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The Patient Buyer

In the dead of January under gray skies and gloomy headlines, savvy hotel investors see a glimmer of light off in the not-too-distant future. The growing consensus among hotel experts is that in the third or fourth quarter, the wrappings will come off the start of a rebound in deal making.

The acquirers will be investors like Thayer Lodging Group in Annapolis, Md., which was smart enough to sell off a couple of dozen hotels near the market's peak in 2006 and is now looking to replenish its portfolio of 14 remaining properties, most of them full-service facilities with flags like Hilton, Marriott and Wyndham. The company has raised a $300 million investment fund and is still adding to that total. Ultimately, the fund could have $1 billion in leveraged purchasing power.

“We think 2009 is going to be a very good year for us,” says Bruce Wiles, Thayer's managing director and chief operating officer. “We expect to be quite active on the acquisition front. In fact, we hope to get most of our equity invested in the coming year.”

Other prospective hotel bidders are emerging from the shadows. Noble Investment Group, based in Atlanta, raised $310 million 18 months ago and sank part of that total into the acquisition of the 244-room Hyatt Regency Valencia near Los Angeles in July of last year. The firm still has more than $200 million in equity to invest, and that total could swell to nearly $800 million with leverage and infusions from well-heeled partners.

Noble owns 42 properties, but Rodney Williams, a managing principal and the chief investment officer, says his firm doesn't expect to be doing any selling this year. “This is a horrible time to be a seller,” Williams declares.

“However, we feel lucky to be in a position to take advantage of a tremendous buying market that should become active by the summer of 2009. We expect to invest all of our $200 million in the next 12 months.”

Finding a catalyst

Before that can happen, the market needs a catalyst, or multiple catalysts, to rouse it from its slumber. Williams believes the first push will come in February, when publicly traded hotel REITs report depressed results for the full year of 2008 to their shareholders.

Asset owners in the private sector who had hoped valuations might remain near 2007 levels will be jolted into reality and finally prepared to mark down their properties and put them up for sale, Williams predicts. “Sellers will be ratcheting down their expectations early in the year,” he forecasts.

The most important transaction trigger of all that looms ahead is the great mass of hotel debt maturities expected in 2009. Industry observers say that 10-year notes negotiated in the late 1990s and five-year mortgages cobbled together in the 2004-2005 period are all coming due.

Trepp LLC estimates that a record $5.9 billion in commercial mortgage-backed securities (CMBS) in the hotel sector alone will mature in 2009. The heavily leveraged borrowers of yesterday will find a new day of reckoning in negotiating with banks today.

“Hotel owners who borrowed 75% of the price of their assets against yesterday's values will find that they must now renegotiate a loan of perhaps 50% at today's value,” says Wiles. “That's going to cause a lot of pain.”

There is more to it than mere maturities. PKF Capital's latest forecast calls for a 7.8% decline in revenue per available room (RevPAR) in 2009. Experts point out that number will be merely an average, with some properties performing far worse.

Where's the bottom?

There's also a suspicion that conditions could worsen even further. “We're in free-fall,” admits Robert Eaton, executive managing director of PKF, which recently formed a distressed hotel solutions program within its firm to consult with troubled lenders and borrowers in coming months. “It's like jumping in a lake and going down, and not knowing where the bottom is.”

Negotiations between borrowers and lenders will become complicated in coming months as hotel owners fall into technical default by violating financial covenants. Many mortgage contracts include provisions for minimum levels of operating income and interest payment coverage. Eaton flatly predicts that we'll see more foreclosures in 2009.

Community banks with small loans to limited-service properties aren't likely to relish the idea of becoming hotel operators. But owners of CMBS pools won't be afraid to hire servicing firms that take back properties and hire asset managers. “These servicers in some cases will file notices of default, and then fight the bankruptcies that borrowers subsequently try to file. There will be a lot of stress occurring,” Eaton predicts.

