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Weekly UpdatesHotels, Casinos, Entertainment Parks, Senior Living Facilities, Franchised Gasoline Stations, Convenience Stores & Restaurants
THE PIPELINE BEGINS TO FILL
After unprecedented years of economic expansion, our teetering economy was shoved rudely to ward recession by the September 11, 2001, terrorist attacks. In the immediate aftermath, more than 100,000 people were laid off by the airlines and travel was down by more than a third. The travel, tourism, and lodging industries were hardest hit. One respected national firm predicted the worst performance for the hotel industry in 33 years. Most hotel stocks lost between 20 percent and 70 percent of their value in the first week of trading after the attack. Many hotels and restaurants watched their business fall by 40 percent or 50 percent. Conventions, meetings, and vacations were canceled or postponed.
Another major national hotel consulting firm agreed that recent declines in the revenue per available room, a common measure of hotel profitability, showed the biggest drop in the 80 years the firm has been tracking the industry. It also analyzed the financial statements of more than 3,300 hotel financial statements in its database and in late 2001, the firm predicted that the number of hotels unable to generate sufficient cash to meet debt service would rise from 16.4 percent in 2000, to 20.9 percent in 2001, and to an astounding 36.5 percent in 2002.
Prior to the events of that fateful September, many lenders' pipelines were starting to see a flow of troubled real estate loans--particularly those loans secured by hotels, casinos, entertainment parks, senior living facilities, franchised gasoline stations, convenience stores, restaurants, and other special purpose real estate associated with operating businesses. Now the pipelines are starting to fill with such loans gone sour.
This article will provide a brief reminder to lenders about the basics of working with troubled loans, and then it will quickly go beyond those fundamentals to discuss some of the unique issues and problems encountered in dealing with troubled loans on special purpose real estate assets with operating businesses.
QUICK REVIEW: BASIC DO's-AND-DON'Ts OF WORKING WITH TROUBLED LOANS
The 1980s and 1990s saw an explosion of troubled real estate loans and specialized lender teams to handle them. The ensuing years saw veteran workout teams clean up the mess and ultimately disband, as troubled loans all but disappeared. While each lender tended to have its own name and acronym for the troubled loan department, most lenders recognized the need for a special assets group or "SAG" to handle the problems presented by troubled loans. Savvy lenders also realized that workouts take time, and that line officers who spend time on workouts can't spend that time generating new deals.
These lenders focused on prevention, monitoring, and early detection. At the first signs of trouble, they brought the SAG into the picture or transferred responsibility to the SAG. They recognized that information is powerful and constantly updated critical information about the loan, the collateral, and the borrower. They analyzed their options in light of clearly defined goals and policies. They developed a game plan for each asset and they stuck to it. And having been burned by lender liability claims, they used pre-workout agreements and team members knowledgeable about lender liability matters. They also knew that complete documentation of any deal was essential. We have summarized these fundamentals in the "Basic Do's-and-Don'ts" set forth in Appendix 1.
WHAT MAKES SOME SPECIAL PURPOSE ASSETS DIFFERENT?
Special purpose real estate assets associated with operating businesses present unique problems. The pipelines of lenders and special servicers are filling with troubled loans secured by such hotels, casinos, entertainment parks, senior living facilities, franchised gasolinestations, convenience stores, restaurants, and the like. Each of these assets involves an operating business that is integrally intertwined with special purpose real estate, and that operating business comprises a large component of the asset's value.
It is the operating business that raises some thorny problems. The operating business often needs management and franchise affiliations, licenses and permits, extensive vendor relationships, marketing efforts, and a significant work force. Many of these aspects of the operating business are critical to the value and success of the asset and the recovery to be realized. They can evaporate very quickly during the handling of the troubled loan.
