You Need to Reset Your Exit Strategy
By Jim Burr, CHA
Jim Burr, a graduate of Cornell University’s School of Hotel Administration, has more than 40 years hospitality industry experience, including asset management, 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. Jim is the Group Leader for Cayuga’s Asset Management and Distressed Properties Assistance Group.
Last year I posted a blog to remind hotel owners that they needed to have an exit strategy that embraces the circumstances and timetable under which they plan to exit their hotel investment. Since then, major and dramatic – some say seismic - changes have occurred in the domestic and international economy and in the hotel capital markets. It is advisable to revisit the exit strategy and revise it to reflect the current environment and foreseeable circumstances.
First the good news:
- The hotel industry is and remains
cyclical and demand is closely correlated with GDP. So when the national
economy becomes strong again — some are already calling an end to the
recession — the demand for hotel rooms will improve.
- Supply growth has been sharply constrained by changes in the financial
markets so little new product has entered most markets and not much is
foreseeable for a while. So when demand strengthens, an existing hotel
that has been well-maintained and well-operated through the down cycle
will be likely to benefit.
- A property whose financial capital was put in place before the high-leverage, low cap rate era should, with aggressive asset management in place to tighten costs, be able to survive until the upturn.
Now the bad news:
- Average daily rates are going to take a while to come back. We saw
this after the September 11th event and this time around it may take
even longer for hotels to regain enough pricing power to achieve the
rates that were in effect in mid-2008.
- Between tightened underwriting standards and increased interest rates,
most five-year term loans that come due this year, or in 2010 or 2011,
will not be able to be fully rolled over. The hotel’s value is going
to have to be reset and, in most cases, additional equity injected. The
“experts” are forecasting “haircuts” ranging from 25-60% of 2005 – 2007
value. And a number of vulture capital funds are waiting patiently for
weak owners who fall by the wayside.
Let us review and update some of the circumstances that indicate that it is time to leave a hotel investment:
- You are out of money [“the
well is dry!”]
Either the hotel isn’t doing well or financing to replace outstanding debt that is maturing isn’t available. The hotel needs an infusion of equity and you don’t have it, cannot get a return sufficient to warrant investing it or cannot raise it. This is what the bankers call a troubled asset and brokers refer to as “a distress sale.” The selling price is going to be favorable only for the new owner.
- The
picture isn’t pretty [“it soon will be raining on my parade!”]
A new competitor is coming in – the brand is out of favor – the location is no longer prime – demand is declining -- the property is older and needs much upgrading and refurbishment – a union agreement (or the threat of one) or a legislative mandate such as a “living wage” or retroactively applied building code change has changed the economics – and so on. For whatever reason or reasons, a large outflow and/or a small inflow of cash are foreseeable. Clearly, this hotel will not produce the desired return on investment in the near or medium-term future.
- My ship has
come in [“here’s my pot of gold!”]
There are at least two versions of this: One is the “Greater Fool Theory” where a prospective buyer wants the hotel so badly, for whatever reason, that he is willing to overpay for it, giving you a handsome profit.
The second is where the land the hotel occupies has become so valuable that it makes economic sense to buy the property, tear the building down, and replace it with a different, more profitable use –shopping center, mixed-use development, offices, condos and the like.
Believe it or not, these “ships” will be sailing again in the future. But presently they are far out at sea, or perhaps even in dry-dock. The challenge is to forecast how long it will take, and how much additional cash outlay will be required before they arrive at the pier.
- The time is right (again) [“timing is everything!”]
The bulk of the tax benefit has been realized – Opportunities considered more attractive (or safer) are available – cash is needed for other purposes — estate planning (or estate settlement) needs dictate a sale – the partners are arguing about objectives or future strategies. These are just a few examples.
If a potential or planned exit strategy is thought out, it can be modeled in a pro forma and the effects of various strategies considered and refined. The forecast and an asset management approach can then be utilized by the owner to increase his total return on the investment by:
- Managing the outflow of capital expenses (and maintenance costs) appropriately.
- Structuring financing and lease versus buy decisions for greatest benefit.
- Making short-term decisions on a host of other items, including service contracts, booking agreements, sales & marketing activities.
- Creating an audit trail of exceptional expenses to make a case to a prospective buyer as to why the net operating income (NOI) should have been higher.
Several hotel owning companies periodically perform an exercise called a “re-buy analysis” on the hotels they already own. Considering present property and market conditions, availability of financing, new opportunities or potential threats that have arisen, capital needs, return on investment objectives and alternate opportunities available, would they buy that hotel asset today? Would they now revise their strategies from what was originally put in effect? This is a great asset management discipline that should be applied by any hotel owner on an individual asset basis.
If you model the likely income and realistically project the amount of debt that can be supported for at least the next five years, you will quickly pinpoint opportunities and roadblocks. If the hotel was highly-leveraged and its debt is maturing in the next few years, this would be a very good time to reset your exit strategy. Will it be on your terms or someone else’s? If you plan to stay in the hotel, you will need to restructure your capital stack. If you can come up with strategies to add value, perhaps you can convince the lender to write down the loan by less than he would be facing if he put the property into foreclosure and sold it to a new owner at market rates. Even though the loan decision is likely to be made on the basis of trailing twelve-month’s earnings, and not the proforma, if the future scenario is presented carefully and thoughtfully, it can enhance the prospects for a favorable outcome.
If the conclusion is to exit the investment, you need to become knowledgeable about today’s cap rates and the amount of financing potentially available to a buyer. Couple that knowledge with a current cash flow forecast and you can easily determine how long you can hold out, and what a realistic value is for your equity.
A sound exit strategy, put in place and then reset to current conditions, will greatly increase the likelihood that when you exit your hotel investment it will be on the most favorable terms available, and that your return during the holding period will be optimum for the circumstances.
