While growing room demand leads to new supply on a limited basis, distressed assets linger.
Liz Burlingame

Steve Van, president and CEO of Prism Hotels & Resorts, describes the current state of the hotel market as “two worlds.” Hotel fundamentals are improving, net operating income (NOI) is up and transactions show very few signs of petering out. The volume of hotel transactions that closed in the Midwest in the second quarter of 2012 reached $718 million — up from $405 million one year ago, according to Real Capital Analytics.

First Hospitality Group is converting a Milwaukee landmark — The Loyalty Building — into a new 128-room Hilton Garden Inn hotel. The building features a six-story atrium and original granite and limestone floors and facades.

But while hotel performance is expected to remain strong this year, the overreliance on cheap debt in early 2007 has left many owners with flagging hotels and negative cash flow. Additionally, “all of the sins of the past are coming due,” Van adds, referring to the lax underwriting standards pervasive in 2006 and 2007. A wave of CMBS maturities and the lack of available replacement capital will lead to more defaults in the coming years, he predicts.

“The hotel loans made during ‘06 and ‘07 were, in some cases, 50 percent more than would be made today,” says Van. “Too much money was borrowed and lent during this time, which is leading to an inevitable train wreck.”

To find out how the industry is resolving these issues, Heartland Real Estate Business recently spoke with hotel real estate experts about some of the acquisition and management strategies employed at troubled hotels and the outlook for the lodging industry over the next six months.

Boosting Business

The problem for hotels in distress isn’t just poor operations or overbuilding, Van explains. Some borrowers, for instance, missed payments when business began to slide during the recession.

Steve Van, president and CEO of Prism Hotels & Resorts

Franchise companies have also mandated that owners complete expensive renovations, after granting owners a reprieve during the financial crisis. However, many owners are still waiting for the value of their properties to outweigh the high mortgages they incurred during the boom. Van says it could take as long as three to four years for hotel values to fully recover.

“Owners are being told by brands, ‘If you don’t remodel now, we’re going to take the sign off the building,’” says Van. “This is another force driving a lot of hotels into default and ultimately foreclosure.”

Van’s company, based in Dallas, has handled more than 170 receivership assignments of all varieties, in many cases taking over a distressed asset’s operations for a lender and repositioning it for sale. Assignments generally last for about two years. The receiver’s first six months on the job are critical and require an effective turnaround plan, says Van. “When we take over, we try to stop the bleeding and see what we can do so the lender will be able to get more money for it.”

The job generally begins with assessing and motivating the staff and setting a new tone. Employees tend to feel demoralized because the hotel has a negative reputation in the marketplace. Van notes that it’s important to impart energy and set and address expectations.

“Every month you don’t turn around the hotel you lose money, so speed is very important to us,” explains Van.

RockBridge and Musselman Hotels opened the Marriott Louisville East in June, following a $30 million rebuild. The companies purchased the former Park Inn hotel at 1903 Embassy Square Boulevard in December.

While roughly half of Prism’s business focuses on troubled hotels, the other half specializes in long-term hotel management. Van anticipates that hotel real estate fundamentals and asset appreciation during the next five years will “have never been better.” Hotel income growth has risen nationwide, while supply growth is at a historic low. Supply growth is projected to remain at less than 1 percent through the end of 2012.

Leisure and business travelers continue to fill rooms as hotel development remains muted, elevating occupancy in the majority of markets, according to Smith Travel Research. Occupancy nationally year-to-date through July averaged 62.3 percent, up 2.9 percentage points over the same period in 2011. Revenue per available room (RevPAR) rose 7.3 percent during the same period.

If hotels do come back to market through a foreclosure, there will likely be eager buyers. Van adds that those who didn’t overleverage their hotels will prosper well in the next few years. In addition, new buyers can take advantage of today’s attractive valuations and industry upside. “Today, it’s great to be a new hotel owner and bad to be an old hotel owner.”

Trickle or flood?

In April, Rockbridge Partners acquired the 224-room Doubletree Hotel Times Square South in Manhattan. The building is six blocks from Times Square.

While some industry players are bracing for a wave of distressed hotel product coming to market in the near future, others predict the floodgates will hold. “The tidal wave hasn’t really happened and I don’t suspect it will happen,” says Robert Habeeb, president and chief operating officer of First Hospitality Group. “For the most part, lenders and borrowers have been working together as best they can and in assets where they can to develop a strategy to avoid the ultimate default.”

