The double-edged sword in this case is ADR. Even as we begin to see moderate gains in occupancy, it will take years for rates to recover. RevPAR will turn positive after 18 to 24 months of declines, in the third quarter of 2010. Year-end occupancy projections by Smith Travel Research are projected to be 55.5%. We haven't had industry occupancy that low since the 1940s. It isn't pretty.

What is the nature and volume of hotel defaults currently? How will it work itself out? What strategies are servicers and lenders employing when dealing with distressed assets today?

George: Nationally, CMBS, which makes up about 26% of all commercial loan activity, has recently climbed to over $50-billion in defaults. Hotels represent about $6 billion of that, which is about 12% of the total CMBS default activity--a disproportionately high amount. This figure includes maturity defaults, as well as financial defaults at least 60 days old. CMBS hotel defaults will exceed a 25% default rate by the summer of 2010. This includes all types of defaults--some curable, some extendable, and others, not.

The silent 800-pound gorilla in the room is the non-securitized debt being held by banks and finance companies. These groups hold 74% of all commercial debt, and are in the same boat as their CMBS cousins, though many do not have the experience or the expertise to deal with mass defaults. This is why you see a much more cautious approach here, with "hope" playing a major role. This hope strategy is reinforced by the fact that there is no requirement for federally insured lenders to "mark to market." As such, banks are not under pressure to recognize the problem loans on their books or to increase reserves, giving them more of an incentive to "extend and pretend."

In California, there are about 250 hotels in some stage of default or foreclosure regardless of the mortgage structure (CMBS or not) and this number is expected to increase significantly and quickly, perhaps doubling by the end of the year.

Lender or special servicer responses to this default volume will be varied and encompass every response imaginable, from granting extensions and hoping for the best, to exacting a pay down of the mortgage when it matures, to accepting a deed in lieu of foreclosure, to placing a receiver on property and empowering the receiver to sell it, to restructuring the existing mortgage, to selling the paper at a discount. What strategy the lender will employ depends on the perceived credibility of the borrower, whether or not the borrower will infuse fresh cash, and whether or not the borrower has a viable exit strategy, which many times includes the borrower writing a check.

Conversely, the borrower may not give the lender the option to make any decisions whatsoever. Depending on how bad a particular market is, what the prospects are for recovery, whether or not there is recourse, and whether or not the borrower has financed out of his equity position, lenders may find that many borrowers simply throw in the towel with the keys rolled up inside.

What transactions are happening now? Who are the buyers? What will be key in driving transactions when they begin again?

George: There are a few transactions occurring now, mostly below $10 million and the majority of those below $5 million. Local lending relationships, SBA, and seller financing are all hallmarks of the financing associated with these deals. There have been a handful of notable larger transactions, but many of these have been all cash and as such have had the requisite all cash discount applied, and their numbers are very small, in fact, CBRE reports that there have been only 22 hotels sold in the US through the third quarter over $10 million.

The bottom line is that transactions are a function of two things: capital appreciation and debt, and since neither exists right now, there are few transactions.

The return of the transactions market this cycle will look far different than previous cycles for some very fundamental reasons, primarily related to the very different nature of the government response this time around, and as a result of said response, the big players will dominate this cycle. The flow of assets, while significant, will resemble a garden hose, as opposed to the fire hose some had hoped for. The good news is that the garden hose will be running for quite some time, the bad news is that while opportunities will be good, the average investor will be excluded from the tremendous investment opportunities experienced during the RTC workout years. For buyers, it's best when things go fast, and go furious, as in the case of hotel defaults. Unfortunately, that will not happen this time.

Other factors mitigating the "fire hose" effect are as follows:

• To date approximately 100 lending institutions have been taken over by the FDIC, but the FDIC is short on cash, and is running out of healthy banks it can coerce to take- over sick ones--and there are over 400 banks on the FDIC watch list. To alleviate this pressure, the Fed recently established rules by private equity funds can buy troubled banks, which, it has been estimated, have already amassed over $40 billion to do so. This will reduce the number of distressed assets that reach the market in a flood.
• Over $14 billion has been raised, or soon will be, by large investment firms for the purpose of investing in CMBS securities, whole mortgages, and in some cases, issue new debt. Large pools of assets will be transferred at discounts, which will leave the individual investor waiting for the drops of water to trickle down the spout into their parched mouths.
• The nature and type of note sales will reduce the potential transactions pool. Still solvent notes are currently being sold at discounts and other larger pools of notes are being sold, wholesale, that include a mixed bag of product types. Wholesalers will offer some notes to borrowers, giving them an opportunity to purchase their own debt, the balance of which will be sold off to buyers in that particular segment - office buyers for office notes, etc. All this note disposition activity will be sold at commiserate discounts, which will provide the investor with a high yield spread, and reduce the amount of real estate hitting the market for the average Joe.
• Protracted CMBS foreclosure timeline. Due to rules regarding loan modifications and transfers to special servicing along with inherent conflicts between the investor classes, and the complexity of hotel operations, the average CMBS foreclosure takes 13 months. By the time clear title can be delivered sometime next year, there will be significant capital competitively bidding up prices.
• Offshore investors and sovereign wealth funds will aggressively compete for quality assets and large pools of assets.

• So what will bring transactions back? Debt availability, an appreciating market, and a seller's ability to deliver clear title. Unfortunately, as it relates to CMBS, delivery of clear title is inexorably tied to the current mark to market rules, which, if they do not change, will ignite a wildfire of note transfers representing the largest portion of the wealth transfer this cycle.

How are you valuing hotels today?

George: Very conservatively. If we are crafting a projection, we're not showing RevPAR growth until late next year. We're modeling 10-year DCFs. We're using very conservative cap rates, and discount rates. Our IRR analysis reflects what investors today are theoretically seeking, and our debt assumptions are based on the current market, and if it's less than 50% for a particular deal, then it is less than 50%. So essentially, we're plugging in investor yield expectations as well as current debt assumptions, and solving for the value. It's all very theoretical since there are really no comparables.