April 13, 2009
By Joel Ross
 

As the original creator of hotel commercial mortgage-backed securities programs in March of 1993, it’s useful to review how the programs began, what went wrong and where we go from here.

My perspective is based on that experience, 45 years on Wall Street and the deal world. From 1989 to early 1993, there was almost no financing available for hotels. The industry suffered terrible times, and the savings-and-loan crisis almost caused a lending shut down to what was then a money-losing industry.

In early 1993, it appeared the hotel industry was stabilizing, and net operating income would rise. That led me to create a way to restart hotel lending. In March of 1993, I teamed up with Mike Lipson and Jerry Earnest, and we developed the first hotel lending programs using CMBS structuring. In October 1993, I convinced Henry Silverman (with HFS at the time) and Nomura to agree with us to launch the first official hotel CMBS program.

We were deeply involved in creating the underwriting manual, on which loans were to be based, and attendant legal documents. We had lived through the absurd 1980s lack of underwriting and were determined not to make the same dumb mistakes. We built the program to correct the errors lenders made during the ’80s.

The initial underwriting was based on historic cash flow only. We determined appraisals were worthless and usually intentionally overoptimistic, so we never used them for underwriting.

Debt cover was the key, and it was 1.4 to 1.5 times trailing 12 months NOI after we discounted food and beverage because we knew F&B was a loser in many hotels. We never looked at projections. We used a mortgage constant of 11.33 percent to underwrite because we felt that added to the safety of the underwriting and covered any rise in rates we could foresee during the 10-year life of the loan.

Amortization was 25 years, and there was no interest only because that would mean the loan wouldn’t be sufficiently amortized by the 10-year maturity to ensure ability to repay. Sponsorship also was important to us.

We never accepted old properties because in 10 years, if a property was more than 20 years old, the cost of renovation to keep the asset competitive would be uneconomic in many cases. We made the assumption that because there had been no new development for five years, there would be a lot of development happening later in the cycle and before the maturity of the loans we were making.

The lawyers created the bad-boy carve outs to try to stop the bad behavior we saw from owners and developers during the ’80s and up to 1993, when so many hotels went into foreclosure or bankruptcy. We also determined never to allow a second mortgage after seeing the problems they caused in foreclosures at the time. This is what led to the start of mezzanine lending.

While we were well aware of the way servicing was required to be done under the Real Estate Mortgage Investment Conduit rules, it would lead to serious problems down the road when loans went bad. There was nothing we could do to change that process, even though we knew it wouldn’t work. The rules were set in stone by the tax code.

CMBS takes a turn for the worse

In November 1993, I had a conversation with one of the bankers at Nomura, discussing how CMBS was the new S&L crisis and that Wall Street would take what was a basically good idea and run away with it. The result would be a crisis worse than the S&L problems. We commented about how all the young MBAs working on the trading floor in front of us would end up unemployed. The only thing we got wrong was we thought it would blow up after seven to 10 years, not the 16 years it took.

Many of us knew exactly what was being created and where it would lead. All the older people in the business and government who publicly say they didn’t know are covering up their own role in what happened. All the grown-ups knew, but the profits were so good and the compensation so high, nobody wanted to blow the whistle.

Then, underwriting standards in all parts of CMBS were loosened, and all the credit rules we had put in place in 1993 were eliminated over time. By 2005, there were essentially no underwriting standards for anything. The entire emphasis was on volume to fill CMBS pools to make them US$2 billion or more.

The young MBAs thought they understood real estate and hotel operations, but they had no clue. What they knew was how to push paper through the system and make big bonuses.

Interest-only loans were allowed, and underwriting moved from three-year historic NOI  to 10-year projections by appraisers who were paid big fees to turn out overoptimistic projections to support the absurd loans, which were based on these wild appraisals – exactly what was wrong in the ’80s and what caused some appraisal firms to go out of business.

Loan to value, which we had required to never exceed 60 to 65 percent on our own internal valuations and always used at least a 10 to12 percent cap in 1993, were allowed to move up to as much as 90 percent with mezz and 80 to 85 percent for the senior loan. These were based on values that had no basis in reality, so they were loans that were 130 percent or more of real value.