There will continue to be a trickle of hotels coming to market that are distressed, and that won’t change anytime in the immediate foreseeable future, Habeeb adds. “It will likely take a year or two for all of the distressed product to work its way through the system.”

Rosemont, Illinois-based First Hospitality Group has been involved in the development, ownership and management of hotels since 1985 and has a portfolio of more than 50 hotels, consisting primarily of Hilton and Marriott-affiliated assets. Habeeb says the company has made significant progress since the peak of 2007 and is still “clawing its way back up.” He reports RevPAR has grown 8.5 percent year-over-year across the portfolio.

Meanwhile, Marcus & Millichap expects RevPAR to rise 6 percent nationwide this year, up from an average of $61.02 in 2011 to $64.69.

Beyond an increased demand for hotel rooms and improving market conditions, another profit driver for First Hospitality has been repositioning buildings. The company has continued its track record of converting historic structures, such as the former Federal Building in Omaha, into hotels.

The Federal Building project began in April, and First Hospitality partnered with Iowa-based Nelson Development. The plan is to transform the vacant art deco-style office building into a 152-room Residence Inn by Marriott extended-stay hotel, which is set to open by mid-next year.

Habeeb says conversion projects are not for the faint of heart, as construction challenges often crop up in century-old buildings. “However, our experience is that the real estate is irreplaceable. You couldn’t replicate them today,” says Habeeb. “If you do your homework and nail down every detail before you start the project to the point that there are as few surprises as you can manage, they can be very profitable.”

First Hospitality is also redeveloping the historic Loyalty Building in Milwaukee, which served as the original headquarters of Northwestern Mutual Life, circa 1886. The final product will be the 128-room Hilton Garden Inn Milwaukee Downtown hotel. The hotel is on track to open this month.

Future of Financing

Hotel construction is showing some signs of life in Midwest markets such as Chicago and St. Louis. However, credit is still very restricted, says Habeeb.

Construction financing remains more challenging than acquisition financing, and many lenders remain fearful of the immediate and potentially adverse effects of another economic slowdown, according to Marcus & Millichap. Even the planning pipeline remains thin, as about 300,000 rooms are either under construction or well along in planning, marking a 10 percent decrease from a year ago.

“However, some of the national brands with extensive pipelines of planned projects include Holiday Inn, with more than 17,000 rooms spread over its various price segments and Hampton Inn, which has 7,000 rooms under construction,” the Marcus & Millichap hotel report states.

RockBridge Capital, a hotel lender and owner based in Columbus, Ohio, has completed more than 300 debt and equity investments in the U.S. during the past two decades. The company placed $350 million in loans in 2011 and expects to meet or exceed that number in 2012, says Adam Valente, managing director of RockBridge’s investment origination group.

“If you look at 2011, the loans we have closed thus far in 2012 and what we have on the books, it’s about 70 percent acquisition and the balance is refinancing,” says Valente.

Hotel investing has also become an important segment for RockBridge over the years. “For a long time we’ve been considered a lender, but the reality is with a portfolio of a little over 100 active investments, we’re about 50/50 for equity investments and debt investments,” says Valente. RockBridge often pursues value-add deals for properties that are undercapitalized, undermanaged or in need of extensive renovation.

“We look at hotels that are ripe for new capital, vision, a new brand or reprogramming, such as reducing the key count or relocating the lobby for example,” says Valente. “We don’t do much in the way of luxury, economy or resorts, partly because they are very time-intensive.”

During the recession, Valente says RockBridge spent its energy ensuring portfolio success as opposed to being a rampant acquirer or new deal originator. “We had to be introspective and focused on maximizing the value of the investments we made, which we did with great success. It’s why we we’ve been one of the more active participants since the recession on the new business front.”

Last March, RockBridge Partners, a division of RockBridge, acquired the 275-room Atlanta Perimeter Hotel & Suites, a full-service hotel in Atlanta. The property will undergo a $20.5 million renovation and will be reflagged as the Le Meridien Atlanta Perimeter. Upgrades will include a new lobby, restaurant and expanded fitness center.

The following month, RockBridge Partners acquired two hotels in New York City: the 146-room Hampton Inn 35th Street/Empire State Building and the 224-room DoubleTree Hotel Times Square South.

Valente also expects to see a continued trickle of distressed assets which, combined with favorable market conditions, will bode well for the industry in the next six months. “We continue to see more and better opportunities by and large as it relates to our appetite for hospitality and lending.”

©2012 France Media, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 553-9037.

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