Financial Challenges For Hotel Owners, Lenders

-- Hotels, 11/13/2008 9:31:00 AM

By: Bob Voelker and Jay Ong

 With the current credit crises and looming recession, 2009 will be a challenging time for hotel owners and operators. From 1997 through 2008, the US hotel industry will add 1.4 million rooms (45% increase), with almost 500,000 of those new rooms occurring in the last 3 years. Hotel development usually proceeds under short term construction loans which must either be replaced by, or rolled into, more permanent loan facilities. Permanent loans, whether used to refinance construction loans or to purchase hotels, typically require that the hotel attain and maintain certain debt service coverage and loan to value ratios, which are directly impacted by falling occupancies, average daily room rates (ADR's) and revenue per available room (REVPAR) and higher cap rates.  Under the current economic climate, featuring the meltdown of the market for securitized loans and the recapitalization of the financial industry, credit has further diminished, making permanent loan take-outs unavailable or prohibitively expensive to owners and developers and limiting the pool of prospective purchasers.

The Challenges

 Restrictive Lending.  To the extent they are currently making loans, lenders are responding to these economic challenges with revised loan pricing and tightening credit requirements, just as a record volume of hotel loans are approaching maturity. With the lack of credit in the marketplace, resulting in fewer buyers, cap rates will increase and values will decline, further exacerbating the inability of hotel owners to meet loan to value targets for refinancing.

 Dwindling Occupancy Rates and Increasing Supply.  At the same time, hotel operators are facing multiple economic pressures at the operational level.  Consumers are facing rising fuel costs, disappearing home values and increasing mortgage pressures, job cuts, lack of consumer and industry confidence and diminishing availability of credit – many of which also impact businesses and all of which combine to depress the demand side of the equation with reduced frequency of both business and recreational travel – with a resulting lowering of hotel occupancy rates. The anticipated decreases in demand are compounded by increasing supplies and competition. Supply has steadily increased from 1989 to the present and will continue to do so through most of 2009 as pipeline projects are completed. The results are reduced occupancy and pressure to lower ADR to increase market share, which will create a double hit to REVPAR and an even greater inability to meet loan thresholds for loan to value and debt service coverage. These market forces will cause a rising number of hotel construction loans to go past maturity due to the inability to secure permanent loans, and will push many hotel owners into default on their loan covenants.

 Lender Issues.  Lenders considering their options for troubled hotel loans must be mindful of the "Subordination and Non-Disturbance Agreements" (SNDA's) that were executed when the loans were originated. These agreements typically require that the hotel brand remain in place and that the lender respect the rights of the manager under existing management agreements. As many hotel purchasers reposition hotels through rebranding or acquire hotels for management fee revenue, these provisions may restrict the pool of potential buyers. If the hotel owner defaults under the hotel management or hotel franchise agreement prior to the lender taking action, or if the lender or buyer of the hotel subsequently default after taking possession, the hotel may lose its brand and management contract, significantly lowering the value of the hotel. Moreover, hotel loan workouts involve more lender liability pitfalls as actions taken to preserve value are more focused on operational issues (demand, pricing, management, expenses of operations, etc.) than is the case for more passive real estate such as offices and warehouses with longer term leasing.

Proactive Responses

 We've all heard the commercials on the radio aimed at defaulting homeowners – the problem won't go away by ignoring it or hoping the situation will improve. Similarly, hotel owners and lenders should evaluate their current hotel loans now and begin dialogue on addressing the market forces that are hurting hotel operations and value and that will ultimately require loan modifications and extensions.  Hotel owners, operators, managers and lenders faced with these challenges have a number of choices:

 Interim Cash Flow Management.  Hotel owners and managers should resist the temptation to lower ADR's to drive occupancies, as the resulting "rate war" hardly ever benefits the overall market and is particularly harmful in industries with high fixed asset costs, such as airlines and hotels. Staffing represents one of the highest variable costs in the hotel industry, and to the extent consistent with brand standards and prudent business operations, the level of staffing may be adjusted as demand/occupancy slips. Another significant expense is capital asset maintenance and compliance with brand standards for upgrades, and as REVPAR's decline the hotel operator/franchisor and the hotel owner should consider whether these obligations can be postponed without significantly impacting on the brand image. At the far end of revenue erosion, the hotel operator/franchisor and hotel owner should consider temporary reductions and/or accruals of the fees that operators/franchisors charge the hotel owner (e.g., base fees, brand service fees, additions to replacement reserves). Although the hotel brands/franchisors are facing their own financial performance issues (and the impact on their stock prices) in the current economic climate, there may be a willingness to work with the stronger hotel owners/developers to maintain loyalty to the brands as the market recovers.

Consensual Restructuring.  Where permanent replacement loans or loan conversions/refinancings are not available, and to wait out the return of more normal credit markets, precious time may be obtained through negotiated forbearance agreements. Hotel owners/borrowers should maintain close working relationships with their lenders to manage and update expectations and coordinate resolutions before issues become critical. Negotiations are complicated by the presence of multiple negotiating parties with critical roles and substantial leverage – lenders, owners, operators, franchisors, managers and critical vendors – all of whose participation will be necessary to facilitate a consensual restructuring. Close coordination with such parties is critical to ensure the exchange of accurate and timely information and to address the various parties' concerns.