For example, what is the value of a Marriott, Holiday Inn, Hilton, Hyatt, or Four Seasons if it loses the brand and professional management? It becomes just a big box hotel with no name, no reservation system, and no professionally run staff. What impact does it have on the lender's collateral if breach of a management or franchise agreement exposes the owner to the expected profit of the brand or operator for a remaining 20- or 30-year term, or more? What damage is done to the public image of the asset if quality is not maintained, rumors of bankruptcy taint expectations of service, inventories fall below acceptable levels, and relations with critical vendors are damaged?
Or, to use another common example of loans secured by gasoline stations with franchised restaurants and convenience stores, it may be easy enough to renegotiate gasoline supply agreements, but what is the value of a Burger King or Del Taco restaurant that loses its franchise, jeopardizes its ground lease, and faces default under its franchise agreement and other contracts?
USING A HOTEL EXAMPLE
Many lenders and servicers are unfamiliar with the business and legal "structure" of these special assets, so we will first use a hotel example to illustrate the franchise and management overlay that complicates working with many of these assets. The typical hotel is owned by an individual, institutional investor, or investor group, and this owner is usually the borrower on the hotel loans. Complications grow geometrically when the operator also has a joint venture or other investment interest in the ownership, and such arrangements are common with many hotels. The hotel company--Marriott, Starwood, Hilton, Hyatt, or whatever--is a separate entity that will manage or franchise the owner's hotel.
When you drive by a hotel and see a big red Marriott sign on top, the chances are great that an owner has entered into a franchise or management agreement with Marriott to brand the hotel and plug into Marriott's reservation system and expertise. But it is fairly unlikely that Marriott owns the property or a significant interest in it. In many instances, the hotel is managed by the branded hotel company, but often the hotel will have a franchise from Marriott or one of the other branded hotel companies, and an independent management company--unaffiliated with the brand--will manage the hotel under a separate arrangement.
In the jargon of the hotel industry, these independent management companies are often called independents or "third party managers" because they do not own a brand and are a third party to the owner-franchisor-operator relationship. In any event, these arrangements are governed by complex and critically important franchise agreements and management agreements that can add or subtract millions to the value of the hotel.(1)
Depending upon the nature of the property, there are also likely to be a host of important agreements, licenses, and permits. Resort properties often have "use agreements" or leases that provide access to hotel guests for golf, tennis, marina, spa, or other facilities. Licenses may include cabaret and business licenses, liquor licenses, and many other permits such as FCC licenses for base-to-shuttle or ship-to-shore communications for shuttle buses, marinas, and similar operations. The ability of a foreclosing lender or buyer to continue to enjoy rights under these agreements and licenses can be critical. One can imagine the impact on value when a resort hotel loses its golf, tennis, beach club, and other amenities, or can't serve liquor at large group meetings, banquets, weddings, and events. And, of course, it is almost certain that there will be a significant work force that may be technically employed by either the owner or the operator, but for which the owner will have full legal responsibility and exte nsive indemnity obligations. There may even be union contracts and potential labor claims and liabilities.
The lender's choice of options in dealing with a troubled loan on a hotel is complicated by the typical hotel management or franchise agreement. It tends to give tremendous control and many exclusive rights and powers to the operator and franchisor. The owner's (and thus the lender's) access to information, the work force, and the asset itself may be greatly limited. It is also common for the lender's position on the loan to be subordinated to the hotel management and franchise agreements so that upon a foreclosure, the lender or its successor will continue to be bound by the old management or franchise agreement. Alternatively, and sometimes worse, the lender may lose the benefit of the franchise or management agreement and find itself with an unbranded and unmanaged asset.
THE PRACTICAL IMPACT: SPECIAL PURPOSE AS SETS MEAN SPECIAL PROBLEMS
All the basics of troubled loans summarized in Appendix 1 still apply to the special purpose assets we are focusing on. One need only add the overlay that the operating business creates. Without repeating the basic principles, we can continue using the example of a troubled hotel loan and focus on what is different, beginning with the first principle-- prevention.
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