Interview site: The Meet the Money Conference in Los Angeles, California.
Interview date: 5 May 2010
Moderators:
Rob Stiles, executive VP, Cushman & Wakefield Sonnenblick Goldman
Mike Cahill, CEO and founder, HREC
Participants:
Bruce Lowrey, principal, DB Capital
Ryan Krauch, principal, Mesa West
Barry Olson, COO, Archon Capital
David Millard, executive VP, Washington Holdings
Jonathon Benowitz, managing director, RockBridge Capital
Rob Stiles: "Good morning. My name is Rob Stiles, executive vice president and principal with Cushman & Wakefield Sonnenblick Goldman and I'm joined with my fellow co-chairman of the ILFC (International Lodging Finance Council) Michael Cahill, CEO and founder of HREC. We're here for a roundtable with the ILFC at the 20th anniversary of the Meet the Money conference in Los Angeles. Gentleman, I'd like to start the discussion by providing a brief description of where you are in the finance market and what sort of assets are you looking to lend and what are sort of your key defining, underwriting parameters today? Maybe, Ryan we'll start with you."
Ryan Krauch: "I think we're focused on the meat of the hospitality industry. I think it's anything from a limited-service to a full-service branded and potentially unbranded hotel if it's strong, in primary markets, maybe some secondary markets, if they're strong. For us, what we're looking for is not necessarily in-place cash flow, which I think in hospitality lending is a necessity in this market. We all know that cash flow has been quite depressed, NOIs are down. We have the capability and flexibility to look at those and move forward. With the assets potential is from a cash-flow perspective kind of looking back further than the last couple of years and seeing what it was producing and try to get it back to that sort of level. So for us it can be anything from a stabilized asset that just needs a little time to get through these choppy capital markets to something that maybe has a brand change PIP requirement or some sort of capital requirement that we can help fund."
Michael Cahill: "You had mentioned earlier that you made one or two hospitality loans this year already and you have a couple in process. Can you talk about the specifics? I don't know how specific you can be about those two deals or three deals."
Krauch: "We closed one deal just last week; it was just outside of Chicago. It was an unbranded hotel that is being converted to a Hilton Garden and it was probably over-renovated back in the heyday and now can benefit from a brand just to help pick up some of the weak business. So we're providing a loan to not only, in this case the existing loan was being bought at a deep discount. So, same owner buying their own note back. We were able to finance the acquisition of that note, recapitalize that note and also provide some future funding for the PIP. So, great sort of win-win where the owner of the property gets to recap or reduce his basis and also put some money into the asset to help generate some more business."
Cahill: "How did the overall proceeds relate to the total invested capital?"
Krauch: "Yeah, we were probably about, call it 75 percent of where they were originally buying the note."
Cahill: "So you bought it pretty high up the capital stack?"
Krauch: "Yeah pretty high up the capital stack. And in that case, again, it's very hard to assess value today. So it's kind of tough to say on today's value that was probably a very full note but on a more stabilized value it was probably in the 55 (percent), 65 percent range."
Stiles: "Interesting and just the last question, the 75 percent, was that with the purchase of the note?"
Krauch: "Yes"
Stiles: "Did it include the additional capital for the renovation?"
Krauch: "The renovation wasn't too big in this case because they had spent a ton of money on it. We're just talking about systems and some branding, so it was plus or minus, I don't remember exactly, but it was right in there."
Stiles: "But it's interesting because that's attractive leverage to current costs. And it really wasn't widely available six, nine months ago."
Krauch: "And that's when, in fact, when the process started for this particular one. It closed just a week or two ago but this transaction started at the end of last year."
Stiles: "Congratulations."
Jonathon Benowitz: "Ryan, a question on that. When you look at deals like that, often when they're storied, so your sort of counting on cash flow picking up maybe a year from now, two years from now, how do you deal with that in terms of giving the property or the borrower the breathing room they need or do you just not price it so high where they actually can cover it without too much stress?"
Krauch: "You're absolutely right. I think the big concern now is term and working through this period of time where cash flows are depressed and I think we're starting to see at least the glimpse of some of this potential recovery, but that could take some time. So what we'll do is we'll provide a very healthy interest reserve in cases where we don't think there's coverage available. And try to get plenty of runway for that ramp-up to continue. Obviously from our perspective, we want to make sure that the sponsor is well-capitalized so if that ever became in jeopardy we could help write a check and sustain that. For us it's sort of taken where we've perceived the cash flow to go underwrite that and give ourselves a little bit of a cushion in case we're wrong and then make sure there is plenty of capital to adjust the interest on that."
Stiles: "Bruce, where are you looking to participate with your new fund?"
