Surviving the Deleveraging Storm
By Jim Burr, CHA
Jim Burr, a graduate of Cornell University’s School of Hotel Administration and a member of Cayuga Hospitality Advisors, has more than 40 years hospitality industry experience, including asset management of more than $900 million of hotels, single and multi-unit hotel management, franchise operations and strategies, consulting at the Principal level, organization development and planning, and control systems development and installation. He is now the principal of Burr Company specializing in Asset Management, Strategy Development, Due Diligence, and Workouts of Troubled Properties for a variety of hospitality industry firms. He is also the Group Leader for Cayuga’s Distressed Properties group.
If the grimmest of the prognosticators turn out to be correct, the old fundamentals probably are not going to work for a while. Scarce availability of financing, reduced loan to value requirements, tighter loan terms and higher interest rates are combining to substantially reduce hotel values. Using the mortgage/equity approach to underwriting, it is not difficult to predict that, if everything else stays the same, a hotel financed with 75% debt a few years back may qualify for perhaps 60% of the original loan amount when the note comes due. Then factor in a drop in NOI because of market conditions and it is easy to understand why some experts are forecasting reduction in hotel values of up to 50%.
As CMBS and other term notes come due in 2010, 2011 and 2012, hotel owners and hotel lenders could face a host of disagreeable choices:
The Hotel Owner may need to consider:
- Raising more equity
- Replacing a part of the debt with high-cost mezzanine financing
- Renegotiating and substantially reducing the amount of debt
- Entering bankruptcy, either voluntarily or involuntarily
- Providing the lender with a deed in lieu of foreclosure
- Other alternatives
The Hotel Lender, who could be facing major losses, would look to mitigate them. His options could include:
- Restructuring the loan and leaving the facility and debtor in place
- Foreclosing on the loan and eventually selling the property. Before
the sale:
- Keeping existing management and brand
- Securing appointment of a receiver
- Replacing management and or rebranding
- Demolishing or marketing the land value
- Converting to alternate use
- Pursuing other actions
In choosing the course to pursue, the lender needs to consider several variables, mostly in areas in which he will not be an expert, including the property condition and location, market potentials and the hotel’s competitive position and a “highest and best use” determination for the asset. If the best use of the asset is to remain as a hotel, then what immediate actions should be undertaken to limit losses by increasing revenue and/or reducing costs? What are the opportunities to add value?
The workout of a troubled hotel loan needs careful study and analysis. A strategic review must cover all the bases, as a miss could lead to invalidation of the determined action plan. The assessment needs to encompass the following major areas:
Financial Review:
A straightforward approach to include a summary of the loan terms, any payments past due, the resources available to the borrower and an updated financial proforma – to be based on a current business reforecast, not the now outdated annual budget - to decide the debtor’s ability to repay.
Property Condition Review:
The first phase of the property condition review, perhaps best performed by a specialist engineering firm, consists of a physical inspection and evaluation to assure ADA compliance and that the HVAC, plumbing and electrical systems as well as roofs and major mechanical equipment are in satisfactory condition. The purpose is to be certain that there are no immediate problems that need correction and that any near-term fixes necessary are identified and costed.
The second phase is assuring compliance with franchise brand standards via a review of the most recent property inspection report. The consultant will also need to determine the status of any property improvement plans (PIP).
The final phase is an assessment of the appearance and condition of the guest rooms, the exterior, grounds and public areas of the property compared to its direct competitors. If the subject hotel is inferior, the occupancy level and rates it can command are likely to be substandard as well.
Market Potentials and Hotel Competitive Position Review:
Almost anyone with access to Smith Travel Research data can prepare a hotel market study. But an experienced consultant with a track record in this field is needed to assure that: (1) the competitive set for the subject hotel is actually the right competitive set; (2) the property’s performance within that set, as expressed in penetration of occupancy and average rate, by market segment and RevPAR levels, accurately reflects its position in the market and (3) that potential growth in area demand generators and competitive supply is weighed against the physical location and the strengths and weaknesses of the hotel to develop the most likely forecast of the property’s potential. Occupancy, average rate and RevPAR should be estimated for at least the next five years.
Highest and Best Use Determination:
Should the property remain a hotel, and if so, should it keep its current brand? Part of the answer to these questions will be clear when the property condition and market reviews are finished. But it may be necessary to bring in an appraiser or to talk with the local economic development or planning agency. A proforma showing expected hotel net operating income, after normal and any extraordinary capital replacements, should be compared to the cash flow foreseeable from other potential uses to make this determination.
The recent announcement that the Century Plaza Hotel in Los Angeles is to be razed to make way for two high-rise condominium towers proves that the highest and best use may not always be a hotel, even in the 2009 economy. In prior cycles, hotels have been demolished to be replaced by shopping centers, condominium developments, mixed-use projects and even newer, larger and more vertical hotels.
If the hotel’s location is no longer strong; if the market it is competing in is weak or if physical property issues are too severe, alternative uses may need to be considered. If the brand affiliation is not adding sufficient value, rebranding may be appropriate. Or, it may be workable for the hotel to become unbranded. If the existing flag is no longer a good fit with the property and its market potential, a new, either down- or up-market brand might produce more revenue. Keep in mind that large changeover costs may be incurred; besides new signage, logo items and property management system, most franchisors will look for liquidated damages if the license is surrendered before the end of the franchise term.
Immediate Actions to Reduce Losses
In perhaps most cases, the highest and best use will continue to be a hotel and the brand and management company now in place will be considered suitable for the future. If so, immediate actions should be undertaken to reduce losses. A host of these have been identified from past cycles, and recent developments have provided other opportunities. In considering areas where costs can be cut, it is important to remember that the hotel guest experience should not be noticeably reduced because other hotels in the market, whether troubled or not, are aggressively competing for the same business. If service is greatly cut or property physical condition is allowed to deteriorate, customers are likely to go elsewhere and 100% of the revenue formerly produced by their business will be lost.
Happy hotel staff is a key to customer satisfaction, and preserving a favorable environment in times of a sharp reduction in business levels is a major challenge for the general manager. Reorganization and layoffs are unavoidable, but these should be completed with as much openness and decisiveness as possible. Ongoing communication with the staff is critical and actions to celebrate success, when achieved, are important. With the specter of Employee Free Choice Act (“card check”) legislation, which would cause easier hotel unionization, managers need to be especially careful to keep a positive work environment. If they do not, union organizers could soon be in the hotel executive office with a fistful of signed union cards.
Opportunities to Add Value
A physical property inspection, combined with a P & L review and interviews with key managers will usually disclose several opportunities to add value. Some possibilities will require capital investment and will need to be evaluated on the expected ROI within the planned holding period. Others can be carried out at little or no cost. Low-cost, quick payback items should be put into effect at the same time as critical loss reduction measures.
