Time to Check out of This Troubled Sector

Apparently, the allure of free coffee and musty rooms has lost its appeal for Red Roof Inns.

Behind on their check-ins, the popular budget hotel chain defaulted on $367 million worth of mortgage debt. It's the the latest hotel casualty since Extended Stay Hotels filed Chapter 11 a month ago.

Along with the rest of the sector, numerous commercial hotel REITs are now staring into the same abyss that dimmed Red Roof's lights. In other words, Misery will be having plenty of company.

In a preview of what's to come, Red Roof's owners missed scheduled payments on four mortgages with 131 Red Roof Inns pledged as collateral.  Meanwhile, the chain is heavily weighed down by nearly $1.2 billion in debt, including mortgages, mezzanine loans, and other notes.

The culprit, naturally, is the economic downturn which has put a major league crimp in hotel revenues, since both businesses and consumers tighten up like clams and rethink their travel plans.

As a result, occupancy at Red Roof's properties ― which averaged 62% at the market peak ― has fallen to 50.7% this year. That matches the downturn of the U.S. budget hotel industry, which registered a 9.7% decline in occupancy in the first five months of this year from the same period last year, according to Smith Travel Research.

That has created a cash flow crunch and left the chain unable to meet its debts. When that happens, bankruptcy is not usually far behind.

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Commercial Hotel REITs Teeter as Customers Check Out

Unfortunately, Red Roof Inns is hardly alone. Money is getting tighter everywhere.

"Cash-flow performance issues and default concerns in 2009 have extended themselves to that of budget-priced, limited-service hotels," said Frank Innaurato, a managing director of Realpoint, in a recent interview. "We would expect to see more instances of this type of default as borrowers continue to struggle with diminished cash flow from their properties in the not too distant future."

The growing problems for commercial hotel REITs, however, are two fold.

First is a shrinking RevPar, which only exacerbates the cash flow issue of lower occupancy. RevPar, or revenue per available room, is the metric used by the industry to indicate the overall financial performance of a property.

Not surprisingly, RevPar has taken a beating this year.

In fact, according to the most recent data, while the industry's occupancy fell 11.5% year-over-year, revenue per available room decreased by 20.5% as room rates fell.

As expected, it will get worse before it gets much better.

"The good news is that the bottom of the current cycle for the U.S. hotel industry is soon to arrive," R. Mark Woodworth, president of Atlanta-based PKF Hospitality Research, said recently. "The bad news is that 2009 will be the weakest year on record for the domestic lodging industry, and 2010 is going to be disappointing as well. If you are wondering when we'll start to see actual growth in RevPar, then you'll have to wait until 2011."

However, aside from a shrinking RevPar, property valuations in the industry are also taking a nose dive.

For example, earlier this month, Sunstone Hotel Investors Inc. revealed it planned to walk away from its 258-room W. San Diego property, turning the hotel over to its lender, Gatehouse Capital Corp.

Meanwhile, in a national telephone conference call, Sunstone president and CEO Arthur Buser told hotel industry analysts that other Sunstone properties may also be deeded back to various lenders if they fail to modify loan balances.

But here's where it gets really interesting. . .

Buser also said even though Sunstone had enough cash to make the June 1, 2009 mortgage payment, he decided to walk away from the W. San Diego property after the market value of the hotel today fell below the $65 million due on the note.

Of course, that is considerably less than the purchase price in 2006, when Sunstone bought the hotel for $96 million. So, they basically handed the keys over to lender, even though they could presumably service the debt. Three years later, Sunstone said no deal.

Meanwhile, Sunstone owns 43 other hotels totaling 14,755 rooms that are generally operated under nationally recognized brands such as Marriott, Hilton, Hyatt, Fairmont, and Starwood. However, given the circumstances, you would have to wonder how attached Buser is to any one of them.

Since then, the news within the hotel industry has only gotten worse.

Welcome to the Hotel California

In that regard, I bring your attention to a story that was published just last week in Hotel News Now. Aside from a massive budget shortfall, the hotel industry in the Golden State is also struggling to stay afloat.

The story was entitled California to see record number of hotel foreclosures.

It read:

The number of California hotels in default or foreclosed on jumped 125% in the last 60 days. The state now has 31 hotels that have been foreclosed on and 175 in default, according to California-based Atlas Hospitality.

Initially, the wave of distress in California was seen by the smaller, non-flagged hotels in secondary and tertiary markets. As the hotel economy worsened, we have seen it impact all property types. The properties range from the luxurious St. Regis Monarch Beach Resort in Dana Point to the more economical Extended Stay and Red Roof Inn chains.

No market or brand is immune in this downturn. In reviewing the hotels in default or foreclosed on, we found that over 75% of the loans originated from 2005 to 2007. During this period, over 2,500 California hotels either refinanced or obtained new purchase loan financing.

Unfortunately, based on today's market values, we estimate that none of these hotels have any equity remaining. The unprecedented decline in room revenues (California is down 21.5% year-to-date) combined with the jump in cap rates has resulted in a massive loss in values.

We estimate that values are currently 50-80% lower than at the market's peak in 2006-2007. (Emphasis mine.)

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Now, if that doesn't spell trouble for commercial hotel REITs, nothing does.

As for the state of California, all I can say is I'm haunted by something a teacher said to me a long time ago. . .

"Steve," he said, "if you want to know what's going to happen next, just keep your eye on California."

"Everything," he warned, "happens there first."

That's why I believe this is a trend that is just getting started as "jingle mail" now moves into commercial real estate.

By the way, my Hawaiian contact tells me that hotels on the Big Island are running at about 25% occupancy, which, if true for all the islands, would be devastating. Meanwhile, just last month, the Sheraton on the Big Island went into foreclosure after the resort's owner defaulted on its mortgage.