Bruce Lowrey: "Where we want to play is maybe a first round a little bit less than where Ryan is. It's a senior debt platform and it will focus on we think the primary risk mitigant to good lending is really strong sponsorship. People who have significant experience and exposure in the business. Maybe one of the lessons of this cycle will be that lodging is unique. It's an operating business and if there is an opportunity to get 25 extra basis points of return it may not compensate for the risk if you don't know what you're doing. So, it's always been our bread and butter to stay with a really good sponsorship. I think the other two things to focus on our quality assets. New generally beats old. And generally staying with brands. Stronger brands. Although historically we've done a lot with independent if there is a good operator. And then we like to stay in top 50 (metropolitan statistical areas) MSAs. So, where we want to play is where the banks are not, where the life companies are not. It's a little further up the stack. More in that 70-percent range, doing bridge lending. I agree 100 percent with Ryan that what's really needed here is a bridge to smoother times so we are seeing improving performance metrics at the property level, at the market level. We're down so far that even stopping a decline is positive news. So that's good for everybody. And our focus is we will underwrite more aggressively on today's cash flow, and in-place cash flow. Call it a 10 percent debt yield. So 10 times cash flow, but we want to see that our underwriting will show that that's a 13 (percent), 14 percent debt yield in two or three years. So as you said on valuation, it might be really aggressive today. But we think on exit value that's a 70 percent loan."
Stiles: "Where do you think pricing for that debt is going to be this year?"
Lowrey: "Well I think it probably is in a range of 8 to 10 percent for us. I think if banks are lending at the 6- to 7- to 8-percent range for roughly in the 50 percent leverage maybe that's as high as 60, but there is a level of recourse. We think the incremental cost in capital to get a little more leverage and probably be nonrecourse, it's not renovation or reposition or construction that's a cost of capital when blended in that is less than the cost of equity. So it's worth it to borrowers to pay a little bit more. We also think that there's very much a binary market. That if you have an attractive asset and if you look at some of the purchase transactions that have occurred, there's not a lot of stuff that is trading right now on the buy or sell side. But when something does trade it tends to be because it fits that box of what is attractive. So either you like it—institutions like it—or you don't. And when institutions like it there's a lot of competition for it. So, in some ways real estate is trading almost on a scarcity value because of progressive cap rates and I think every one of those transactions is justified truly by investment committee. But it doesn't fit the overall picture of lodging as a very depressed place to play. Those returns, I think there is a little bit of a mismatch. So we think that where the dominant capital is the banks, the life companies they're able to be more selective and they're not going to get as much yield but they're going to be further down the capital stack. So there's an opportunity for a lot of people who are in that gray area. Good borrowers, good assets, good markets who are kind of frozen out from capital that we think we can provide capital for.”
Krauch: "You talked about the capital stack and John you may be able to jump in here too. So my question is, let's say a property is bought for $100 a couple of years ago maybe you got a $75 or $80 loan on that. Now you can get it recapitalize if that loan is coming you have to recapitalize. You pick the number. You or I may go to $50, $60, where does that other piece come from? How does that stack get filled? Do you see the borrowers out there having the equity to put it in themselves or John are you back filling with some more mezz parts or what is everybody seeing from that perspective?"
Lowrey: "I think that's a great question because, we use as a hypothetical, real deal to our investors, somebody bought a hotel for $20 million in 2006. They got a 75-percent bank loan for $15 million. The cash flow went up, the cash flow went down and the loan is now due in 2010 four years later. The lender says it's not even worth the debt. But the lender would say 'I'll write you a new loan or refinance it at $9 million.’ So that's a $6 million capital shortfall and I think the space between recovery and where we are now is just recapitalization, so how do you fund that shortfall? So, I think it's a number of different ways. I think lenders in some ways are willing to give a bit of a discount if there's new capital. If they can just get paid off, there's maybe a smaller discount. So that gets funded I think by, in a lot of cases, that borrower doesn't have the $3-$4 million to do. So pref-equity or mezz is a little more leverage."
David Millard: "If I could jump in, John, one of the hopeful thoughts we have is that in fact from an opportunity standpoint some of those loans that perhaps weren't crazy leverage. Maybe they were 70-percent loans that now look more like 90 percent in value that will be coming due that weren't fundamentally flawed. We continue to look for the same types of high-quality assets, high-quality borrowers, strong market position assets, but simply sort of the conventional money will not refi out that whole space. So for a company like ours that relies on B-note, mezz opportunities to generate the yields that an opportunistic investor needs to deliver. That is a space that we think is going to produce opportunities for the simple fact that, as we know, there is a tremendous amount of debt put on assets over the last five years that in the coming five years is going to expire and needs to be replaced and not all borrowers are in a position to do that. Not that they are necessarily doing anything wrong. But at this point in time cash flows are down. We like cash flow. We'd love to see strong coverage but you can't always get what you want. So if you have a good borrower and a good asset that's well-positioned if cash flow is down, we can certainly underwrite a business plan that shows how it's going to get back up and we're happy to come in with $10 to $15 million to come behind conventional lender not necessarily conventional, but someone with a lower cost of capital and hopefully blend to a solution that makes sense for our guys."
Lowery: "Would you do a smaller like in this case a $3-million piece? Is that too small for you?"
Millard: "It's probably too small for us. We have a small team and we do one-off deals for the most part. If we did a deal a month that would be a pretty historic pace for us. Probably not $3 million, but $10 million we would on a $40-million loan. Maybe we are the 50-75 percent of the cap stack piece or going up."
