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Secondary Debt Market Still a Concern

I was asked to speak at a hotel investors’ conference a couple of weeks ago as part of a four-person panel. We were asked where the hotel transaction market is today and what we see ahead. The first gentleman was more eloquent in his speech than me and after 15 minutes of background, his summary was that we are two years into a seven-year recovery.

Additionally, there were comments of what IRR returns, rates, etc. would be over the next couple of years and various other valuation factors that all pointed to the next three years being sunshine and smooth sailing. By the time the question got to me, the crowd was trying to forward value all their assets for 2015 and feeling really good all the bad news was behind us.

There are two schools of thought on the next several years and I hope the first guy on the panel is correct, and I am wrong. If he is correct, Hotel AG will still perform very well. However, my concern is the secondary debt market. As we all know, the secondary hotel debt market hit the skids October 2007, resulting in the January 2008 forecasted economic downturn to the hotel market.

Few thought the downturn would be drastic and deep, and most were met in early 2008 with concern and denial. By September 2008, the concern turned to fear and the next 18 months were a RevPAR freefall. The point that many people miss is the importance of the secondary debt market and its relationship to the overall market. The secondary debt market drives the primary debt market, which drives real estate sales and value. Without debt, prices compress and risk curve yields increase.

The existing hotel debt in CMBS and whole loan lending is what gives me pause and concern over the secondary market. As with most real estate sectors, the bellwether is its public companies. If the public companies are healthy, the private side of that sector is typically healthy as well. Therefore, in the hotel debt world, CMBS is the public side of lending that affects the success of the private side of lending.

The CMBS recovery is still very tenuous at best and our concern is any bad news could derail the recovery. The potential bad news is made of the 2,994 CMBS hotel loans coming to term between now and mid-2015. These loans are simply coming to term and not in default status and the debt is being paid as agreed. Add to those loan maturities the hotel debt already in special servicing and additionally the loans that will be moved into special servicing because of default and there could be approximately 5,000 CMBS hotel loans in various stages of trouble. Coupling the CMBS side with the whole loan bank side, one could estimate 9,000 to 11,000 hotel loans potentially in trouble and needing some level of workout over the next 30 months.

Making very broad assumptions, after loan adjustments, note sales, forbearance and all the other buzz words we hear about today, we estimate there will be 2,000 to 3,000 hotel loans taken back as REO and in need of disposition. The concern we have is the effect these loan issues will have to the debt market and whether it will be viewed as a determent.

Therefore, I am much more concerned about the hotel secondary debt markets and see a level of risk to this current recovery.

The other question asked of the panel was to respond to the reported softening in the hotel transaction market. We closed 75 hotel transactions last year and have 272 hotels on the market today totaling $2.7 billion of value with many of those in some form of sale agreement. Clearly, there is no more gap between bid and ask price and we believe the transaction market will be stable for the first two quarters of the year.

H. Keith Thompson is a principal of Hotel AG, a national hotel specific brokerage firm and works with REITs, investment funds, management companies and private operators. Hotel AG closed one hotel transaction every seven days for the past 29 months.

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