lenders who had the benefit of one-year minimum cash
flow-only tests of performance appear to be enjoying a higher survival rate in this recession.
As a result, some investors and lenders will seek at-will termination rights and cash flow-only
performance standards as necessary inducements to take on new and restructuring hotels. In
this, it will not be the New Normal. It will be a reestablishment of what has historically
served best the most successful investors and lenders.
CAVEAT
Unfortunately, the reality of what is happening today in the market place is that the
past is becoming prologue. As relatively few healthy or trophy hotels come on the market
due to the forces described above, the perceived competition for the few desirable hotels
available in major gateway cities has been increasing. The trend for lenders to relax the New
Normal for these few deals has been accelerating. We already see financial covenants
loosening and owners/lenders agreeing to concessions just to get “just this one deal” done.
We see the same willful lowering of prudent standards among lenders and servicers seeking
restructurings that will stave off further additions to loan loss reserves and require
management companies’ consent or concessions.
The test for the New Normal is when the supply of hotels begins to exceed the real
demand. Can and will lenders and investors say no to fundamentally unsound underwriting
practices? If this lax lending and short-focus investment expand as the economy and hotel
industry continue to recover, history may repeat itself. We have not yet, however, faced the
real dimension of the losses in hotel loans and investments. Most lenders are still on the
sidelines, and CMBS originations for hotel debt is still non-existent. The key to the New
Normal will be the permanent realignment of the interests of the investor/owner, the lender
and the brand manager, reflecting the requirements of all of them as investors and lenders
come back into the hotel capital stack on terms reasonable in light of their actual risks.
Where the realignment settles will have much to do with the level of insight and willingness
of professional advisers to challenge the unthinking assumptions and “everybody does it”
attitude that infected hotel documentation, just as similar assumptions and attitudes did in the
wider commercial lending market.
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