Barry Olson: "I would just add, it's because restructuring is the topic du jour, it should be and will be for a while. We've looked at a lot of those opportunities as well but I will tell you the space in which we are looking at, almost in every case when we got very close to doing a deal, the special servicer or whomever, just renewed the deal for a year or a year and a half or two years. Whatever was allowed under the CMBS documents. So, our biggest competitor isn't you guys because all of us would be willing to step in and find that capital. The biggest competitor is actually the existing lender and so when we show up to the table and say here is what you need to put in to reset the value so we can reset the loan, they're taking that piece of paper and they know what their opportunity costs are to go negotiate with their current lender and nine times out of 10 right now they've got the better deal with their current lenders."
Benowitz: "And there's a big gap there because the existing loan is done a few years back and it's cheap and so when you show up trying to be the rescue capital to help save the day, you're priced at 12 percent and like you said the servicer is going, 'Well you know maybe I'll just extend at the same rate. Or I'll extend it at a little higher rate.' That gap and what we've seen and that's the competition. So you are almost hoping for a more distressed situation. You are hoping for a more distressed situation because that is when somebody really needs you."
Stiles: "It's probably going to be more difficult for that strategy because special servicers are really waiting for the operating fundamentals to move to the point where they are fully back into the money as a strategy."
Olson: "Like what Ryan said, we can't do deals without cash flow. We can look at a major discount to replacement cost and go through all that analysis, but if we're all sitting here saying we really like assets that are cash flowing and we all look at it as maybe it's a nine yield or an eight yield to our debt today and I may need to put in some interest carry for 10 because 10 and most of the gateway cities are worse than nine, or started out at least the year and maybe it will be better, but if you look back at the numbers, then you've kind of got that dichotomy that we're talking about. We've got cash flow. The servicer is saying we have cash flow and I can kick the can down the road and go and then back to your point, it's binary. If there is no cash flow then there are opportunities but those of us around the table are having to look pretty hard at those opportunities whether we can even get in and actually start funding operating costs, let alone debt service."
Krauch: "And I've been somewhat encouraged. Last year I think that was certainly the theme 100 percent 99 percent of the time. I think we're finally starting to see on a very, albeit one-off sort of sample set, we're starting to see the banks play ball. Starting to say, I'm willing to shed this asset at a discount. We actually just tied up a deal this week that we thought was gone for exactly the reason you said. They went out did a bid process on the debt, the existing lender came back and said, 'Hold on, let's cut a deal.' So we thought OK, great, we've been through this game before and it's wasted a lot of time. So they went back and couldn't do it. So it's back in play and we were able to sign it up. So, that wouldn't have happened a year ago. I'm at least somewhat encouraged that we are seeing some signs that the banks are willing to play ball again. Special servicers maybe not, but at least some of the banks."
Millard: "And Ryan, I don't know if you agree with that. It seems that plays into kind of a fundamental increase in the velocity capital generally where we as a portfolio lender are actually shedding assets at least in a couple of cases where just six months ago the value on a secondary market with mezz position would have been 25 cents on the dollar. Perhaps that rebounded to 65 percent of value and I think it's a view from capital saying, I like that position on the capital stack and maybe a larger opportunistic investor would say I would take that mezz position and the downside is I get paid off and the upside frankly is I own the asset. So it's interesting to watch the velocity pick up in real time but we just don't directly sell assets. But there are cases where maybe there's so much senior debt in front of us that we're not equipped to deal with the problem and somebody else who is will take a view that we can own that."
Olson: "I'll also tell you right now the paper-selling market is robust. There's a story there where people have raised money from investors that have been sitting on the sidelines and if there's a story and if they think they are buying it at a major discount they can buy paper. The paper is almost trading as good as the fee simple and we had a situation arise just recently where we weren't even planning to test the market. We were just going to keep the asset and we liked the manager, keep the manager in place and just restructure the deal and keep moving forward and the manager went out and tested the market and asked if he could buy it at a discount. I said 'Sure. You're not in the penalty box, you've done everything you said you would do. It's just the market is moving against you. So you're not in the penalty box, give me an offer.' So, he does that and unfortunately he hired a broker which created a little stir in the market. For him it was a little unfortunate. Because what that created was I got within a day or two four phone calls from people not working directly with that broker, but hearing about it from friends and family saying you should call Barry because it looks like the deal’s in play and I'm like, the deal is not in play. I don't know what you are talking about.' So we created what I call the best unintended auction of all-time. And we had several people show up and bid and it was kind of funny because I said not disparaging your profession but, the borrower actually got mad at me for bidding him up. I said 'I don't know what you expect me to do. You created the auction and all of a sudden someone came in higher than you and ultimately we ended up transacting with him and his new group of equity. But at a fairer price."
Benowitz: "Speaking of brokers, what are you guys finding and we're talking about servicers and you're talking about approaching them as a principal or as a fund that has capital that wants to cut a deal. How possible is that in your opinion in terms of the servicer, not hiring a broker."
Olson: "Impossible. They have a fiduciary relationship. It's a certain standard they have to adhere to. "
Benowitz: "Even with the existing borrower?"