This process is already unfolding. In October last year, a $209 million loan originated by JPMorgan Chase & Co. and packaged into a CMBS note for two Westin hotels — one in Tucson and the other in Hilton Head, S.C. — was transferred to a special servicer due to imminent default. Then in December, the 684-unit Extended Stay Hotels chain, acquired in April 2007 for $8 billion by Lightstone Group LLC of Lakewood, N.J., was close to being returned to its lenders.

“You have to ask if lenders will roll the notes [extend the loans] on properties that are still cash flowing positive,” says Jim Butler, chairman of the global hospitality group at the Los Angeles law firm Jeffer Mangels Butler & Marmaro LLP. “And then you have to wonder if a hotel that is still cash flowing right now will continue to cash flow for another year, if RevPAR falls a lot further.”

Back to the balance sheet

In the past couple of months, most lenders have refused to consider making new hotel loans altogether. But many observers don't expect that inaction to continue past mid-year.

“Lenders have been waiting and watching what other lenders are doing,” says Mark Gordon, head of the U.S. hotel group at Cushman & Wakefield in New York. “We're seeing some of them move now. Big money-center banks are getting back into the hotel lending business.”

Loans made this year are likely to be syndicated with other institutions, with perhaps three or four banks coming together to lend on bigger projects, says Gordon. Stringent due diligence will be adhered to and loans will be on the banks' balance sheets, he adds.

The loans also will look very different from a couple of years ago. Deals done at 80% loan-to-value (LTV) in the past will be displaced by loans somewhere between 50% and 65% of value. Even then, value may become a matter of dispute in a market with pricing in free-fall.

“Lenders want to make LTV loans, yet they're not confident what the ‘V’ is in that equation,” says Daniel Peek, senior managing director of the Miami office of dealmaker Holliday Fenoglio Fowler LP. HFF predicts that hotel operating incomes will fall 20% in 2009, which should translate into a fall in valuations of 20%, too. But those are only rough averages. “There isn't a lot of clarity yet,” Peek concedes.

Capitalization rates are changing swiftly, too. Hotel properties were trading at cap rates of 6% to 8% two years ago. Today the range is roughly 8% to 10%. The expectation is that deals will be done near the high end of that range later in 2009.

Big stable properties in gateway markets may trade hands at 8% cap rates, while less stable select-service properties are likely to trade at cap rates of 11%. Sellers haven't completely accepted these numbers yet, but observers like Peek think they soon will. “People are going to have to put the old numbers from 2004 to 2007 out of their minds,” he warns.

Brandt Niehaus, president of hotel brokerage Huff Niehaus & Associates in Louisville, arranged the sale of a 145-room Ramada in July 2008 at a price of $4.15 million, equal to a 9.7% cap rate. A year earlier, he figures, the same hotel might have sold for $4.8 million and a cap rate well below 9%. But the hotel needed more than $1 million in renovations and its old owner, First Hospitality Group of Rosemont, Ill., decided it made more sense to sell than invest.

“Hotel values will continue to fall further in 2009 and owners will be deciding that they don't have the patience to wait for a turnaround,” he says. “RevPAR numbers are likely to be negative for the next two years. So an asset owner who would like to sell in a positive environment may have to wait until 2011 or even 2012 before he has some good operating fundamentals to show a potential buyer. A lot of owners can't afford to wait that long.”

Opening the candy jar

That is what investment groups like Fairwood Capital LLC in Memphis, which has an equity pool of $150 million to invest, are counting on. Through much of 2008, Ed Ansbro, Fairwood's executive vice president, estimates there was a cap rate gap of 200 basis points between buyers and sellers. He expects that gap to close by late this year and anticipates that the market will hit bottom — in terms of valuations — sometime late in the year or early in 2010.

“Deal flow will kick in mid- to late-year and then 2010 could be a big year for transactions,” asserts Ansbro, who believes that seller financing will help fill some of the mortgage gap in the market in the next year. “The most stress will occur in older properties with less attractive brands. They'll be most vulnerable to turnover.”

For the first time in years, buyers like Ansbro are beginning to talk about discounts to replacement cost. Everybody seems to be seeking hotel bargains at discounts of 25% or more off replacement. Chartres Lodging Group LLC in San Francisco paid roughly $750 million for a big portfolio of five hotels, including the 1,840-room Sheraton Dallas and the 1,225-room Sheraton Denver, last February with the help of seller financing from former owner Fred Kummer, owner of St. Louis-based HBE Corp.

