The number of hotels that are “underwater” financially is substantial and growing.  The challenges of today’s economic and capital market conditions has brought even solid, experienced operators to their knees.  So when looking at investing in a hotel deal today, should you recapitalize the current owner or acquire the property and start over?

For starters, it’s helpful to analyze the subject hotel in comparison to its competitors.  If the property is maintaining its relative pre-down-cycle position with its competitive set, you might conclude that the problem is less likely due to the operator. By interviewing ownership and key employees, reviewing property records such as quality scores and operating statements and physically inspecting the property, an experienced investor can come to a reasonable conclusion about whether or not to consider recapitalizing a current owner.  

Assuming that this review indicates that the problems are not operational, the key to putting a deal together may lie in a capital restructuring.  In this regard, it’s helpful to understand the motivations of the equity and debt participants in the transaction.  Equity investors, after careful analysis of their position may be motivated more by “mitigation of personal guarantee liabilities” or “recovery of principle” than by return on their investment.  Lenders and special servicers may be as motivated by timing and overall loan portfolio considerations as they are in getting the loans off their books. An approach that we are getting some traction with includes recapitalizing “underwater deals” as follows:

Sufficient new equity is brought into a deal to enable the loan to be restructured, to position and operate the property, and to provide for capital requirements and reserves.  Typically, this new equity receives priority returns over the current owner’s equity. The value of the original equity is negotiated, but generally is discounted. 

The existing loan on the property is restructured to a level that works in light of the current market.  Generally, this involves a discount on the principle amount of the loan and well as the interest rate, term and amortization.  We have seen a willingness on the part of some special servicers to discount an outstanding loan balance by 20-30% with term extensions of 3 to 5 years at attractive interest rates in exchange for new equity contributions that further decrease the loan balance and provide adequate operating capital.

The pool of troubled hotel deals in the hands of quality owner/operators that could be recapitalized is substantial and may be a better investment target than the volumes of properties caught up in the unrealistic bid ask schism and the legalities of lender borrower disputes.

-Paul Reitz

Paul Reitz, CCIM is Senior Vice President of Investment Services at NAI Global and is a hospitality specialist in NAI Global’s Special Asset Solutions and Investment Services groups.