By Chauncey Swalwell, March 22, 2010
The opening of the JW Marriott-Ritz-Carlton hotel tower at the L.A. Live entertainment complex comes amid the worst commercial real estate recession in recent American history. The new L.A. hotel tower is one of the few slivers of sunshine in a thunderstorm that’s almost four years old.
Occupancy and room revenues at some hotels have deteriorated to levels that make paying the bills almost impossible, resulting in values dropping more drastically than those for office, retail and industrial properties.
In “normal” times for real estate, when values and prices fall, buyers jump in and markets balance between supply and demand. Every commercial real estate sector is experiencing the impact of the recession, but hotels suffer most immediately with business and leisure travel (and revenue) dropping precipitously.
Hotel values have dropped faster than Tiger Woods’ advertising revenues. According to consulting firm HVS, the average value per room in the U.S. hotel sector crashed 45 percent since peaking in 2006; HVS forecasts an additional 10 percent drop in average room value in 2010. There appear to be few transactions involving hotels (traditional sales or lender foreclosures and deeds in lieu of foreclosure) even compared with the similar relative dearth of transactions for other types of real estate.
As the economy recovers, business and leisure travel will increase, which will push occupancy and room rates higher. But such a rebound will be too slow to benefit many owners and lenders saddled with underperforming, overleveraged properties. Opportunistic investors, including domestic and sovereign wealth funds, have been much slower to acquire distressed properties than many experts predicted. Some blame this on the limited supply of distressed loans and properties up for sale, others on the asking prices being higher than current market value.
But owners and lenders need to face reality and accept the pain of write-offs on their investments.
‘Pretend and extend’
Many equity investors have resigned themselves to accepting the current value (or lack thereof) of their investments more readily than lenders, which may have regulatory reasons for not seeking to sell loans or foreclose. But this process is necessary if the market and the overleveraged status of properties are to clear. Until an increase in the rate at which holders of existing debt either agree to reduce the amount of their debt to reflect current market values to allow for short sales or recapitalization through new investments, or take back properties (either by foreclosure or deed in lieu) and sell them at current values, properties will continue to languish and investors will sit on the sidelines.
In short, 2006 isn’t coming back. Recognizing massive losses on commercial real estate will severely affect the capital of banks holding such loans, but lenders must realize that “pretend and extend” (or “extend and pray”) won’t work for properties that are severely overleveraged and need new capital (new equity investment or through sale to new ownership) to recover. As this recognition by lenders starts to occur more frequently, transactions will start to increase and investors will be able to establish a market for distressed properties and/or loans more readily.
For hotels unable to generate sufficient cash flow to support operations, this likely will mean all cash investments and carrying properties for several years before new debt will be available. But that will be priced into the market, and will allow investment in commercial real estate to rebound – perhaps not to the often overheated levels of a few years ago, but hopefully at sustainable levels that remove the fear that the “other shoe” of commercial real estate will drop and impede the recovery.
On the bright side, the hotel market is so terrible that fewer new ones are being built – the JW Marriott-Ritz-Carlton tower being the exception – so the market may not get further saturated. That’s a distant light at the end of the tunnel, but for the first time in years, at least we can see a way out of the darkness.
Chauncey Swalwell is a partner at Stroock & Stroock & Lavan LLP, concentrating in commercial real estate.