 Bankruptcy.  If consensual restructuring is not feasible, bankruptcy, whether voluntary (to obtain the protections of the automatic stay) or involuntary (to ensure orderly and fair treatment of claims with those of other creditors) can be a powerful tool to resolve the financial implications of troubled loans. For voluntary debtors, bankruptcy provides a precious breathing spell from demands, termination, foreclosure and other self help action by creditors. Burdensome and underperforming executory contracts entered into in more robust hotel cycles can often be rejected. Landlord claims may be limited. For creditors, it provides not only an orderly process for fair treatment among creditors, but assets may be sold free and clear of claims and encumbrances in order to maximize the value of the operations for interested purchasers and ensure that the property remains viable as a going concern under new ownership. Secured lenders may be given replacement liens and super-priority claims to protect them against losses in the value of their collateral, while the owner, secured creditors and manager/franchisor benefit when unsecured trade creditors are prohibited from taking action against the debtor or terminating their contracts, to allow the debtor or its management company to continue to operate the hotel asset and preserve going concern value. 

 At the same time, parties should expect the bankruptcy case to present substantial valuation issues. A debtor will be inclined to assert that the value of the property greatly exceeds the amount of the secured debt, rendering the lender over secured with a corresponding equity cushion for the debtor. At the same time, the secured creditor will assert that there is little, if any, value in the property above and beyond the amount of its debt, thus maximizing the argument for lifting the automatic stay to allow foreclosure on the hotel assets. The lack of credit liquidity and resulting drastically diminished volume of current comparable sales will further complicate the valuation process.

 Bankruptcy Code Treatment of "Single Asset Real Estate" (SARE).  The Bankruptcy Code defines SARE as a single real estate property or project that generates substantially all of the gross income of a debtor.  Hotel owners who fit the SARE classification will generally be required to propose plans of reorganization within 90 days or recommence monthly, nondefault interest payments to each secured creditor.  Secured creditors in SARE cases also enjoy lower thresholds to obtain relief from the automatic stay in order to foreclose on the property because the debtor has the burden of commencing payments or proving its viability (often through the injection of new equity to buy down the debt) and unlike many requests for relief from the stay, the creditor (after waiting 90 days) need not deal with issues of whether the debtor has any substantial equity in the property.

 State Court Receiverships.  State court receiverships vary from state to state, but generally present many of the same options and protections as bankruptcy cases – they usually may be commenced voluntarily as well as involuntarily and provide the protections of injunctive stays against the debtor and a structure for the fair treatment of creditors of similar priority. Under a receivership, the receiver, appointed as an officer of the court, takes possession of the debtor's operations and assets, and administers its affairs under court supervision.  Receivership cases are typically ideal alternatives to bankruptcy for smaller operations as they are usually less expensive to administer than bankruptcy cases, but provide some inferior protections that larger debtors and operations require under the Bankruptcy Code. Because of a lack of a controlling federal statute, the receivership may encounter jurisdictional issues reaching creditors and assets out of the state's jurisdiction and attempting to treat obligations owed to governmental agencies. Because receiverships are creatures of state law, they often provide less protection against secured creditors who would otherwise face bankruptcy code provisions trumping certain of their state law rights, and typically lack the globally effective discharge provisions provided for under the Bankruptcy Code. A debtor opting for state court receivership remains at risk that an involuntary bankruptcy case could nevertheless be commenced by creditors, thus taking primacy over the receivership. State court judges can be expected to have less insolvency experience than specialized bankruptcy judges. Chief among these concerns is the automatic loss of control that comes with a state court receivership. Although bankruptcy provides for management to continue in chapter 11 reorganization cases, there is no equivalent under most receivership laws – the receiver displaces owners and management, who become the receiver’s employees.

 Preventative Care.  The greatest advantage of preventive care is negating problems before they arise. Historically, a surprising number of lenders have utilized substantially inadequate documentation for their loan transactions, thereby permitting far more, and more uncertain, disputes.  Lenders and hotel owners should seek the advice of counsel to formulate, negotiate and review documentation regarding loan transactions, subordination agreements and management contracts to ensure adequate provisions addressing future financial contingencies that may affect the hotel industry and the hotel owner and manager. A system for detailed and regular, but not overly burdensome, reporting is critical for both lenders and owners to ensure that problems and troubling trends are identified as soon as possible. Restructuring consultants and advisors can also be engaged to firm up balance sheets and efficiencies in the business model, to identify causes underlying underperformance and formulate solutions. Maintaining sufficient capitalization (in particular reserves for operations, replacements and periodic renovations) is also critical to navigating unforeseen contingencies. Management and owners should regularly revisit capitalization issues and market analyses in the process of formulating and reformulating both short term and long term business plans.

The information contained herein does not, and shall not be construed to, constitute legal advice. The contents of this article are not intended to be used as a substitute for specific legal advice or opinions. The effectiveness of any legal advice depends on the attorney's familiarity with the underlying facts; thus, this article should not be considered a substitute for the informed advice of an attorney.

Bob Voelker is the head of the Munsch Hardt Hospitality and Mixed Use Group. Over the last 3 years, the Hospitality Group has worked with developers on the W Hollywood hotel and condominiums; W Dallas hotel and condominiums; Hotel Palomar hotel and condominiums in Dallas; Stoneleigh Hotel and condominiums in Dallas; Centrum Tower office, retail and condominiums in Dallas; Houston Pavillions condominiums, office and retail; the So-Co Urban Lofts in Dallas; and the Westin St. Maarten condo hotel in the Netherland Antilles; and is currently working on hotel (from select service to 5-star) and mixed-use transactions in Dallas; Milwaukee; Philadelphia; Jacksonville, Florida; and Honduras.

Jay Ong works within the Insolvency, Restructuring & Creditors' Rights group at Munsch Hardt. He concentrates his practice on bankruptcy, reorganization and creditors' rights, as well as corporate finance and commercial litigation. He has extensive experience representing various parties in bankruptcy and large business reorganizations, including senior lenders, trustees, debtors, committees, trade creditors, bond holders, insurers and receivers, as well as commercial defendants.