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Mr. Courtnell
Hospitality Law
The Musical Chairs of a Hotel Loan Workout: Who Will Be Left Sitting When the Music Stops?
By Paul Courtnell, Director, Leisure & Resorts Group, Gunster LLP
The hotel industry is experiencing a severe down turn. Many hotel loans are in monetary default. A significant number of hotels are not even able to pay operating expenses, let alone service debt. What should the borrower do when the loan goes into default? This article explores strategies for dealing with lenders in this most difficult economic climate.
What to Do
Most industry experts agree that the hotel industry is experiencing its most significant downturn in generations. The gross revenues for the entire hotel industry are off nearly 30% with the luxury hotel market even more distressed. Although experts are in agreement that the industry will eventually recover, most are of the opinion that it will take a long time to return to 2007 levels. Given this rather bleak prognosis, what is a hotel owner to do in the interim if the cash flow from the property is insufficient to cover both the operating expenses and debt service?
Unfortunately, there is no “one size fits all” approach when addressing under-performing hotel loans. In most cases, the workout process will be initiated by the lender. Also at the negotiating table will be the borrower, possibly an equity investor and/or mezzanine lender, the operator, the franchisor (if different from the operator) and, in the case of securitizations, the loan servicer(s). In a traditional, non-securitized commercial real estate loan, the hotel lender essentially has three choices when dealing with a hotel loan default:
1) sell the loan as is;
2) leave the owner/borrower in control of the property and explore workout
options; or
3) push to get a third party to take control of the asset.
How the lender elects to proceed will oftentimes depend on several factors, including:
1) the value of the underlying property;
2) the quality of the operator;
3) the terms of the controlling documentation;
4) the property’s cash flow;
5) the strength of the franchisor;
6) supply/demand conditions; and
7) the borrower’s abilities and reputation.
In situations where the debt has been securitized, workout negotiations can become extremely complex as loan servicers oftentimes lack the incentive and/or flexibility to restructure an underperforming loan. Given the fact that there can be multiple servicers, it is often difficult for the hotel owner to determine if it has all the indispensible parties at the negotiating table.
Even with traditional, non-securitized loans, workout negotiations become more complex in situations where there is an independent branded operator involved with the property. Since an operator will have rights and obligations under its agreements with both the lender and the owner, they will also have a significant impact on the workout process. Depending on the specific facts, these legal rights may inure to the benefit of the hotel owner. For example, if the operator’s agreement with the lender limits the lender’s termination rights, the operator will have substantial leverage during the negotiation process.
The key document here is the Subordination, Attornment and Non-Disturbance Agreement ("SNDC") between the third party operator and the lender. The SNDC addresses whether the operator may be terminated by the lender if the lender acquires the property through foreclosure or deed in lieu of foreclosure. Very often, the SNDC provides that the operator may not be terminated if the lender becomes the owner of the hotel unless the operator itself is in default under its management agreement with the borrower. It is rare that the operator is in default even though the borrower is in default.
It is also important to keep in mind that the hotel owner also has several arrows in its quiver during the negotiation process. The hotel owner can move for an immediate sale at a substantial discount, or it can attempt to delay the process for as long as possible in order to attempt to benefit from a rise in the market value of the hotel property. Given the fact that nationally there is nearly a ten year supply of hotels on the market at the present absorption rates, being able to sell in the short term at anything close to the original market value will be somewhat unlikely in most cities. Both the hotel owner and the lender need to determine if it makes financial sense to sell in a dismal market or continue to absorb the carrying costs and operate a property which has a negative cash flow.
Size Matters
Whether the lender is a large money center bank or a regional/local bank may have a significant impact on the borrower's negotiations with the lender. The large money center banks have had significant profits in the recent past (due primarily to government policy), and are in much better position now than they were in 2009 to absorb losses in the context of loan workouts. Thus, the climate for working out a loan with a large bank has markedly improved in the recent past.
Most regional and local banks, however, are still not in financial position to take write downs on loans, and generally speaking are not being forced to do so by the regulators. Many of them continue the "extend and pretend" strategy (also called "delay and pray") that has been prevalent since the collapse of Lehman Brothers in the Fall of 2008. Some of these smaller banks have been willing to sell commercial real estate loans at a discount to third party buyers, but usually not to borrowers. Thus, a strategy employed by some borrowers has been to find a third party "rescue capital" fund to buy the loan from the lender, and then do a workout with the buyer of the loan. These types of workouts usually involve the "rescue capital" taking an equity position in the hotel by diluting the borrower, in return for renegotiating the loan terms.
When developing a strategy on how to deal with a lender on a underperforming loan, the borrower is well advised to get answers to the following questions:
- Does the lender have the flexibility to renegotiate the loan terms and do a workout?
- Who at the bank has the ultimate authority to make a deal? Many banks now have people from their credit departments handling non-performing loans, rather than workout specialists. The bank personnel who originally made the loan are usually not involved in the workout.
- Does the lender really have an appetite to own the asset through foreclosure or deed in lieu? Many banks do not want the problems and liability involved with outright ownership, but alternative lenders and "shadow" banks are much more aggressive in getting rid of the borrower and taking over the hotel.
The Silver Lining
Hotel values will certainly come back eventually. In the interim prudent hotel owners should also focus on the upside of the current economic downturn. One upside to the economic downturn for hotel owners is that it creates a world of opportunity for those positioned to take advantage of it. With valuations down by almost 50% in certain regions, existing properties can be purchased at a fraction of their replacement costs. For those thinking of developing a new hotel, although still somewhat daunting, the economic landscape looks better than it did three years ago. Property values and construction costs have both declined precipitously. In addition, municipalities are likely to be more receptive to a project that will generate jobs and increase tax revenue.
Even if a hotel owner is not in an acquisition mode, now is a tremendous time to examine local property tax assessments to determine if the hotel’s assessed value exceeds its current fair market value. If so, a property tax appeal will likely result in a reduced tax burden. Finally, low valuations also create estate planning opportunities for family-owned or closely-held hotel properties. By transferring a property at a lower valuation the transferee not only avoids some transfer taxes, but also gives the transferee’s beneficiary the benefit of the properties appreciation.
Kevin Lamb contributed to this article. Mr. Lamb is a shareholder in the West Palm Beach, Florida office of Gunster, Attorneys at Law. He concentrates his practice in Mergers and Acquisitions, Venture Capital and Private Equity; General Corporate and Commercial Law; and Creditors’ Rights and Corporate Restructurings.
Paul Courtnell Jr. is a senior partner at Gunster, Attorneys at Law with eight offices in Florida. He developed The Leisure and Resorts Group and serves as Director. The Group provides specialized legal and consulting services to the hospitality, recreational and resort development industries. Mr. Courtnell earned his undergraduate degree from Ohio State University in 1965 and his Juris Doctor degree from the University of Florida School of Law in 1973, both with honors. Mr. Courtnell can be contacted at 561-650.0517 or pcourtnell@gunster.com Extended Bio...
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