Hotel REITs Default and Deflate – Can Shareholders Benefit?

It’s almost factual at this point: most 2006 and 2007 buyers of hotel properties will likely default on their mortgages. The reasons are simple: pro forma room rate and occupancy assumptions are being crushed, existing mortgage debt cannot be serviced, and the resulting drop in property values is preventing any kind of loan workout (other than through receivership and foreclosure). The interesting aspect of all this is that some hotel REIT shareholders could actually benefit from this huge mess.

First though, here is a hit parade, if you will, of defaults related to hotels located in “superstar” cities that were previously thought to be impervious to market downturns:

The St. Regis Monarch Beach hotel, an Orange County luxury resort in Dana Point, has completed a “consensual transfer” of ownership (it was late, and they were drunk) from its owner to its lender, Citigroup.

The Four Seasons Hotel in San Francisco has defaulted on a $90 million mortgage loan.

The Stanford Court Hotel, also in San Francisco, has gone into receivership after defaulting on an $89 million mortgage. JE Roberts bought the place for $93 million in 2007 and then dumped $32 million more into renovations.

Sunstone Hotel Investors chose to make an “elective default” on its the June 1 payment for the $65 million mortgage on the W Hotel in San Diego, which reflected “significant and continuing deterioration in demand for luxury lodging.” According to Sunstone’s CFO, the value of the W San Diego is “meaningfully below” the what it owes on the property. This is only natural, as they “elected” to overpay in the first place.

According to Commercial Real Estate Direct Sunstone’s 366-room Embassy Suites Chicago, is also not generating anywhere near the amount of cash flow needed to service its debt, nor is the 284-room Marriott Del Mar in San Diego, or the 299-room Ontario Airport Marriott.

The 469-room Marriott in downtown L.A., purchased by Ezri Namvar’s Namco Capital Group in 207 for approximately $115 million, recently filed for bankruptcy protection.

Luxury hotels in “superstar cities” aside, every day cities are feeling the pinch too. Red Roof Inn Inc., a hotel chain popular with budget-mided business travelers, defaulted on $367 million in mortgage debt earlier this year. Red Roof Inn was acquired for $1.3 billion by a syndicate led by Citigroup’s Global Special Situations Unit. It remains unclear whether the unit’s mandate is to create special situations, or to invest in them.

Not to be outdone, the Lightstone Group bought Extended Stay Hotels, a chain which operates 680 hotels catering to budget-minded travelers on longer trips, for $8 billion. Lightstone agreed to the purchase in 2007, and financed it at at 92.5% leverage. Unable to service $7.4 billion in debt, the chain promptly filed for Chapter 11 bankruptcy protection 24 months later.

As many as 500 properties could be in default by year’s end, according to Atlas Hospitality Group. “The bright spot is that this is going to be the best buying opportunity since the Great Depression,” said Alan Reay, the group’s principal.

This, perhaps, is what’s causing vulture investors to pick at these carcasses. This weekend, REIT Wrecks reader NS alerted me to the Vector Group’s (VGR) purchase of over 7% of Strategic Hotels and Resorts’s (BEE) common stock. Vector bought the shares for between 96 cents and $1.74 per share in the first and second weeks of July. At this point, despite BEE’s hyper-leverage relative to it’s underwater NAV, Vector Group and Bill Gates’s Cascade Investment Company, another early vulture, now own slightly over 13% of the Company.

Vector is not the only one picking through the rubble. Hong Kong’s Keck Seng Investments Ltd. just agreed to buy the San Francisco W Hotel for $90 million. According to The San Francisco Chronicle, although the price represents a 50 percent drop from peak values two years ago. The seller was Starwood Hotels & Resorts, which sold in order to “further reduce its debt levels.”

Ironically, Hotel REIT investors could wind up benefiting from these moves, since dumping underperforming properties, even at a loss, will ultimately be accretive to both net asset value and FFO. This may be what is attracting intrepid investors back into the space, but if you choose to play a Hotel REIT recovery, you may need some need patience: Cascade Investments is down about 50% on its initial 2008 investment in BEE (Although BEE is well-managed, it’s not worthy of investment in my opinion).