Cahill: "Well, not with the existing borrower. But they still have to get BOVs. They may not have to market it, but they have to do some type of effort. Let me throw out a scenario to you guys because you guys are going through these various things. Most of the stuff we are seeing that's getting put on the market especially by the servicers right now is the stuff with hair. So, in other words, we do work for all the major servicers, we're in line on brokerage and the stuff they are giving us to sell now is something where someone had to write a major check and most of these buyers are just assuming they have to buy all cash. They're going to take it down all cash and they're going to refinance two or three years later. Is anything out there in terms of decent debt for some who's buying a value-added turnaround losing $3 million or do these people still buy all cash and come talk to you in two or three years when they want to refi? How do you define decent debt? In my eyes, I think you go out there and right now there's a fine line between someone goes 'Hey, that's kind of reasonable.' Versus all of a sudden people for certain lenders it's hard money. Then it starts getting referred to as Luigi. Then all of a sudden people are going 'My God this is equity masquerading as debt. I think there's a range of options out there. And I don't see many people taking the higher options because once you get up to that level you might as well buy all cash because you're paying your lenders equity money anyway on the deal. At least for $20 million and under, it's amazing. We're seeing guys just write the check."
Lowrey: "And I certainly understand, but as you were saying before, if you've got an existing loan that's tied to LIBOR or LIBOR’s a quarter and you made that loan a couple of years ago and it's got a spread of 200 and there's no floor. So you got an interest rate of two-and-a-quarter, two- and-a-half percent. Is that a reasonable loan? Because if that's your expectation of where reasonable starts, then there is no reasonable loan. And that's why I think there's a lot of gravity between existing borrower and existing lender. It's not necessarily a happy marriage and they both would like to be rid of each other but that's a pretty strong, compelling argument to stay together."
Cahill: "It's a great argument except when that hotel's negative cash flow before debt service of $3 million a year, then all of a sudden that beautiful marriage falls apart."
Olson: "I agree, but I would say that's in the perpetuity by the means. We generally look at bigger deals. So our minimum size is $40 million. So we're either a mezz piece of $40 million, a much larger piece or we're in the process of taking down a loan that's in access of $150 million in a senior position. That's kind of the space we play in, but what we're seeing right now is the delta that would cause us to go chase that type of asset is so large that it would either crush the asset, the interest rate and it doesn't really make sense for the asset. And also because of the opportunities we're seeing today, I mean we're having enough opportunities with cash-flowing deals. They're a little stressed, they're way off their ’07 marks obviously, but for us they are in gateway cities ... so we can transact on those deals. We've done about a quarter of a billion this year and be very happy putting into our debt fund and not have to take a lot more risk to chase that kind of asset. And it's the same thing from a development perspective. I did development back in ’04, ’05, I wish I hadn't in a couple of cases, but in a couple of cases it turned out just fine. But that was all because I was able to get LIBOR 700 or 800 versus being at a similar place in the debt stack with a stabilized asset getting LIBOR 350 or 400 if you remember the day. So that delta created an incentive for us to go out and find a couple well-placed construction loans with great sponsorships, etc. I would say the same thing is in play today. It hasn't changed, it's just the risk adjustment return to replace those deals if you're already talking eight to 10 on your senior loan on a cash flowing asset that may have a little stress, and you've got a little structure. What does that mean? I don't know. It's 12 to 15 to chase that kind of asset and A, it probably kills the asset and B, you may not need to do it because you already seized another opportunity."
Cahill: "So these guys should stay all-cash buyers?"
Millard: "I'd take a different view of that. I think the reality is what is happening a lot is the best thing for a special servicer to do is to in fact extend many, many cases. We are at the trough in cash flows will likely pick up from here where more conventional servicers with capital will come back in. But even with deals that a borrower is out of capital the servicer know it's got to make a decision with an asset. The asset is repriced market date. There is a market for 60-percent financing and frankly if there is some cash flow it's probably pretty competitive. So there's debt out there. Maybe not for very small deals, maybe not for very hairy deals and of course it's dependent of who the servicer or special servicer is and so every deal dynamic is different. But I think again we feel that the day of reckoning will come for a lot of the CMBS trusts anyway and the two- to three-year extensions cannot go to by virtue of their formation documents. So when they come to market, and they will eventually come to market, there will be a market there to meet it. The borrowers going to have to start paying that debt down to a certain amount. Maybe you have to put together a slightly more complicate capital structure. Or the cash buyer is going to win the day and own it at a cheaper price and be happy, and then they can come back to market. So we are seeing a little bit of that. The cash buyer is the one that gets the deal from the servicer and maybe they wait for three to six months."
Cahill: "That's what we're seeing. Because your servicer when your cash buyer comes in, and buyer that comes out today and says I have a financing contingency, I'm working on raising my equity. They're not going to get the deal. We had one hide on the market, a distressed asset. We had 23 written offers on the asset and it get bid up way above even our broker opinion of value for what the asset is going. But it's all-cash buyers."
