Global Hospitality Advisor: National Implications of the July 2010 Atlas Hospitality Group Distressed Hotels Survey

ess than two weeks after the quarter's end, Atlas Hospitality has released its California Distressed Hotels Survey (2nd Quarter 2010).

Here is our executive summary of that report, our view of its national implications and what we think it means for owners, lenders and investors.

The Atlas Surveys -- background.

Atlas Hospitality Group specializes in the sale of California hotels. It was founded by Alan X. Reay in 1997. Since its inception, Atlas has sold more hotels in the state than any other brokerage firm. Atlas tracks every hotel in California. Their surveys covers only California hotel deals, but we believe it is reflective of consistent national trends.

Executive Summary of Atlas Survey - hotel defaults and foreclosures

The Atlas Survey released July 14, 2010 focused on the number of hotels in default or foreclosed. Details of NODs, foreclosures and REO are calculated on a county-by-county basis in the report, but as an overview, we can say that they all continued to escalate through the second quarter.

Atlas Survey highlights disclose:

• 478 California hotels are in default or have been foreclosed on, an 18% increase from the 1st quarter 2010 and 132% over the 2nd quarter of 2009. 
• The number of foreclosed hotels increased 27% from the 1st quarter, from 79 to 100. 
• The total number of hotel rooms foreclosed on was at 7,560, up 255% from the same period in 2009. 
• The largest hotel to be foreclosed on was the 512-room Holiday Inn in San Jose. 
• 78% of the hotels foreclosed on were independent properties, down from 90% in the 1st quarter 2010. 
• Riverside County led in the number of foreclosed hotels with eleven which was 11% of the total. San Bernardino County followed with nine and Los Angeles County had eight. 

Alan Reay says, "The California hotel market continues to experience a high level of distress as the pace of defaults and foreclosures has continued to accelerate through the 2nd quarter."

He finds it particularly significant that of the 100 hotels that had been foreclosed on, only 12 (12%) had been resold to new investors.

Although recently there has finally been some positive news for the hotel industry in terms of increased occupancies and possibly even some slight movement in average daily rate (ADR), Reay says that there is still a lot of pain in the market.

He tells us, "We estimate that there is a huge backlog of distressed California hotels -- with more than 1,000 hotels operating under some form of forbearance agreement."

National implications of the California hotel foreclosure data for other U.S. markets

California, Texas, and Florida have approximately 30% of all commercial real estate loan delinquencies today, and the top 10 states have 60% of the loan delinquencies. California has about 13% of all CMBS loan delinquencies, and by May 2010 hotel delinquencies were more than 12.5%.

As Atlas tells us that 75% of all hotels in California (and the rest of the U.S.) were financed or refinanced in the 2005-2007 period, they have no equity left, may not be covering operating costs and likely will not recover their peak values until 2015-2016.

If Atlas is right that 2,500 California hotels -- from economy to luxury -- are under water, there must be double or triple that number in the United States, perhaps approaching 10,000 hotels which have no equity, and struggle to cover debt service, or even operating costs.

What conclusions does Reay draw from this Survey data?

When I asked Alan Reay what this means, he had two answers.

First, we have a 10 year supply of hotels on the market at the present absorption rate -- and that assumes no other hotels are put on the market, which Alan thinks is "highly unlikely."

Second, unless you are prepared for a fairly long term hold -- say 3 to 5 years -- "a hard present value analysis is likely to show that you are better off selling today at a realistic market price." The alternative may be feeding a negative cash flow beast and waiting for a long time for value recovery." 

Reay says, "If you don't like the market price today, you are really not going to like it in 12 to 18 months from now." Basically, Alan sees that sellers have been looking for "yesterday's prices" and by the time they reconcile themselves to the price they were offered 6 months ago, that is not longer achievable.

What does this all mean?

Cash flows for all will be slower to improve, values will lag, and expenses will escalate quickly. All players will be affected by the new reality. By all accounts, including the Federal Reserve, the U.S. economy will recover more slowly than anticipated, with it potentially taking 5-6 years to get back to "normal" if we don't have a recession before we reach that milestone.

NOI and available cash will be threatened by:

• Big capital expenditures required to maintain properties starved for cash the past few years while in survival mode - they can't be deferred much longer. 
• Restoring big "survival mode" operating costs cuts - payrolls were slashed by an average of 22% in all hotels in the U.S., and general operating costs were by 18%. Like holding your breath under water, these survival measures simply cannot be maintained too long. 
• New costs and increases in costs created by re-regulation of ADA compliance, DOL audits on all federal wage and employment matters, increased interest costs as world governments, banks and major corporations try to refinance more than $10 trillion in debt in the next few years, and increased taxes to pay for all the programs we have adopted. 

In practical terms, this means:

• If you are a lender, watch your assets carefully. You may have rolled a maturity, but any hotel financed between 2005 through 2007 probably has no equity, and it is going to take years for the situation to improve. So when you calculate the present value of your alternatives, think about all the above factors that push improved cash flows significantly further into the future, while adding significant cash flows in the near future for CapEx, negative cash flow, higher interest rates, more taxes and big compliance expenses for ADA, DOL, and a continuing stream of expensive regulatory requirements.
  Don't be caught by surprise when a borrower gives back the keys and tells you payroll is due Friday (and there is no money in the operating account to pay it).

• If you are a borrower, what are your options? Are you feeding a negative cash flow beast? Do you have the capital to withstand a much longer recovery time than anticipated and the increased costs that you will soon be facing? Is there a positive ROI on your continued investment, or are you throwing good money after bad?
• As a lender or note holder, what is your investment horizon or time schedule? If it is short, sell or foreclose (and sell) now -- before further price deteriorations. If it is longer, and you have the capital and stamina, re-calculate your IRR with realistic new assumptions on all your cash flows. Get some good advisors to help you plot the strategy to survive and thrive.

What do the hotel lawyers at JMBM's Global Hospitality Group® advise?

Do the math yourself! Run a present value analysis of likely cash flows on 3 alternate scenarios. Decide whether you have the stamina and capital for a long haul if you intend to hold. Or decide that you are a gambler.

Be realistic. And if you are going to be a seller, then sell quickly. Many experts see values continuing to decline until at least 2011. Some think values recover peak levels by 2014 . . . or more likely 2015-2016 . . . and others think recovery to 2007 levels is TWO real estate cycles from now (given that a typical hotel cycle lasts 7 to 8 years, this could possibly be 10 to 16 years, i.e. 2019 to 2025).

We would be happy to help you evaluate your options and develop the best plan from here.

If you would like to speak directly with Alan Reay about the Atlas Surveys or get a copy of them, he can be reached at (949) 622-3409, alan@atlashospitality.com or www.atlashospitality.com. You are also welcome to contact me at jbutler@jmbm.com.

This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We've done more than $50 billion of hotel transactions and more than 100 hotel mixed-used deals in the last 5 years alone. Who's your hotel lawyer?


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