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Is the Wait Over?

Hotel investors like Marcus Corp. have built up war chests to buy distressed assets that now look ripe for the picking.

It's a late August weekend at the Grand Geneva Resort & Spa in Lake Geneva, Wis., and the place is a beehive of activity. Two wedding parties and a community wide Venetian Night have combined to fill every one of the venerable facility's 355 rooms. Tee times are booked solid on the hotel's two golf courses and the spa is busy with women lined up for massages and manicures. Maybe the malaise that has struck the lodging industry so low this year is about to lift after all.

But then again, that may be wishful thinking. Since the start of summer, the lodging sector has been in upheaval across the country. In Dana Point, Calif., the 400-room St. Regis Monarch Beach resort was handed back to its mezzanine lender, Citigroup. Sunstone Hotel Investors skipped payments on the mortgage for its 258-room W hotel in San Diego and said it would hand the asset back to mortgage administrator Centerline Servicing. Meanwhile, Millennium Partners stopped paying the $90 million mortgage on its 277-room Four Seasons San Francisco and was close to default.

Corporations are slashing their travel budgets while both occupancy and room rates are in free fall as the lodging industry faces a dark gloom not seen since at least the mid-1970s, and perhaps longer. Many hotel owners are faced with stark choices between default and bankruptcy. The best capitalized may survive by merely writing off debt and somehow restructuring their operations while waiting for the market to turn and the recession to end.

“Our hope is that the lodging marketplace has reached bottom,” says Gregory Marcus, president and chief executive of Milwaukee-based Marcus Corp., the owner of the Grand Geneva resort. “But it's hard to tell since our industry tends to lag the economy.”

The buzz of the moment in this beleaguered industry is “jingle mail” — the practice of returning the inn keys to the lender. Such an alternative once would have seemed humiliating, but today jingle mail is considered a viable corporate strategy.

Out of this chaotic ruin, nevertheless, new fortunes stand to be made. Investors who have bided their time on the sidelines — the merger-and-acquisition landscape has been barren in the past year — are now watching more intently as discounted assets are poised to come up for sale.

There is a rising expectation that as the market scrapes bottom, probably in the fourth quarter this year, hotel deals will begin flowing again. There is plenty of capital available, and as banks continue to fix their balance sheets it's likely that debt will loosen up and leverage will make a comeback.

Raising capital for deals

Who exactly will be shopping for hotels? Practically everybody. The newly created Starwood Property Trust raised $810 million in an initial public offering (IPO) of stock in mid-August to invest in both distressed debt notes and properties. LaSalle Hotel Properties, based in Bethesda, Md., has raised $260 million in two equity offerings this year to prop up its balance sheet for deal-making opportunities.

Host Hotels & Resorts, also based in Bethesda, has issued both debt and equity and built up a war chest of more than $1 billion. Management has made no secret of its intention to be a net acquirer of new assets beginning in 2010. The biggest dealmaker of all might become Chicago-based Hyatt Hotels, which has filed with the Securities and Exchange Commission to raise $1.15 billion in an IPO so that it can chase after acquisitions.

There is a long list of private equity investment firms with capital. Morris Lasky, CEO of Lodging Unlimited in Chicago, is nearly finished raising a $350 million hotel investment fund and believes that opportunities are imminent.

“We're talking to a lot of lenders who inform us they'll be taking assets back this fall,” Lasky says. “They had been holding off on foreclosure with the hope that things would get better, but they haven't. In a few months we expect to be dealing with lenders as sellers looking to get rid of assets they don't want to own and manage for very long.”

To stabilize their balance sheets, many hotel companies are seeking to prune their portfolios, and they're already finding interest from overseas buyers. In July, for instance, Starwood Hotels & Resorts Worldwide of White Plains, N.Y., announced the sale of the W San Francisco for $90 million to Hong Kong-based Keck Seng Investments.

Marcus Corp. has a credit line of $113 million available from its lenders and is watching and waiting. The company invested more than $15 million earlier this year in renovations on the Grand Geneva, and has embarked on an even larger rehab of the 730-room Hilton Milwaukee City Center adjacent to Beer Town's convention center.

Business has fallen overall at the company's 19 hotels, with revenue per available room (RevPAR) likely to end 2009 down 15% or more over 2008 levels. But Marcus hasn't made a deal since 2007, when it acquired and rehabbed the long-shuttered 240-room Skirvin Hotel in Oklahoma City. Management is getting itchy to start growing the hotel group again.

“I can't predict the exact timing, but I know something has to happen to spur deal making in hotels,” says Marcus. “We expect that the market will become more active, and if the pricing is right we hope to participate.”

William Otto, president and chief operating officer of the Marcus Hotels & Resorts division of Marcus Corp., echoes those sentiments. “We have capacity on our balance sheet and could do a $100 million acquisition if something came along that was compelling. But what is compelling these days? There are a lot of people, perhaps us included, who feel that there is still more real estate fallout ahead, with rising foreclosures creating bigger discounts on assets.”

