Hotels, especially California hotels, have been among the hardest-hit segments of the real estate industry in the economic downturn. While the distress of several high profile hotels in the state, including the W San Diego and the St. Regis Monarch Beach, has made national news, the depths of the distress in the California lodging industry goes well beyond these headliners. According to reports issued by Atlas Hospitality Group in April, at least 406 hotels in California are either in default or have been foreclosed on by the lender.
The improving national economy and the beginning of a rebound in lodging fundamentals has led some prognosticators to suggest that the lodging industry might lead the real estate recovery. National occupancy rates grew 5.9% in March, while revenue per available room recorded a 3.8% in- crease during the same month. In spite of these promising fundamentals, the outlook in California is unsettled.
California is expected to experience an increase in the number of hotel defaults in the next two years. With a significant number of lodging loans originated during the boom
years of 2005 to 2007, many highly leveraged hotels are not only struggling to meet current debt obligations-both debt service and financial covenants, but are also confronting the need to repay the outstanding debt at maturity. Fitch estimates that 78% of hotel loans originated during 2006 to 2007 will mature in the next two years. The extend and-pretend workout model once so prevalent in the real estate market has shifted as lenders today look at other options, especially for assets that are unlikely to recover value for years.
The increase in hotel defaults may well result in an uptick in the number of hotel asset and note sales in California during the remainder of this year and 2011. But the volume and pace of such sales is difficult to predict. The critical question is whether lenders will elect to foreclose on and sell hotels in the near term at discounted prices, or wait out the market.
The answer will depend in large part on the timing and magnitude of the recovery in the operating performance of the hotel sector as a whole, which is ultimately tied to the broader economic recovery. As to individual assets, the hold-or-sell calculation will be affected enormously by the scale of the operating deficits that the lender may have to fund to continue operations and the specific requirements of franchise or management agreements that the lender is unable to shed.
With only a handful of hotel sales closing to date, pricing remains very difficult. Buyers expect deep discounts. Conventional debt financing remains scarce. Lenders seem to have learned their lessons from the boom years, and are adhering to strict underwriting requirements. They are offering acquisition financing at lower loan-to-value ratios that require greater equity investment and provide a reduced return on investment.
Given the realities of the real estate market, prospective buyers will likely be those with limited debt needs and fairly long-term horizons, such as REITs, private equity funds and foreign buyers. Foreign buyers have already made a few high profile acquisitions in California, such as the W San Francisco and the Downtown Los Angeles Marriott.
We expect that top-quality hotels in the full-service upscale, upper-upscale and luxury-but not resort categories with strong brand affiliation that are located in the 24-hour gateway cities like San Francisco will be the most attractive acquisition candidates. The relatively low supply projections in places like San Francisco also attract investors concerned about over supply that has impacted many of California's markets, especially inland areas where development was robust. While the increase in hotel loan defaults may increase the number of hotels for sale in California, the outlook for the transaction market for years 2010 and 2011 is far less clear than a sun-drenched California day.
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