Five things to remember when buying hotel notes
The hotel industry experts have published their forecasts for 2012, and they seem to agree on the following two predictions:
- The hotel sector will continue to improve in 2012, with RevPAR increasing anywhere from 4% to 6%, depending on which expert you follow.
- It’s going to be a rocky year for hotel loans held by lenders, particularly for those loans made at the peak of the last cycle in 2006 and 2007, and especially for loans that cannot be extended further. Some of these loans are securitized with complicated structures that involve multiple tranches of senior and junior debt sold. Others never got securitized and weigh heavily on lenders’ books.
While the capital markets are warmer, they are still cold, and the velocity of debt and equity flows are currently insufficient to preserve many of the hotels in the hands of their current owners. As hotel metrics improve, hotel notes will command a better price, and lenders will sell more of them. We predict that capital providers and special servicers will sell more notes and assets in 2012 than in the past two years.
Experience tells us that most note buyers (other than institutional participants) are looking to obtain the locked-up value in the hotel real estate — and not really interested in the fixed income of the note. These note buyers want to get at the hotel asset as quickly as possible, and either operate or sell the underlying hotel. This is the case whether it is a portfolio or an individual note that is being purchased.
What buyers of hotel notes need to know
If you are a buyer of hotel notes, whether it’s a portfolio or single loan, there are some key things to keep in mind, particularly for this coming year. Here are my top five:
1. Update your checklist and use it.
We almost always find concerns in the hotel loan file that need to be addressed. Do not assume because the loan was prepared by a good law firm that the loan documents work. First, good firms can make mistakes. Second, many hotel loans are done by good law firms that simply do not typically handle hotels, so they miss many hotel-related issues.
Remember, a hotel is made of anywhere from 15% to 25% personal property. Some of that property could have liens or be leased from third parties. The UCC has an entire body of hidden liens many real estate lawyers simply do not know about. The note buyer must run a proper UCC search. In many states, liquor licenses, which provide value to the hotel, cannot be collateralized. Also, the loan may have been previously modified without guarantor approval; there could be important waivers missing in the note or guaranty. Finally, your checklist needs to take into account any new laws that have come into effect. The loan could have been assigned multiple times, but the assignment documents are incomplete. The note buyer may find it has to prove up the outstanding amount of loan in front of the bankruptcy judge who requires additional proof. (Good luck getting that done without the assistance of the note seller!) And if you are buying from a note flipper … beware.
2. Think like a lender: You are buying a loan, not the real estate.
Before buying a loan, know the “dos and don’ts” of lending. If you do not have that expertise, you are strongly advised to engage legal counsel who does. A wrong step can cause you to lose lien priority of all or a part of your loan. Even seemingly innocent acts such as your making decisions on hotel operations or approving or disapproving borrower expenditures can be problematic. In some states, the note buyer can lose its security interest in the hotel altogether.
Hotels are operating businesses, and it is rare that a lender will be comfortable leaving the operations of a distressed hotel in the hands of a hotel owner who has lost its equity. The sophisticated note buyer will understand the applicable rules of receiverships and employ a receiver where permitted. In many states, the receiver has authority to cause a transfer of the liquor license, even if not collateral of the hotel, which can be quite valuable.
3. Due diligence, due diligence, due diligence.
Substantially more due diligence must be done when buying a hotel loan than most typically real estate-secured loans. The hotel note buyer needs to review the loan file, the operating business of the hotel and the real estate. Make certain the loan file is complete with all loan documents in place, and that the documents work properly. If possible, obtain a copy of the note seller’s correspondence file. Pay particular attention to any hotel management agreement in place and any subordination or comfort agreements. Depending on how they are drafted, they will likely affect the value of the note collateral.
Understanding hotel operations is important. A greater scrutiny of the physical improvements is required for a hotel than for ordinary commercial real estate. For example, if the secured property were a retail supermarket, the supermarket tenant is charged with maintaining and insuring the asset. Thus, if the windows leak or the sprinkler systems do not comply with applicable law, the burden and costs of fixing these items often can be passed through to the supermarket tenant. Not so with a hotel. These issues fall squarely on the shoulders of the hotel buyer. To make matters more challenging, note-selling lenders actually often give a shorter period of time to note buyers to review the file and asset when compared with sellers of other real estate.
Use experienced hotel contractors and engineers to walk through the level of physical due diligence needed. Have a zoning specialist ready to review the hotel entitlements. Confirm all signage and parking are on the real property collateral. Confirm the number of parking places complies with zoning requirements. Confirm the asset complies with all environmental laws and any governmentally issued conditional use permit. Hotel owners often tweak the physical improvements, which can cause the hotel to become non-compliant. The key is to have your due diligence team (hotel consultant, construction/engineer consultant, zoning consultant and legal counsel) ready to move before the note-hunting begins, so they can hit the ground running.
4. Understand the hotel business.
- Labor and employment. Replacing hotel employees is costly. Review employees’ records to determine if they are legal workers. If the note is secured by a major hotel, the note buyer should analyze all employee positions. Is the hotel the subject of a union campaign? Unionization increases hotel operating costs by as much as 38%. Employee morale will likely be at a low, so the note buyer should be prepared, following foreclosure, to implement a program to boost employee morale and implement an employee policy handbook and benefits package.
- Brand issues. Keep in mind that the franchise brand owner has to approve any new hotel owner. The brand may insist on the payback of all unpaid fees as a condition of keeping the franchise. The brand may require a costly property improvement plan. These will impact the value of the loan. Determine whether the current brand is the best one for the hotel or should be replaced. This can be challenging, and should be discussed with legal counsel with substantial experience with removing the brand.
- Hotel systems. The note buyer should also review the cost of keeping or changing hotel concepts, protocols and systems. The note buyer should assume it will have to correct and/or complete the hotel’s budgets and financials (which will not be easy if the current owner has mismanaged the hotel) and implement new revenue management and cost containment systems, reservations systems and booking engines.
Finally, do not forget tax considerations. Many note buyers end up restructuring the notes with the current hotel owner/debtor. Most of the tax consequences from restructuring a secured loan will belong to the debtor, but certain actions can hurt the note buyer, some of them significantly. Experienced note buyers will review their plan with a tax lawyer or accountant. Again, because hotels are different from typical real estate, it is important that you consult legal counsel with experience in tax planning for hotel loan or hotel asset ownership.
Truth be told, there are many more than five key considerations for buying hotel secured notes. Do not let that be daunting. Purchasing hotel debt can be exceptionally attractive — but not for the inexperienced note buyer or hotel novice. Experience is the key. With seasoned hotel advisors behind them, the experienced note buyer can carefully and fully understand the issues at hand and how they impact the note purchase and business plan.