All the foolish errors of lending in the ’80s that should never have been repeated were being repeated in spades. Even the bad-boy carve outs were relaxed after 2005. Then there were all the collateralized debt obligations, derivatives and other unfathomable financial engineered instruments the child math geniuses created on their computers. Even Warren Buffet said he couldn’t decipher them. There was no way it wasn’t all going to collapse. It was a game built on quicksand.

2006: Wall Street catches on

As early as the start of 2006, many senior professionals on Wall Street were discussing how this made no sense and would end badly. A bunch of us thought 2006 would be the end. Subprime housing was a massive failure because it wasn’t adhering to sound underwriting throughout all aspects of the lending and investing world.

It wasn’t the cause at all, and solving the overvaluation and foreclosures of housing will not magically solve the problem. The whole system is broken worldwide, and we’ve finally broken the back of the out-of-control financial system we created. Had it not been for Ben Bernanke, Henry Paulson and the Troubled Assets Relief Program, and Mervyn King, governor of the Bank of England, the worldwide financial system would have collapsed in October. We came terribly close.

So where do we go from here? Any of the comments I’ve seen about the return of hotel lending anytime soon, or how the Public Private Investment Program is going to bring in spreads that will get hotel lending going again, are failing to appreciate the gravity of the financial system collapse or the severity of the problems in the financial as well as the hotel worlds. It will be a long time before hotel lending resumes in any meaningful way.

This is similar to what I saw in 1993, only vastly worse, so I have a unique perspective on where we go from here.

The hotel industry is experiencing the worst depression since the 1930s. Many hotels won’t meet debt service this year. Many, maybe as many as 50 percent, will go into foreclosure or deed in lieu.

The return of lending

When lending returns, it will be similar underwriting to what we set up in 1993. Low leverage based on trailing 12 numbers and values based on higher cap rates, 10 to 12 percent on trailing 12, with leverage limited to 60 to 65 percent of that number. Appraisals will be ignored. Cash flow again will be the only thing that matters in sizing loans. Quality of the sponsor again will be critical, and how they handled the 2009 to 2010 period will be looked at just as we looked at how borrowers handled the 1989 to 1992 period. Sponsor liquidity will be a significant underwriting aspect. Projections will be ignored. It’s likely mezzanine lending won’t be allowed in many cases because that’s causing serious issues in foreclosures by senior lenders, just as second mortgages did from 1990 to 1993.

Maybe the most important thing is young lending officers won’t be rewarded for volume, but will be measured on credit quality three years after the loan is made. That’s where the new compensation programs are going, which changes everything. The world has learned what many of the older banking guys knew: When you pay lending officers on volume, you have bad loans and an eventual collapse.

It took five years after things stopped in 1989 for us to get lending started again, and that crisis was nowhere close to this one. Volume didn’t really begin to pick up for hotel lending until later in 1994 and in 1995. This time will be slower.

The result is values aren’t returning to anywhere near where they were in 2006 to 2008 for at least 10 years or probably more. Those prices were driven solely by the grossly irresponsible lending and terrible underwriting. Cap rates are back up to 10 percent or higher. The consumer is so devastated, and retirement savings so depleted, that it will take until 2011 for RevPAR to begin to rise to any material degree, which means NOI stays at lower levels for many years to come.

If one measures from the start of the last crash in 1989 to full reinstatement of RevPAR and NOI, it was seven to 10 years. In the new world of lending, this will be how underwriting will be based. This time is unlike anything any of us have ever experienced. Life isn’t returning to the Golden Age of 2005 to 2008 for a generation. Use this as a guide to develop your own strategy for where you go from here.


Joel Ross is principal of Citadel Realty Advisors, successor to Ross Properties, the investment banking and real estate financing firm he launched in 1981. A Wharton School graduate, Ross began his career on Wall Street as an investment banker in 1965. A pioneer in commercial mortgage-backed securities, Ross, along with Lexington Mortgage, and in conjunction with Nomura, effectively reopened Wall Street to the hotel industry. Ross also was a founder of Market Street Investors, a brownfield land development company. A member of Urban Land Institute, Ross conceived and co-authored with PricewaterhouseCoopers The Hotel Mortgage Performance Report. Ross served two tours in Vietnam with the U.S. Navy.