Most brands have been forgiving in terms of property-improvement plans, and the expectation is that it will continue through this year, but that only delays the inevitable monster waiting on the sidelines. As time passes, more renovation will be required because almost all available cash these days is being used to cover debt and meet operating costs. The more a property is struggling, the less money is going to even routine maintenance. In some cases, lenders and servicers are allowing a deferral of furniture, fixture and equipment reserves to allow debt to be covered.
Buyers need to be sure to do careful due diligence on any asset they are acquiring because the deferred routine maintenance may not be apparent. It is not just the obvious lobby and room cosmetics. It might be a systems issue.
There essentially is no cash flow and no financing for this work to get done by current owners in the near term. Silverton Bank and many other lenders that had been funding this work are gone. Local banks are unlikely to be willing to add to the already over-extended debt burden of an existing loan. New acquisition lenders are not likely to fund it because they are only funding against cash flow. The Small Business Administration might do a little, but it is very limited in size of loan so it will not be useful for any midsize or larger deal.
The acquirer must take this into account when buying an asset. Sellers or special servicers need to clearly understand that whatever a smart buyer might pay for an asset will get reduced by the full cost of the property improvement plan. The pending PIP is as much a part of the investment as the purchase price and anyone who does not include the PIP as part of his investment cost basis is going to find he has a potentially bad investment.
As time goes by and no funds are available to do the work, more and more owners are going to be under growing pressure from both lenders and brands to do it or be in default. If the property is allowed to deteriorate too much, it is possible a lender could claim waste and try to trigger the waste clause under the carve outs, which would make the borrower personally liable. This is a potentially major issue for owners. I would not expect the brands to provide any cash to do the work in most cases, and where a loan has been extended, this PIP requirement is the snake hiding in the shadows waiting to bite you.
A major source of funds for the PIP work may well be the well-capitalized funding sources and owners who will offer to step into such situations with senior equity or mezzanine loans to fill the gap, and possibly to negotiate a reduced and extended loan on the outstanding principal as the extend and pretend deals start to explode on everyone with new maturities then looming. It is going to be impossible for most extend-and-pretend participants to find both the funds to pay off the extended loan, even if it had been reduced with a previous equity infusion from the borrower. Now the borrower is faced with no more extension time and the PIP. The borrower will find that the equity infused into the property in 2009 or 2010 will be gone, along with his original equity, and they cannot pay off the remaining balance and the PIP. It will mean there is no further pretending and reality will arrive.
A lot of borrowers forgot about PIPs and assumed the world would be all better, and values back to where they had been during 2006 and 2007at the end of the two-year extension. Really dumb fantasy. This is why the industry has a very long way to go to sort out who the real owners will be when all of this finally gets resolved, and why it is going to take years to work through. That extension period goes a lot faster than many had hoped.
Hotel owners need to be finding the payoff and PIP money at least six months before the restructured maturity date in order to be able to hope to have funds available by the maturity date. If you are smart, you will be looking one full year ahead because it will be nearly impossible to find. When you do find a possible source, the due diligence and commitment period will be far longer than anything you experienced over the past 15 years—and then you can’t count on most lenders to commit these days. You also need to be gathering additional equity because the new loan proceeds are not going to be sufficient to pay off even the restructured loan amount and surely not the PIP. As we already see, 2010 is not going to generate any material cash flow to help you. There goes one full year of the extension period.
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 pioneer in commercial mortgage-backed securities, Ross, along with Lexington Mortgage and in conjunction with Nomura, effectively reopened Wall Street to the hotel industry. A member of Urban Land Institute, Ross conceived and co-authored with PricewaterhouseCoopers The Hotel Mortgage Performance Report. Ross is also the author of Ross Rant, a commentary on the economy, financial markets and politics that’s available through his website.
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