Wave of 'Physical Distress' Still to Come

Jan 11, 2011 7:43 AM, By Eric Stoessel, Lodging Hospitality Managing Editor

While hotel transactions have increased from a trickle to a steady stream in recent months, not everyone is feeling the flow. Trophy assets in gateway cities are trading at pre-recession prices, while many distressed assets continue to languish.

Meanwhile, a new wave of physically distressed properties is emerging. Many owners are being forced to deal with significant property improvement plans that were neglected during the downturn, says veteran hotel broker Bob Hunter.

Jones Lang LaSalle Hotels estimates last year's hotel transaction volume reached $10.5 billion in the Americas, up fivefold from an anemic $2.1 billion showing in 2009. The hotel investment services firm, which tracks asset sales $10 million and higher, forecasts the volume to reach $13 billion this year. The U.S. market is expected to be one of the most active globally.

Hunter, the CEO of Hunter Realty Associates, and Teague, his son and the firm's president, believe the bid-ask gap has narrowed significantly and more transactions will follow this year and next.

Founded in 1978 by Bob Hunter, the Atlanta-based national hotel brokerage firm now has offices in seven locations across the country. The firm also hosts one of the longest running hotel investment conferences each year in Atlanta. The 23^rd annual Hunter Conference is slated for March 6-8 at the Atlanta Marriott Marquis.

The duo recently sat down with Lodging Hospitality magazine to discuss the bifurcation of the transaction market and the state of hotel distress.

Bob Hunter

Stoessel: How do you define hotel distress?

Bob: There's operational distress - where there's bad ADR (average daily rate) and bad occupancy - and you can't operate efficiently with that. The other side is financial distress. If you've got a nice hotel, a good brand, but you bought at the peak and financed the asset at 95% [loan-to-value] and it's no longer worth its mortgage or the mortgage payment is so high, it's hard to pay.

Stoessel: Which form of distress are you seeing more of in the market?

Bob: The reality is we're looking at that second wave. The first wave was when lenders were doing "delay and pray." Their prayers were answered in some ways because some value has come back. The property that was worth $10 million went down to $5 million and came back to $8 million. The magnitude of the distress is much less now.

Meanwhile, five-year loans made at the height of the market are now coming due. We survived that first wave of operational distress. The lender didn't foreclose, and the sun is coming out again. Now it's,"Hey, Mr. Lender, I don't have the $8.5 million coming due on that mortgage." In the past, there was a lender out there to refinance and give you the $8.5 million and pay off the first guy. But you turn around now, and there's no lender.

Teague Hunter

Teague: We used to say any of the hotels built, bought or refinanced in 2006, 2007 and 2008 were underwater. It's probably not 100% anymore because some have worked their way out.

Stoessel: Are there more problems lurking?

Bob: There's a whole new category of distress coming - physical distress. You had many seven-year-old properties due for renovations when the economic storm hit. They had no money, and the franchise company wasn't as demanding. So for three years they deferred maintenance and held on, laid off staff and now the property is physically distressed.

As performance starts to improve, the franchisor starts saying, "OK guys, you'll start having money to catch up. Here's a great big PIP (property improvement plan). So the owner wants to sell the $10 million property now worth $8 million and with a $2 million PIP.

Back in the heyday, the buyer would pay the PIP. But today, the buyer is going to subtract that and have $6 million in the purchase price and $2 million in the PIP. So there's $8 million, but the seller doesn't get it all. People are starting to realize the PIP is going to have to be dealt with.

Stoessel: What's going to happen to the wave of owners facing financial distress because their loans are coming due?

Bob: The existing lender has to do something, and we think more of them will start exercising their rights to take over the properties now that they see they can get out without taking a big hit.

Stoessel: Are owners gaining confidence too, and will that lead to more transactions?

Bob: We're seeing it happen at the low end (economy segment) where the numbers are smaller. There are also buyers for top-end properties in cities like Manhattan, for trophy properties and for the better brands like Hilton and Marriott. Cash buyers are buying in the top markets and [Small Business Administration] loans and some conventional banks are helping at the bottom, but the midmarket hasn't figured out the answer yet.

