Based on very good work done by PKF recently, we see that on average net operating income for hotels declined by about 39 percent on a revenue decline of around 18.5 percent, according to Smith Travel Research (Read “Who won in 2001?”). This is by far the worst decline in history, and it shows the high operating leverage hotels have. 

Joel Ross

If you are old enough to recall, nobody wanted to make a hotel loan in 1993, because the whole world thought the losses in the hotel industry were so bad. Hotel lending essentially stopped in 1989. It took five years to restart, because the perception of lenders was that the losses were so bad and the risk so high. I make this comparison so you understand the magnitude of the problem of trying to restart lending this time.

When we did restart lending with the CMBS program in October 1993, we used an underwriting basis of 1.4 to 1.5 times debt service coverage on historical, beaten down NOI. We assumed a debt constant of 11.33 percent even though the actual constant was less. Loan to value was essentially ignored. It was all about provable cash flow.

In 2005-2007, the underwriting moved to 1.25 to 1.3 times debt cover or less. Often there was no debt cover, and it was assumed there would soon be debt cover based on a projection. For floating rate deals, there was essentially no underwriting. Appraisers dreamed up projections, and the lenders bought the story. Often loans were interest only. At first it was three year IO loan, then five, and at the end, before the world exploded, it might have been 10 year IO. In short, it was a no document, adjustable rate mortgage loan with a teaser rate just like in subprime housing, based on the same ridiculous, make-believe projections and appraisals. This was exactly like 1988 and the savings and loan fiasco all over again. Nothing ever changes, just the names of the new set of youngsters who think they can defy the natural rules of the market with a “new paradigm” and a fancy new computer program.

Now we are back to reality. So here is what happens:

• Assume the hotel earned US$1 million in 2006-2007.
• Assume a fixed-rate loan at a 1.25 debt cover with 25-year amortization and actual rates. So let’s assume the 10-year Treasury was around 4.75 percent on average in 2006.
• Spreads were around 150 over versus the 350-400 or higher that we used in 1993. So the rate would be 6.25 percent with a 30-year amortization, or a constant of 7.39 percent.
• Using our US$1 million NOI, we get a loan of US$10,825,000.

Under the new paradigm:

• Now in 2009 we have a 39-percent decline in NOI, so NOI is US$610,000.
• Now underwriting goes back to 1.4 debt cover. The underwriting constant goes back to 11.33 percent.
• The new loan is sized at US$3,845,000

This is the reality of what you will have when lending resumes, whenever that is. So now you say, “NOI will rise by 50 percent in three years from 2009 levels and will be almost back to the levels of 2007. That means a compound annual increase of 14.5 percent starting in 2010. So now in 2012, the NOI is US$915,000—almost back to where it was in 2006-2007.

In my view, this is a total fairy-tale scenario.
 
Using the same 1.4 debt-service cover and the same constant of 11.33 percent, the loan is US$5,768,000 to repay your original maturingUS$10,825,000 loan. Under the new underwriting, NOI would have to rise to US$1,725,000 in 2012 to justify a loan of US$10,875,000. That means NOI needs to nearly triple from where it is today and be 72.5-percent greater than it was at the peak of the froth in 2007. 

If you are wondering why the expression, “extend and pretend,” is now what so many of us are ranting about, these are the numbers. Even a three-year extension does not work. Extending makes no sense. Restructuring and resizing is what is required.

This is also why any projection of values returning to 2007 levels anytime in the next five years is absurd. Any appraisal that assumes a 7-percent, or even 7.5-percent, rate is simply unrealistic and misleading as to derived values. It is why cap rates will remain high for years to come. It took from 1993 until 2005 for underwriting to become totally absurd again. That was 12 years after we restarted lending and 17 years after things collapsed in 1988. It is much worse this time. If you are going to be buying hotels, you need to buy right and base it on cash flow in place. If you are a seller, you need to get real. If you are a lender, you need to lower your sale price expectations to a realistic level. If you have a loan maturing in the next three years, you need help now.

Example of Extend and Pretend

Say you bought a property for US$10 million in 2006 with a 75-percent loan of US$7.5 million. It was a three-year floater due December 2009. Let’s say the rate was 150 over LIBOR or around 2.0 percent today.