April 06, 2009
By Joel Ross
Nearly all sophisticated investors now believe there is no value left to the equity in almost any real estate asset that was refinanced since early 2005. There are exceptions, but they are few and far between. As a result, almost all the major investors are seeking to buy notes or real estate owned (REO) direct from lenders, and they are pretty much ignoring offers to buy out the existing owner’s equity.
Virtually every lender that is desirous of selling loans knows that nothing is selling at par today, and they must offer a discount to be able to do a deal. That discount can range from 10 percent to as much as 80 percent, depending on the asset and the particulars of the deal. It also depends on size, and if the lender making the sale is willing to offer terms in the form of a loan to the buyer of the paper or if he just wants cash.
It also depends on the status of the loan. Is it in default now? Is it already in foreclosure? Is it in Chapter 11 or Chapter 7 bankruptcy? Who is the borrower and what is the borrower’s capacity to fight? A number of lenders will sell to a third party but not the borrower since they think the borrower is taking advantage of them—which usually is not the case. The borrower most often is simply trying to save the asset from foreclosure. A borrower’s money should be as good or better than anyone else, since on occasion the borrower will possibly pay as much as a third party.
In an upcoming article, I will explain commercial mortgage-backed securities and the pricing of CMBS paper, but suffice it to say here that you can today buy super senior AAA paper at a 13 percent to 15 percent yield, and junior AAA and AA (known as “AJ”) at 18 percent up to 30 percent over swaps, depending on maturity and credit risk. This is liquid, tradable paper. BBB tranches can sell for much higher yields, but are considered far riskier and often out of the money. BBB paper which was supposed to be investment grade can sell for as little as 10 cents on the dollar. The CMBS traders market assumes hotel values at a 60-percent discount from 2007 underwriting or appraised values. This is all tradable paper, so compare that to tying up capital in a hotel for several years.
The point is that this is the benchmark against which sophisticated buyers are measuring prices. They demand to earn at least 2 times on their equity—and much more in many cases. Often they seek a 30-percent internal rate of return. This pricing is not just the Wall Street fund buyers, but the sophisticated operators who intend to renovate, or in some other way do some repositioning or value add work to a hotel.
If you are dealing with reality, then hotels in general will have a 40 percent or more decline in value this year from 2007 underwriting. If you then make some realistic assumptions that revenue per available room will not return to early ’08 levels for at least seven years, that the bottoming in RevPAR is at least mid-2010, and if you understand what the new financing underwriting parameters will be, then you will see that these sorts of discounts, or more, are required if you are to justify buying notes or REO over the next 18 months.
I will provide a follow-up article to lay out the likely underwriting you will see when lending in any volume or size does return for hotels, which will not be until sometime next year.
As the creator of the original hotel CMBS programs in 1993, this situation is very analogous for me. Cap rates are not used much now, but when they are used, a 10 percent to 12 percent cap rate on trailing 12 months often is the level investors are using. I am sure brokers will argue that this deal or that deal went for a better cap rate, but a deal here or there is not a market. It is an anomaly. There are not enough trades to claim that one or two make a market level. That is the whole point of why the banks are having such problems pricing their assets and the whole reason for all the fights over fair value accounting.
Luxury hotels and resorts I have seen offered for note sale are being priced at far greater discounts than mentioned above. That is especially true for luxury group houses. In the case that I have looked at, a very well known property, the senior note is offered at a price which would allow the note buyer to get the asset at a 75 percent discount to the original price paid to acquire the property just a little over two years ago—and nobody is offering to buy. The real value is estimated at around 12 percent to 15 percent of original value paid for the asset.
The market will sort out values as more and more hotels come to market. That will start to happen in about six months when the summer becomes a total disaster for hotels and owners realize they can no longer hang on or keep feeding the beast, and the lenders conclude that an extension is not going to solve the problem. That is why several senior people in the hotel business quietly have predicted that over 50 percent of all hotels in the U.S. will change ownership during the next three to four years. If you have cash and are a buyer, be patient. Here and there a good deal may show up now that is worth buying, but time is on your side. As one very smart panelist stated at my Urban Land Institute seminar, there is no penalty to waiting right now—and he was speaking about non-hotel real estate, which will come back well before hotel values will.
If you look at the 1989 peak in RevPAR and how long it took to return to those levels (corrected for inflation) and if you look at the period after 9/11, and understand that this downturn is far worse than anything ever seen, then you will understand that to justify buying notes on a hotel means a very large discount if you are to earn the sorts of returns that are required to justify the risk.
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.