Stiles: "That's the same for all property tax, if you have an office building, a big vacancy. Those are all-cash buyers. I think the big issues is the net operating loss issue because the liquidity that came out last year for hotels had pretty tough debt yield requirements and coverage requirements that I think part of what's changed is, you've talked about it . You will finance a deal that has less than 1-0 cover going into the deal as long as you understand how you get to a 13 or 14 debt yield looking forward. But last year that was much harder to execute. But to go from there to negative $3 million in cash flow, that's really tough."
Krauch: "To answer your question directly, we would do that deal if it's the right asset. We would do that deal, we are the very few admittedly, but I think the question for the borrower's perspective that all-cash number whatever it is does have a cost to it. Today that's over 20 percent. So even if you are getting a 12-percent loan or a 14-percent loan, there is some level of benefit there."
Cahill: "It's really interesting. When Rob was on a group called the Lodging Industry Investment Council, we did a survey. It's interesting that the general consensus is that equity rates returns have dropped a lot. And so I don't know if that 20-plus yield is out there anymore. I mean we're talking all cash buyers, 11, 12 percent yield is that they are looking for. So at least relatively cheap in the big picture of the hotel world right now. We're talking to some buyers that are saying I believe in the big picture. Because the stuff that is out there now is a lot of hair. Maybe Rob's firm does get the great cash-flowing stuff that can be refinanced but most of the deals I see the great upside to opportunities are deals that are out there that are broken. They're nasty. But they have a lot of upside for the buyers. You guys are pretty entrepreneurial and you look at these deals. How do you put a deal like that together?"
Benowitz: "I think that the key to making those deals work is you hinted at it. Is it debt or is it equity? Well, it's somewhere in between. But I think the key to making those work is actually the new investor has to back off a little bit. Has to be a little bit less greedy. You've hit it right. If you are looking for that full equity return that was always 20 plus, you sort of have to reward the borrower. If he's got control of the deal, you have to leave enough and this term ‘hope certificate,’ well, it's probably got to be a little better than a ‘hope certificate.’ It's really got to be something legitimate where you, that's why I had the question about breathing room in your deal, Ryan, because they've got to give them a chance. You've got to balance all that by either funding interest reserves or participating on the back end by being overly fair and pulling your deal together. But it's not one formula is what we're finding. And we're also spending a lot of time on those types of deals. It takes a lot of time to get a deal like that, that gets complicated like that done with a borrower so he can go buyout his loan and if it's a bid process and everyone else has cash, you're just not going to have time."
Olson: "Are you emphasizing to engage all parties at once, engage the lender so you know what the benchmark is?"
Benowitz: "I think that's the challenge is get the three parties together, because these things can be structured in very different ways."
Olson: "And that's the winning formula we're seeing but that's not the formula you can really follow all that often, unfortunately. Maybe, again, what David said. With all the stuff that's coming down the pipe, it's going to be maturing, and even your pooling and service agreements have a limitation as to how long they can keep kicking the can down the road. Maybe that will force the issue a little bit more to bring everybody to the table and these assets because then you can transact fairly quickly if everybody is at the table. Just like you were saying, it goes on for a month or two or three and you go to the lender and the lender goes, ‘Are you kidding me?’"
Stiles: "I will add one caution on the leverage return requirements because we are seeing it across all property types in the firm. Yes, they are coming down but they are coming down principally because investors are very low leverages in all classes of real estate. So if you stop moving up on the leverage curve, you'll see the equity leverage returns requirements go up. It's a different level of risk. I had a question for Barry, Dave and Ryan because you guys are sort of hotel focused, your capital is really competing, hospitality is competing against other properties. So it would be interesting, how has the hospitality story right now within your organization. From the outside looking in it must be so compelling where we are on cycle and what you are starting to see."
Olson: "From our fund perspective we do all product types, so we can't overemphasize one product and end up with a 70-percent lodging portfolio. But right now we've done a quarter billion dollars for this year thus far. It's all lodging. And when we really look at that, it's a very compelling story like you said. And able to get into the market, do some senior mortgages. We've also quoted on some mezz and preferred equity as well, but senior mortgages in that 8-10 sweet spot and have a year or couple year lockout at least and give them the bridge to get to a better execution later on down their life of the asset. So we're really encouraged by what we see and we're looking forward to putting some more positions on and we can just because it's a $2.6-billion fund. So a quarter billion of it so far isn't really going to break the bank from a diversification standpoint. So it's a spot right now where we're very encouraged and all of our producers are looking for opportunities."
Millard: "I'll just say similar to Barry's perspective, I think we view the hospitality space as one of the best opportunities right now. That said, if you've been in the business of investing over the last 10 years you've probably been dealing with some issues in your portfolio like we have. So the approach we have is very cautious and we probably will never do another $250-million-plus deal on a $2-billion portfolio. We will do the 10-15 mezz pieces and hopefully have some real in-place cash flow there where we can reliably underwrite current interest payments of 10 to 12 percent. That's really what we would like to see and positive coverage to our debt position in fairly short order. With hospitality it is difficult to predict where you are going to stabilize. Nobody is perfect at it and so we have to feel really good to want to do hospitality deals so we are approaching the space very cautiously, but again compared to office where we also have a core focus and a core competency, I think we are viewing hospitality as an area where we are going to get to those reliable cash flows more quickly because in an office sector fundamentals are still falling in a lot of the markets we are investing in."
