Programs designed to help the real-estate sector are having problems that create an air of uncertainty and a lack of trust in the government from would-be partners.
The stress tests for financial institutions now are finally over and, no surprise, almost all the banks are fine. The government knew this would be the result before the tests started. The regulators actually are living in the major banks full time and have been doing these sorts of tests for many years.
The next thing you will see is that financial institutions that can pay off their Troubled Assets Relief Program money will do so quickly. The government proved once again it is not to be trusted to stick by a contract and stay out of interfering in the banks’ operations and decision making. Do you really think the banks wanted to take the cram down on their Chrysler senior loans when the unions got the control of the company and they got pennies? Why do you think the group fighting it was named the non-TARP lenders? The pressure to fold was enormous. In the future, nobody will want to have anything to do with the government or a unionized business if it can be avoided. Think card check. If we acted like the government and changed the deal after the contract was signed, we would be sued. If lenders tried to tell a borrower how to run his business, they would probably get accused of lender liability. In both cases the media would slam lenders as being bad and corrupt. When a member of Congress such as Barney Frank does it, they call it Congressional oversight, and the media applauds.
None of this means much to hotel lending at all. Nothing has changed since my last columns where I stated that hotel lending for the next several years will be extremely tightly underwritten and leverage levels will be around 60 percent to 65 percent using a 10 percent to 12 percent capitalization rate and high spreads. Do not think that because the major banks are OK, that has anything to do with new hotel loans. It does not. There are a couple of thousand small banks that are not OK, and some will get taken over by the FDIC. There are many smaller banks that made too many bad real-estate loans and held them on book. While there are some hotel loans under $10 million being done at the local level, it is not widespread and will not become so anytime soon.
PPIP is in trouble
The Public-Private Investment Program, a plan designed to value and remove troubled assets from the balance sheet of troubled financial institutions by creating partnerships with private investors to buy toxic assets, now is not as likely to succeed. After the TARP experience, nobody is anxious to get too close to the Treasury Department. PPIP was designed to avoid that, but it still is not certain nor clear that Congress will not again interfere—especially if the program works well and private investors start to make a lot of money. Congress will not care that the taxpayers automatically also will make an equal amount of money. It will make a grab for the profits the private investors earn through higher taxes or some other way.
There was a call recently on which Sheila Bair, head of the FDIC, explained to 1,500 listeners, who also served as potential investors, how PPIP was to work. One listener asked what vote the government will have in a joint venture formed with investors. The answer: 50-50. I am told the immediate response by almost everyone on the call was “I am out of here.” Nobody trusts the government any longer. Barney Frank and Speaker of the House Nancy Pelosi have taken care of that. After the bashing of the banks, the circus Frank and his committee put on with the chairman of AIG, the demands that anyone in Wall Street earning over $250,000 be heavily taxed, and the changes to TARP that Pelosi slipped into the stimulus bill after the banks took TARP money, nobody wants to have the government as a partner—or have it anywhere near their business. Congress has caused enormous damage to the potential success of PPIP and all the other financial rescue programs.
In addition, the change in the Federal Accounting Standards Board’s statement 157 has relieved the pressure on the banks that hold loans on book. The FASB statement requires all publicly traded companies in the U.S. to classify their assets based on the certainty with which fair values can be calculated. Now instead of being forced to take write-offs and sell the loans, they simply say a loan is being held to maturity and they take a normal credit reserve and hold it. If the loan goes into default, which most will at maturity, they will ask the borrower to put in more equity and they will extend. If there is no workout possible, they will foreclose because now they have capital cushion and can take the hit. The PPIP securities program is likely to work but don’t expect PPIP to yield a fountain of distressed hotel loans. The first PPIP package is in the works and will be put to auction in late June. It will include several hundred million dollars worth of all sorts of real estate. There will not likely be any pure hotel portfolios under PPIP, but that could change later. Just do not plan on it to be a reincarnation of the Resolution Trust Corporation days of the 1990s.
It is taking a long time for all types of distressed loans of all types to come to market. It is now likely that not much will happen until fall. There is at least one servicer that is being hard nosed and just foreclosing. The others generally are trying to first work it out before they foreclose. It is assumed in the market that a foreclosed property is worth 20 percent less than one not foreclosed, so that is a motivator. However, it still takes new equity of 10 percent to 15 percent and a good relationship with the lender to do it. In many cases, hotels will be in such bad default that there will be no way to work it out and the bank will take the keys.
If you have a commercial mortgage-backed security loan or other structured loan with mezzanine financing, look out. The new term is tranche warfare. Since the equity in most properties is gone by everyone’s view, it is the mezz lender who is now fighting to get anything. They have been wiped out, but they have the money and motive to fight. They have a fund, and if they take large losses the fund closes, so-called war is declared. In the end it is complex in that even if the mezz has no remaining value, which usually is the case, they make a battle just to try to get paid a go-away gift. The trade is to pay something to make the mezz lender go away, or pay lawyers to fight while the asset suffers from no management and no capital expenditures. It has gotten really nasty in many cases, although some of the grown-ups realize that it is better to get things resolved quickly than have a long battle. That is not the norm. The bad news is there are very few grown-ups doing workouts and a lot of the warriors are in great fear of losing their jobs if they give in at all, so they get emotional. Egos rage. None of this is good for anyone, and it will cause future loan docs to be written much differently in the future.
There was a time before 1993 when a banker made a loan to a borrower he knew. The bank held the loan on book. When there was a problem the borrower drove to the bank, met his regular banker and they tried to solve things. Now, on large loans, there is no banker and nobody knows who all the holders of the loan are. It has been securitized and sold and resold. This will make cleaning things up much more complex, much longer than it needs to be, and the outcomes will not be the best for the asset. It is a terrible legal nightmare. This is why we will not get a clean-up of lending for several more years and that will materially impact your ability to get new loans for a long time. The new form of lending, whatever that might become, has to be created, accepted and then new documents need to be developed. That will take a couple of years. Small bank loans under $10 million will get done, but in the overall scheme of things, they are not relevant to the real problems. So for buyers with large pools of cash equity, life is going to be very good.
In the end, as I have stated before, hotels have real risk, as we are seeing in revenue per available room and net operating income declines, and a large number of defaults. Underwriters will take this risk into account in the future, and we will not go back to the lending practices of 2005-2008 for a generation or longer. That is over and will be outlawed by new regulations. If you have a CMBS loan with a mezz or not, hire a very good lawyer with hotel knowledge, and a very knowledgeable advisor. You will need them.
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 Wharton School graduate, Ross began his career on Wall Street as an investment banker in 1965. A pioneer in commercial mortgage-backed securities (CMBS), Ross, along with Lexington Mortgage, and in conjunction with Nomura, created the first hotel CMBS program, which 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 served two tours in Vietnam with the U.S. Navy.