The price, at $160,000 per room, was less than 50% of the replacement cost of $375,000 to $425,000 per room, says Robert D. Kline, president of Chartres. He expects a long-term leveraged internal rate of return well above 20% on an annualized basis.

Those kinds of prices look enticing to investors like HEI Hospitality LLC in Norwalk, Conn. The firm, which owns 32 hotel properties currently, recently raised its third acquisition fund, worth $515 million. Earlier funds of $275 million and $425 million are fully invested.

Just as important, the company has a separate credit facility of $400 million that it negotiated with a syndicate of banks, including Bank of America, back in 2007. That money will be critical in filling any gap between equity and debt on a deal that might previously have been filled by a mezzanine loan, today deemed too expensive by most borrowers, says Clark Hanrattie, HEI's chief investment officer. “That credit facility allows us to give sellers total confidence we can close on any deal we make this year,” he says.

Elsewhere, deals are somehow getting done. Rick Takach, president and CEO of Vesta Hospitality LLC in Vancouver, Wash., recently got a $9 million loan from First Independent Bank in Vancouver to build a new 100-room select-service hotel, slated to break ground in May. He's using just 35% of his own equity. “We'll open in 2010 and my hope is we'll catch the hotel market in a recovery upside by then,” Takach says.

Timing may be everything in the next 18 months. Arthur Adler, CEO of Jones Lang LaSalle Hotels in New York, says the smartest investors will be lining up deals early this year, not in 2010.

“If you wait a year or more, there will be a lot more competition for any asset that comes up for sale,” Adler predicts. “The trick is to get in early and beat the competition. Forget about today's cash flow. Anybody buying in 2009 is looking for a return well down the road. Patience will be required.”

H. Lee Murphy is a Chicago-based writer.

Hotel REITs are on the brink of distress selling

The entire hotel industry was reeling in 2008, but it was the public sector of the market — the real estate investment trusts — that got really slammed. One stock after another was down by 75% or more for the year as investors went fleeing from hospitality.

Ashford Hospitality Trust was trading in late December at $1.43 a share, down 82% for the year. Strategic Hotels & Resorts, once a high-flyer investing in trophy properties, was trading at $1.41, down 93% from a high of $18.87. Felcor Lodging Trust, once a solid name in the industry, traded as low as 66 cents a share in 2008, down 96% from the $17.23 high.

David Loeb, an analyst with brokerage firm Robert W. Baird & Co. in Milwaukee, covers all 10 major hotel REITs, though at the moment he only recommends buying stock in one of them — Hersha Hospitality — whose shares were down 75% to $2.60 in mid-December from the 52-week high. Hersha gets most of its profits from limited-service hotels in New York, Boston and Washington, D.C. — markets where rates and occupancies have held up comparatively well, according to Loeb.

Loeb expects the companies he follows to be active buying and selling in the coming year. He thinks Ashford, Felcor and Strategic — all stretched for liquidity — will be net sellers in the coming months. Strategic already has a Marriott in the Chicago suburb of Lincolnshire and a Ritz-Carlton in Half Moon Bay, Calif., up for sale, he notes.

Who will be buying? Sunstone Hotel Investors has $200 million in cash on its books and is looking for deals. LaSalle Hotel Properties is carrying modest levels of debt on its balance sheet and can do deals, too, Loeb says. Host Hotels & Resorts Inc. could take on another $1 billion in debt without much effort. And DiamondRock Hospitality Co. is known to be seeking more hotels, too.

“Some of these REIT stocks have fallen so far down that these companies are at risk of being delisted,” Loeb observes. “So some will be forced to sell assets to raise liquidity and live to fight another day.”

Some of the companies might be better off taken private, but Loeb believes that would be the most difficult sale of all. “How do you convince shareholders that any per-share offer to go private is fair? These stocks were trading so much higher not long ago.”
— H. Lee Murphy

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