Krauch: "I think it's a natural part of a diversified portfolio is that all these products go through their cycles at different times, and hospitality has the daily leases basically, you're going to hit bottom first and recover first. So we just view this as a unique opportunity in time where there is not only hopefully closer at the bottom of the fundamental cycle, but there is just very little competition for the good deals. So we just look at it as a good time. Over time you have to diversify that portfolio."
Cahill: "What would be an example of a typical deal you are seeing a lot of that you're not able to help? Like when someone calls you up but it's outside the space still. Any idea for that?"
Krauch: "To me the deals are falling in probably three categories. One is the existing lender pretend and extend concept that Barry alluded to. Two, a deal that really can get done that's very high quality right down the center of the fairway and there's an intense competition with cash flow. And that's very tough to compete with because whether it's a life insurance company or just other low costs of capital, it's very challenging. And then there's everything else. A lot of that falls in the bucket you were describing, which is it's got hair on it."
Cahill: "The value added, storied, no cash flow, believe me."
Krauch: "All those assets are facing the same issue. They've got to be recapitalized. We've got a trillion and a half in the system that has to be recapitalized. Probably only half of that can be done conventionally over the next three or four years."
Cahill: "Now, why couldn't a lender look at one of those loans for the value added, negative cash flow and just approach it as if it was a new hotel loan? A construction deal going off to a hotel that's got to build up. Why couldn't lenders jump in and just approach those as their new construction deals where we would just have a little more facts than you would for a proposed hotel?"
Benowitz: "I think you can. I think that the challenge is the environment that we're in. And those deals, construction loans, just zero-cash-flow deals always are hard to project but more so when you've got less confidence on where you stand today in terms of in-place cash flow. But I think we all know that is improving. I think we all know we're feeling more confident about what given assets are generating in cash flow. So I do think taking that approach can be done. I think the challenge there in all these kind of storied deals is kind of falling in love with the basis play. Falling in love with the story. Falling in love with the hair but you've got to fix it and make sure that the cash-flow story, the detailed cash-flow story, operating plan, where the business is going to come from, etc., is really intact. Because there is a tendency as we all pursue deals and need to put cash out to fall for the story, especially when there is the, 'On that basis you can't lose.'"
Cahill: "Is it perception? Because with a new hotel everyone is happy, everyone is excited and there's no negative to start off with because it really is no different from a new hotel loan. But I guess it's the difference of me coming to you with this shiny brochure with hopes and dreams versus coming to you with the same package and saying 'Well, oh by the way it really sucks now, and it's proven to be bad right now."
Olson: "I'd make a couple of comments on what you're saying because that is obviously where the dearth of liquidity is. I feel your pain."
Cahill: "Part of what I am trying to get a feel for is we have 35 guys, we're like, ‘Great, the guy finds something with great cash flow that's a hotel. Sure you're going to get your deal done."
Olson: "Let me ask you a question. If we go back to 2004 or 2005 or 2006, who financed those assets for you? When you had that deal whether it was coming out of construction and bridge or it was a big PIP in turnaround and rebranding, who financed that for you?"
Cahill: "I would probably say at that point and time it was mostly the regional banks."
Olson: "So that falls into ... because the regional banks and unlike a lot of us we're all talking about relationships and operators and all of that but a lot of us here are nonrecourse lenders and so the regional banks got comfortable with that story lending as much money as we otherwise would, but also taking guarantees from their sponsorship. And they can do those types of deals. Obviously we know where the regional banks are today. They're on the sidelines because of their whole portfolio of stuff they did and that hasn't worked out. They are still dealing and so that's the pain and I think market feels not having those guys back in the marketplace. Hopefully they'll come back in the marketplace and obviously that is the pain that's out there."
Stiles: "The history is sort of CMBS liquidity along with some of you guys chase all those regional banks. They couldn't really participate in the core hospitality financing market, so they had to take on all these higher-risk assets. New development, new construction, existing assets that are floundering with recourse locally, and now they've been crushed."
Olson: "They talked themselves into the fact that recourse was also helping them out with the story where a lot of us who have underwritten lodging from 20-years-plus like recourse, sure, but that's not the panacea. It's the real asset, it's the looking in and doing the real digging down of the deal."
