"That's some catch, that Catch-22." Capt. John Joseph Yossarian (fictional character in Joseph Heller's novel “Catch-22”)
Beyond a willing buyer and seller, a vibrant hotel transaction environment depends on several key supporting fundamentals. Weakness in lending—the most important of those—continues to slow the sale of hotels and the subsequent recovery in the hotel industry.
Interestingly, it is the past providers of credit to our industry that are doing as much to dampen trading volume as is the current lack of credit for new transactions. The thinking here is this:
- Many lenders, large and small, hold an inventory of troubled hotel loans.
- These lenders can’t make new hotel loans until the troubled loans are refinanced or foreclosed/sold.
- Other lenders won’t refinance a troubled hotel.
- The lender is stuck with the troubled loans.
For their part, prospective buyers largely are “keeping their powder dry,” waiting and hoping for hotels to enter the market either at pennies-on-the-dollar, bank-foreclosed pricing or at minimum, valuation reflective of the industry’s lower operating income and higher cap rates. This delta between seller and buyer pricing expectations has led the market to discount the opportunities presented by viable, cash-flowing assets in stable performing markets.
It appears prospective buyers believe so strongly that deals of a lifetime are to be had from real-estate owned (REO, i.e. lender-owned, foreclosed properties) purchases that they simply aren’t seriously looking at stabilized hotel acquisitions that actually have a shot of getting financed. Here’s the thinking:
- Pent-up demand and equity accumulates during this time of hotel industry uncertainty.
- Sellers of stabilized (untroubled) hotels continue to ask for pre-downturn pricing, although pricing has been moderating during Q2 and is expected to stabilize in Q3/Q4.
- Buyers focus instead on opportunistic deals.
- Expectations grow that lenders will begin dumping troubled hotels.
- The great deals remain over the horizon.
Our take
It’s our hypothesis that hotel trading volume will not materially improve until lender (and servicer) patience runs out (See related video interview of Joe Champ) and action is taken on the troubled hotel loans they hold.
We also assert that prospective buyer expectations of “deals of the century” through REO acquisitions are significantly dampening the sales prospects of stabilized hotels.
And finally, the time frame in which lenders finally foreclose on or sell their troubled hotel loans will herald the unofficial start of our next hotel industry recovery.
The catch in this apparent Catch-22
Lenders holding troubled hotel loans are “kicking the can” forward by granting extensions on maturing loans, withholding action on loans in technical and/or payment default, and otherwise delaying foreclosure.
Their preference is to have another lender refinance them out. Other alternatives include foreclosure and outright sale of the note, among others.
The conundrum here is that these lenders need other lenders to create credit market liquidity either so their borrowers can refinance them out or for buyers to finance the purchase of foreclosed properties. And those other lenders? They have troubled hotel loans on their books, too. They need still other lenders to create credit market liquidity before resuming lending again themselves.
The problem of over-leveraged/underperforming hotels is widespread enough that meaningful hotel credit will become available only when banks clean their balance sheets of troubled hotel loans.
(Note: We’re exaggerating the situation somewhat to illustrate the circular nature of the problem. There are in fact some lenders still making hotel loans, but the pool is relatively small when it comes to difficult-to-finance deals.)
Solutions do exist
This would be a double-bind scenario befitting Heller’s Catch-22 were it not for viable, albeit unattractive, solutions. Either borrowers could inject new equity to lower leverage/mortgage payments or banks could write off a portion of the existing loan. Both options recognize the reality that some level of value has been destroyed during the now 20-month recession.
It’s unlikely borrowers in large numbers will step in with fresh equity; more likely that lenders, or bondholders in the case of securitized/commercial mortgage-backed security loans, will have to take the loss. And once they do, the process of recovery can begin.
Lenders are a conservative breed; even more so today. Their patience with borrowers on troubled properties will run out only when it appears the economic environment is improving.
