Real Estate Forum - May/June 2009

risk and seek only the safest portion of the capital stack.

“Everybody’s skittish about deploying capital because they are not sure where the bottom of the market is,” Davis says. “If you are looking to buy senior debt right now, or step into a preferred equity situation, you are probably looking for current yields of at least 15%, and IRRs north of 20%. That’s for putting someone into a senior debt position, which is really unprecedented in terms of the yield requirement. That leaves the guy who’s in trouble, the borrower or sponsor, with limited upside. If you are replacing defaulting senior debt with preferred equity that requires a 20% plus return, it’s expensive money. Eventually, the market will figure out a more efficient capital source to take out these positions. But it’s not going to happen until the market senses we are heading back up in terms of performance.”

Another wrinkle in the workout scenario is deciphering who would pull the trigger on a foreclosure. “Even though an asset is in technical and literal default, with these complex financing structures who knows who the senior lender is?” Swig says. “These loans have been sliced and

Even though
an asset is
in technical and
literal default,
with these
complex financing
structures, who
knows who the
senior lender is?”
Rick Swig
RSBA & Associates

diced and syndicated. An owner of a hotel could be in complete default, but continues to operate the hotel because the senior debt holders will be fighting amongst each other as to who owns the property. We could see bizarre stuff like that.”

Yet while there is almost universal agreement that a wave of foreclosures is imminent—“It’s just around the cor-

ner,” says Swig—workouts are the best route to take, if at all possible. There is nothing a lender could do that the operator hasn’t already tried to make the hotel a success, and most lenders have no experience operating a hotel. “Do the workouts where it makes sense,” Davis advises. “Most deals can be worked out. But if you deny the inevitable that certain loans are in trouble, it doesn’t get better. Values tend to go down, not up, in a distressed situation.”

Still, no one expects major hotels to simply close their doors in the near future, if for no other reason than a foreclosure proceeding takes up to six months. “Hotel closures rarely, if ever, happen,“ Swig says, “because if you close an operating business, then you are extracting all value from the property. Then you have land value minus demolition. The last thing that ever occurs, especially in a substantial property, is closure. It just doesn’t happen. But who knows? A lot of the things that are going on today have never happened before either.” ◆