Lowrey: "I think there's one more thing. If you're talking about a hypothetical, hey, it's got hair on it, it's not performing but it will. I don't know if you can make that assumption that they will. Because let's face it. We've all seen these deals that the property has a negative $3 million operating loss in many cases might be a suburban market, a full-service hotel that's 500 rooms in a market where it's 30 years old. There's a fair amount of functional and economical obsolescence to this property. The demand has changed there. There's a new Hilton Garden Inn or Courtyard or something that eating its lunch. And really where does that property go? It's probably really only got one way to go. It doesn't ever really recover to where its value was in 2004 and 2005. So I think there's a problem. I've done a lot of construction, our bread and butter was renovation repositions. So we're very comfortable with that story but you also have to be very selective about which stories you choose to believe. And I think there's a lot of property out there that's got this that may never recover in this cycle for a long time because this larger 500-room full-service hotel that relied on a lot of group business and meeting space is going to be competing for lower business and because it's not going to do as well. I think we're going through a really socio-demographic change where people's spending habits are going to change. There's a lot less credit in the system, a lot less money for credit cards, for car loans, for student loans. People's savings rates are going to be higher and I think they're going to be more selective on where they spend their money. And so some of these older big boxes are going to find it much harder to compete to return to their profitability levels that they had before."
Cahill: "Assuming the forecast from the potential borrower is realistic. It takes all of those things into fact because I think what's happened, at least what we're finding is that I think there was an overreaction to the negative. So what we're coming back, at least because at HREC with a broker side and the consulting side, on the consulting side we're seeing everybody starting to beat their 2010 budgets. In other words when they put in the rolling budget for January, February, March, all of a sudden everything is coming back in. You're wondering if in November and December of last year things were was so gloomy they went down but consistently and especially on the big-box stuff, we are seeing budgets ahead by a million dollars, $2 million of what they forecast. So I'm wondering if some of that is just perception. If we, there's an old adage for at least appraisers that said they tend to undervalue in a rising market and overvalue in a declining market and I wonder if there is that perception out there. Because the difference between you guys like when I started the business in the early ’80s was that lenders didn’t really understand the hotel business. But now we have guys that are – all the lenders are full-time hotel people. So shouldn’t you guys see through that?"
Olson: "I can answer that: I will tell you right now, from a hospitality perspective, we’re longer optimistic than we were last year, in 2008. So we’re feeling a lot better. But to answer your question, and I sit on an operating committee, that we go through all of our portfolio, not only from our debt side, but from our own side, so we have several billion dollars that we own of hospitality, that we see the results coming in, you know, daily if I want to find out. And it is exactly what we’re hearing at this conference, for the most part, everything is trending up, we’re beating our budgets. But you’ve got to remember, the budgets we’re beating were created in the depths of 2009, October, November, things were horrible. So in a relative basis, to say we made a million dollars more than budget, you really compare that to 2007 or 2008, even, and it still looks pretty horrible. So it’s relative, we’re feeling more optimistic, it’s always good to beat budget, but our budgets were set in the dearth of 2009, so we can’t just jump up and high-five."
Krauch: "Yeah, that’s a very fine way to answer, I think to me, it’s a supply and demand question. If there’s 100 deals out there, but only 10 lenders in the world, just relatively speaking, they’re going to focus on the top 10 percent of those deals. They all want to go back to their investment committees – some originator brings me two deals, one of them is cash flowing, all the good things we talked about, and the other is more challenged, which one on the investment committee do I think we’re going to sign off on? It’s going to be the top 10 percent."
Millard: "As an investor, the goal is I want to show our clients a superior deal on a risk-adjusted basis. The fact is, you know, the capital market’s just disintegrated for this product type and now it’s coming back, but it’s exactly what Ryan said, you have to pick and choose your places, and I would rather choose to underwrite a cash flow that is well off its peak, but is fundamentally easier to underwrite, more predictable than something that is either negative or zero that has to go from zero to a 12-debt yield versus six to a 12-debt yield."
Krauch: "Bruce and I were talking about this earlier – fundraising is a very challenging thing to do right now. Institutional investors are very gun shy on real estate. Now some of them are starting to get back in, but why are they getting in? They’re getting in because they think they can get great assets at great pricing, whether it’s in lending or acquisition, so you show them a picture of a very pretty downtown, sexy, high-rise hotel, which may or may not be fundamentally sound, to your point, versus the first prototype Courtyard in some secondary market, that might have much better margins and much better story to it, but which picture shows better when you’re going to investors? It’s the big pretty one."
Olson: "But to that end, Behringer Harvard has found a pickup in their fundraising, remember they’re retail investors, when they do a shiny new hotel. And the example was, in a Midwestern city they did a new hotel, it was a well-known hotel, I think it was the St. Louis Park Hotel, and all of a sudden, in the St. Louis and Midwestern market, they saw influx of more money being invested. And those are the $30,000 investors, because they’ve heard about it, they saw it, it makes a splash on the news, and they invest more money."
Cahill: "I think it’s an interesting segue way for that, because the question is, as hotel people, are we too beaten up to look at the big picture, because the buyers that we’re coming out with now, if you look at, we take something to market, we have a Hilton Garden Inn with 140 confidentiality agreements executed on us, and we have some other value-added stuff. When you come down to the top 20 buyers, they’re not traditional hotel people. We sit down with our seller, it’s like, all right, this is X, I know him, I know him, I know him, I like him, you know, they’re looking through these lists as the sellers would do the letters like, who are these people? You can’t pronounce their names, and they’re sending us proof of funds by like snapshots of euro-cleared - (laughter ) – and we’re going, I don’t understand what these things are, and we’re trying to track them down, we have to say no, these guys made millions in the jewelry business and they’re vulture-fund real estate buyers, it’s just, and you wonder maybe they see something we don’t because we’ve been beaten up. And there’s general real estate guys who are just looking at this thing going, I had a guy look at me and say, 'My God, I can have this entire hotel for less than my house costs.' He goes, 'I just think I’m going to buy it.'"