Next Page: Hotel loans in trouble

Hotel loans in trouble

The distress is still in its infancy. In June, according to Fitch Ratings, 13 U.S. hotels defaulted on $596 million in loans packaged into commercial mortgage-backed securities (CMBS). Fitch said another $608 million of CMBS loans were past due. In the second quarter, the delinquency rate on securitized mortgages on hotels reached 4.75%, up from 0.5% a year earlier, according to Trepp LLC.

Fitch predicts the delinquency rate will rise to between 10% and 15% by the end of the year, a level not seen since the lodging crash of 1990 when more than 14% of hotel loans were in arrears.

In May, the 390-room Stanford Court in San Francisco, operated under Marriott International's Renaissance brand, was put into receivership by Barclays Capital, which holds the property's $90 million mortgage. Apparently, cash flow did not support interest payments.

Signs of suffering also are rampant elsewhere in the industry. The bankruptcy filing by the 680-property Extended Stay chain has involved the Federal Reserve, which holds $900 million of the company's debt. RevPAR is down 23% this year at Extended Stay.

The Harp Group, based in suburban Chicago, filed for bankruptcy on its 556-room Chicago O'Hare Hotel, open since September 2008, and the smaller Radisson Hotel at Los Angeles Airport. The company owes a combined $278 million to two lenders, San Diego National Bank and Amalgamated Bank in New York.

With air travel down nearly 7% this year, occupancies in the O'Hare Airport market have plummeted 16 percentage points to nearly 50% this year compared with 2008. Another hotel in the market, the 525-room Westin O'Hare, was close to defaulting on a $101 million loan financed by Morgan Stanley, according to its owner, Dallas-based Ashford Hospitality Trust.

The hotel enjoyed a 69% occupancy rate when Ashford acquired it for $125 million in 2008, but with a current occupancy rate of 53% it can no longer cover monthly interest payments.

David Loeb, a lodging analyst at Robert W. Baird & Co. in Milwaukee, created a stir in mid-August with a report suggesting that FelCor Lodging Trust, the Irving, Texas-based owner of 87 properties, could boost its share price immediately by handing back three money-losing hotels — two Renaissance-brand assets and the Indianapolis Embassy Suites — to its lenders.

He figures a couple of other hotel REITs are poised to hand back hotel assets to lenders. In June, Dallas-based Ashford Hospitality Trust asked the CMBS special servicer to take back its money-losing Hyatt Dearborn.

“We're at a point now where hotel owners like Ashford are no longer meeting their interest obligation and moving toward default,” Loeb observes. “So now the rubber hits the road. Will these lenders go to foreclosure, and when? We may see a lot of the special servicers take it slow. They aren't ready to play hardball quite yet.”

That may be because the market for repossessed hotels still looks shaky. In July, the Watergate Hotel in Washington, D.C., made famous by presidential scandal nearly four decades ago, was put up for auction by its mortgage holder, PB Capital Corp. of New York, and didn't attract a single bid at the $25 million opening price.

David Gutstadt, senior vice president and head of hospitality gaming and leisure at the New York real estate investment banking firm Savills, believes that “banks will soon own a lot of assets.” And they may be in no hurry to sell hotels they take back.

“Lenders won't look to give away assets in a bad operating environment,” says Gutstadt. “They are perfectly capable of hiring stewards for these properties and parking them on their balance sheets for a period of time until liquidity returns to the market.”

On the other hand, how long does anyone want to own an underperforming hotel? William Sipple, a senior vice president with the hotel division of CB Richard Ellis, believes that real profits won't return to the industry for years.

“Unless you're going to hold on to your hotel asset for at least four or five years, you might as well sell now because things won't get any better from here for awhile,” says Sipple.

Most observers figure that the liquidity freeze will thaw by late this year or surely by sometime in 2010. RevPAR comparisons will begin to stabilize in the fourth quarter, and could begin rising by the middle of next year if the economy and gross domestic product begin to recover as forecast and unemployment tapers off.

“Investors are waiting for signs of an upward trajectory in lodging fundamentals,” says Gutstadt of Savills. “By the middle of next year we should see that occur, and then we'll have a healthy flow of transactions again.”

William Reynolds Jr., director of Thayer Lodging Group in Annapolis, Md., has launched his firm's fifth investment fund and is currently looking at sale proposals. He foresees a timetable in which banks take back hotels this fall and then take another six months to sell the assets.

“So maybe in a year we'll see an orderly transaction market,” says Reynolds. “By then our hope is there will be enough transactions to establish valuations that people can agree on. Values all over are being reset, and everybody is watching closely for the new pricing.”

Geoff Davis, president of HREC Investment Advisors in New York, believes that REITs may lead the charge in the coming year. “There should be a lot of transaction volume picking up again in the first and second quarters of 2010,” he says. “REIT values will be going up, and they'll want to get into the acquisition game. Private equity will have plenty of capital available, too.”

Next Page: A new conservative mood

A new conservative mood

Will the market ever return again to the outsized transaction volumes of 2007, when deal volume globally surpassed $120 billion? Davis laughs at the idea. “In 2007 we had irrational exuberance fueled by easy capital,” he says. “The market will be much more conservative going forward. Maybe by 2011 or 2012 we could be back up to half of what we did in volume in 2006 or 2007.”

