by RUSHI SHAH
As the industry maneuvers through the pandemic’s aftershocks, one of the most discussed questions is what will lenders do with all of the hotel loans on their books? For hotel owners, the real question is whether mass asset foreclosures represent value destruction or pose a moral hazard if lenders don’t foreclose. This debate has opportunistic hotel loan borrowers anxiously trying to figure out how to best salvage their situations. The most viable solution for borrowers facing this dilemma is to either convince the lender to reduce the loan principal, or purchase or find someone else to purchase their note from the lender.
NEGOTIATING A DISCOUNT
Borrowers hoping to negotiate a discount on their existing loan balance should ask the lender to run the asset through a new loan-to-value (LTV) test. If the test shows that the asset’s actual value has fallen below the existing loan amount, there may be opportunity for a discount.
However, lender motivation to right-size the loan varies widely depending on the lender type. For example, a regulated bank lender is required by law to reflect accurate LTVs on their loans. If there is a degradation in the loan, banks have a fiduciary duty to their depositors and investors to immediately reduce the loan to its accurate value. This is accomplished by either selling the loan to a third party or reducing the principal balance and restructuring the loan with the current borrower. It is extremely rare for a bank to provide a discount on the loan and still keep the loan on its balance sheet. As a result, bank lenders will typically use discounting as a negotiating tool to have the loan paid or sold off.
Private debt lenders are not subject to these same regulations that motivate them to take a loss, but usually only offer up a discount if they believe the asset is going to take longer to recover value than their accepted investment horizon. Some CMBS special servicers have explored restructuring the loan into an A- and B-note, which also ultimately provides the borrowers with a discount.
As the hotel industry continues to reel from the economic shutdown, the tug-of-war between borrowers and lenders has intensified. Lenders expect to be paid in full and borrowers are desperate for relief. In response to this conflict and in anticipation of expected subsequent note-buying opportunities, many hotel owners, investors, family offices, and private equity shops have raised significant capital. If this friction is prolonged, more and more lenders will sell their positions to private groups that have the means to litigate to either be paid off in full, or to transfer the deed to their name.
Right now, the spread between what note sellers are asking and what buyers are willing to bid is wide. Note buyers expect to be able to buy at a discount to the principal value, but sellers have yet to reach their pain threshold. Most note buyers require a 20-percent internal rate of return (a time weighted rate of return on invested dollars). This type of time-weighted return is a function of the risk the investors take by purchasing a loan for a potentially non-performing asset and is only feasible if paying roughly 50 cents on the dollar (with all other things held constant).
According to the latest economic outlooks from major valuation firms, next year most hotel properties are expected to correct in value by only 35 percent, making hotel loan notes ripe for discounts. This means most hotel values are either the same or lower than its corresponding loan amounts. The note owner then has to factor in cost of collection or cost of foreclosure and any negative carry cost of the asset. This results in the hotel loans trading at deep discounts to the principal balance.
Unlike a fee-simple asset purchase, note purchases have short lead times. Those in the market to buy must therefore have cash ready to be deployed almost immediately. Note buyers must also have sufficient legal and asset management infrastructure in case they need to litigate to get their hands on the deed. Well-connected financing intermediaries and investment bankers can be valuable sources for both note buyers and sellers, as well as borrowers hoping to restructure their existing loans.
Rushi Shah is principal and CEO of the commercial mortgage and real estate investment banking firm and AAHOA Club Blue Member Mag Mile Capital. As a leader in hospitality financing, Shah specializes in structuring and placing high-leverage, non-recourse bridge and permanent debt with cash out for full – and limited-service hotels nationwide. Since joining the firm’s predecessor, Aries Capital, in 2015, Shah has structured and closed hundreds of millions in financing for all property types. Shah has held previous positions at Northern Trust and has an MBA from the University of Chicago’s Booth School of Business.