Benowitz: "I think it’s partly that we’ve been beaten up, but also because there’s – you know, the amount of data that we all have has increased dramatically from 10, 15 years ago when we all got in this business, and we’re all analyzing it like crazy. We’re picking it apart, and I think that, possibly, is making those of us that are in the business a little bit more hesitant to make, sort of, that sector bet, because you’re talking about individuals, but I mean a lot of people are just coming into the lodging sector because they’re just taking that broad view, and they are looking at the price per pound, and they are looking at the economy that’s just, this is obvious to them. Where, us, perhaps we’re getting into the details a little bit too much."
Krauch: … "Real estate in 2005 to 2007, you should be going to triple that in the next 3 years, but it takes awhile for people to get off their gun-shy sort of way."
Cahill: "I mean, because, some stuff in California sold for incredibly high prices, and if you take some of those prices, and you try and – we had our analysts trying to re-create the cash flow scenario that would have to support those values, they just hit analysis paralysis, they just can’t – you know, you just get to that point where someone’s got to say, “All right, can I put in a 14-percent RevPAR increase three years from now, and drop my hurdle rates,” and it’s almost as if you’ve hit analysis paralysis from the institutional guys, where they can’t just perform it, but the other guys."
Stiles: "Well I can tell you, what one of those Asian buyers said to me in the office, because he was asking us to advise him on one of the acquisitions, I won’t mention which one, but he literally sat down and said, ‘Rob, Rob, you don’t understand,’ because I was going through that exercise with him, and he said, ‘Rob, when you can do the math, it’s too late. When the math works, it’s too late.’ I mean, literally, it’s just, this is a cycle play, we feel we’re going in at the bottom, we can hold a long time, we can hold through multiple cycles."
Millard: "We can understand that, too … and you mentioned - but it’s a reasonable analysis, well, OK, how do you prove that to me, because I saw lots of analysis that people swore were very reasonable over the last 10 years that turned out to be garbage. And so the only analysis you can rely on, ultimately, is your own, because you’re the one that’s got to explain it. And I think, perhaps, for some of us, you know, you do have to be more cautious now, because most likely we’ve made mistakes in being too optimistic. So I can understand, this looks reasonable, because this hotel, we’re only protecting it to get back to, you know, 85 percent of its peak ADR, and we’re stabilizing – you know, you can look at that, but again, if you’re at zero cash flow and the expectation is that you’re going to have 125 cover in three years, you better believe in that story with your heart of hearts, because if you’re wrong again – you’re lucky to be sitting here in three years."
Olson: "If I take one big step back from this conversation, and Mike, you’re obviously feeling pain, and you’ve taken us down this route so far … and it sounds very negative, but think about, if we were sitting here having this conversation a year ago, and some of us were. I mean, you’re talking about five guys here who are putting out millions of dollars into the hospitality market that weren’t doing it in 2009. And so, the headline should be, we’ve got guys who’ve got capital that are going out, yeah, the deals, maybe the box is a little bit smaller, but at least there’s a box, and there wasn’t a box last year. So, I step back and I kind of look again, as I said earlier, fairly optimistic as to how we’re approaching this market, and yes, we don’t have as many dollars for the real beat-up deals, but we’ve got dollars for deals. I think that’s the headline for this."
Krauch: "I’ll take a slightly different version on that, because I was on a panel similar to this a year ago, and I took a very controversial approach at that time, is that the capital is an issue. Right? Even a year ago, in that, we were in this room and I said, look, raise your hand if – there’s equity guys and there’s debt guys, who can do this deal? OK, you can do the equity, you can do the credit – we’ve got the capital stack right here in this room, where’s the deal? And that’s the problem, and I think what’s encouraging to me is that we’re finally starting to see, it’s not the dam breaking or anything, but we are starting to see some of that trickle out, and yes, the money’s clearly very defined and there’s still a small box, but what’s more encouraging to me is we are starting to see some of those deals transact as opposed to just pure pretend-extend or as opposed to any other variation, we’re starting to see people get realistic, and that’s to me, the most encouraging sign."
Stiles: "I guess, just to sort of summary comment, what you’re saying is, that from a lender’s perspective, there’s a lot of liquidity represented by the five of you, there’s not really a shortage of debt, at this point it’s a shortage of cash flow."
Millard: "A lot of owners have not, I think, accepted the fact that, and somebody made the comment earlier, that peak value’s probably never coming back, in a lot of cases. And so, until they’re forced into a situation where they say, I’ve either got to put capital in, or let this asset go, they’re not going to do it. So, I think part of our challenge is to be cautious enough now that we don’t do something dumb just because a borrower’s got, you know, $100 million of equity at risk in this thing. They may still very well lose that."
Stiles: "All right gentlemen, thank you for your time this morning."