But lots of adjustments need to be made before that can occur. Owners of hotel assets must get used to the idea that valuations industry-wide are down 30% or more from their peak in early 2007. Banks must get healthy again, too, though much of the action in coming months is likely to be fueled by seller-based financing. There also has to be a clear sense that the hotel market isn't headed any lower. Nobody wants to do a deal and watch valuations sink another 20%.

“There is still a bid-ask discrepancy, but that gap should close when we reach the bottom of the cycle, and I think we're just about there now,” says Davis of HREC Investment Advisors. “Once at the bottom, you'll see some real transaction movement.”

A new survey by Jones Lang LaSalle Hotels suggests that buyers are poised to act. In the first half of this year, U.S. hotel transactions nosedived 86% to $1 billion compared with the first half of 2008. But the company notes that deal volume has been increasing monthly since May.

The results of a survey of 300 hotel investors in the select-service segment — ranging from Super 8 on the low end to Hilton Garden Inn and Courtyard by Marriott in the upper mid-market — found that 44% of respondents were seeking to make acquisitions in the next six months. This was six percentage points higher than the survey in January and was the highest “buy” sentiment ever expressed in the three-year history of the survey.

What has spurred the rising interest in deals? Bargain prices, mostly. The Jones Lang LaSalle survey found that investors expected to buy hotels at a cap rate of 11.6% and a gross room revenue multiplier of 2.7. A year ago investors were resigned to making deals at a cap rate of 9.5% and a multiplier of 3.05.

“When we did interviews in January, we found investors were on hold and preserving their money,” says Mark Fair, a Jones Lang LaSalle managing director based in Atlanta. “The latest survey tells us that people sense a bottoming of the market and they're more prepared to buy. The majority of the buyers are targeting distressed assets.”

They're not likely to be distressed forever, industry veterans point out. Laurence Geller, chairman of Strategic Hotels & Resorts in Chicago, watched his REIT's stock price sink to under $1 this past year when some of its prime hotels such as the Westin St. Francis in San Francisco and the Ritz-Carlton Half Moon Bay south of San Francisco struggled to fill rooms.

But Geller is remarkably upbeat of late, noting that new hotel room supply will continue to dwindle over the next five years. Most hotel operators, Strategic included, have used the recession as an excuse to cut back on labor and other overhead.

During the recent Midwest Lodging Investors Summit in Chicago, Geller suggested that a rebound for the industry was closer at hand than most people suspect. “People's propensity to consume has not changed. Their ability to consume has changed only temporarily,” Geller remarked. “In 18 months time we'll all be saying this wasn't so bad after all. This too shall pass.”

H. Lee Murphy is based in Chicago.

Hotel Indigo bucks trend, continues expansion

One study after another suggests that hotel developers are rapidly shutting down new construction projects. But there are still pockets of growth all around the industry. Marriott International, for instance, opened 8,000 new rooms in the second quarter of this year alone and has another 110,000 rooms in its development pipeline, with more than half of them under construction. The majority of the rooms are overseas.

InterContinental Hotels Group (IHG), the British lodging giant, has 4,222 hotels open with 622,000 rooms. The company is no shrinking violet these days. It has another 1,700 hotels with 236,000 rooms in its pipeline, with the brands ranging from Holiday Inn to Crowne Plaza and Candlewood Suites.

One of the better-performing segments in the industry at the moment is the boutique property. IHG's Hotel Indigo chain is a classic model of the boutique — it has just 100 to 150 rooms per property — and has been on a tear recently. Since its start in Atlanta in 2004, the chain has grown to 29 hotels, with 17 properties due to open in the face of recession during 2009 alone.

There are nearly 60 more hotel projects in the company's pipeline. The goal is to grow to 250 properties globally inside of 10 years and then keep expanding to ultimately reach 650 hotels. Almost all of the properties, which cost $15 million to $20 million each to open, are owned by franchisees that are somehow still finding financing.

“In 2010, considering the economy, it may take longer to get some deals done,” says Janice Cannon, vice president of global brand management for IHG overseeing the Indigo rollout. “But we're still signing deals and expanding globally. That demonstrates this is still a growth industry.”

Indigo has been opportunistic in converting many of its hotels from older buildings. A new Indigo under construction in Miami's South Beach neighborhood was undertaken from an assemblage of four older structures. A historic office building in Baton Rouge, La., is being converted into an Indigo. In Ottawa, Canada, an old YMCA was turned into a hotel, and in Nashville the company will open a converted bank as its latest hotel by October.

In London, the company has already opened one Indigo and has deals for three more. There is even one planned for Liverpool, the working-class seaport that is birthplace to the Beatles. Cannon predicts that as the chain grows over the next decade, 50% of all Indigo hotels will be built in North America, with the other half equally split between Europe and Asia. “If you've got the right product and the right brand,” explains Cannon, “people are interested in investing in you.”
— H. Lee Murphy

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