Stoessel: What do you tell an owner who needs to sell something in between the 300-room trophy asset and the 60-room motel?

Bob: The truth is, if you don't really need to sell, don't. If you've got a Hilton or Marriott property, it's a great time to sell. There are buyers that will pay cash for them. At the bottom, we can get financing through the SBA. It's the middle where you can't get financing, so it's hard to sell anything.

Teague: There are "haves" and "have-nots." If you're a "have," now is a great time to sell because your value has maintained and there are large equity funds sitting on the sidelines that would love to buy your quality, performing asset in a top market. For the "have-nots," the values are pretty weak and we don't see that changing soon.

Stoessel: Are buyers starting to look beyond trophy assets as those prices keep rising?

Teague: A trickle down is happening some, but how quickly and how far? We've got a long way to go. The prices in the top eight markets are very expensive, so people are starting to look outside those markets. But it still has to be a quality product, quality brand and it must be performing.

Bob: If a buyer's desire was a top eight market, now maybe it's the top 25. But I don't see buyers looking at lower-quality products. It doesn't have to be a trophy property in Manhattan. A nice Courtyard or Hilton Garden Inn can be good.

Teague: It's the bifurcation of the market: REITville and reality. It's Wall Street and Main Street. And Wall Street has the money, so anything institutional grade that meets the quality of what Wall Street will buy holds value. If it's not institutional grade, there's a big drop in value.

Stoessel: What will it take to reverse those valuation trends?

Teague: We're off the bottom, the future is strong, and if we feel good everyone will start making decisions. It's people traveling, better occupancy, higher rates and better performance. Lenders will feel more comfortable and we need them back at the table.All of this is happening, just slowly.

Stoessel: Is there a better consensus on values now?

Bob: It's the psychology of it all. The RTC (Resolution Trust Corp.) set the level of expectation in the early 1990s. Values were about 40 cents on the dollar. There was no rule or law, it's just what happened.

This time people thought history would repeat itself, so a $10 million property would sell for $4 million. It didn't and banks didn't foreclose, so there was no rush of properties. Sellers couldn't sell for $4 million and buyers wanted it for $4 million.

Fast forward to now, and buyers aren't expecting to repeat RTC discounts, and they have this huge amount of cash and haven't done anything with it. They've started getting aggressive and said let's buy at 80% [of peak value].

Teague: And the seller will sell at 80%. The bid-ask gap is fairly narrow. Everyone is accepting that reality. In 2009 and 2010, we were the messengers that had to tell people their values were off 50%. Today we're not the messenger. Now they show up and say, "Let's make it happen, we know where reality is."

Stoessel: Are there deals out there for distressed buyers, and what advice would you have for them?

Teague: My advice is to figure out your strategy. Are you a distressed buyer? If you have to buy cheaply, understand what you're going to buy is what no one else wants. If you want a great product, be willing to pay for it and hope your strategy of buying at 80 cents [on the dollar] is fair value and go out and buy. But if your strategy is to buy quality product at distressed pricing, you're wasting your time. If you want it, odds are someone else does too.

Stoessel: What advice can you offer a distressed seller?

Bob: Reality has set in for them. For the guy who wants to sell for more than it's worth, we can give them a handle on its value better now than we could 18 months ago. But then they have to decide what to do.

Stoessel: Has the hotel business changed any as a result of this downturn?

Teague: Some of those higher-quality assets trading, the Hiltons and Marriotts, the owners were family founders, people who put together nice businesses in the 1990s and 2000s and had five to 30 assets. When you talked to those guys during the heyday and asked what their exit strategy was, they said. "What exit strategy? We don't sell, ever. We accumulate and grow the company."

Ask them today, and they say, "Let's talk, what do you have for me?" They didn't like the downturn, cutting payroll and getting calls from their banks. Now we can provide them with an exit by matching them up with Wall Street.

Stoessel: Are these owner/operators getting out of the industry for good?

Teague: They'll take the proceeds, recapitalize and take that equity and go build, but not as hoteliers. They're manufacturers and their customer is Wall Street. They'll build what Wall Street wants - select-service Hiltons and Marriotts in top 25 markets - and then sell. They'll try to maintain management to keep the income stream coming. It's a fairly fundamental change.