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Distressed Small Hotel Opportunities Abound - But Carry Considerable Risks

Yes, small hotel property investments are risky and require operational expertise - which helps explain why so much of the hospitality category's mortgage debt has defaulted in recent years.

But for small-cap investors willing to take some risk and obtain some operational competence, bargains abound today like perhaps never before as lender agents look to move distressed assets.

However, you'll need to bring plenty of cash to the table in the prevailing credit environment. And it wouldn't hurt to make arrangements with a hotel flag franchisor.

Commercial banks and other portfolio lenders, as well as conduit loan special servicers, have become quite serious about shedding distressed hotel mortgages in recent months. And there's a distinct emphasis on the small-cap space.

For instance, dozens of small-balance loans are included in the 60-plus hotel-backed notes, with combined balances of $420 million, that the Jones Lang LaSalle/Real Estate Disposition marketing team is auctioning online this week on behalf of five servicers and two regional banks. Reports have big conduit servicer LNR Partners alone is contributing some $100 million in small-balance loans to the offering.

Smallish limited-service hotels comprise the bulk of the offering's collateral assets, says Dustin Stolly, a vice president in JLL's real estate investment banking group.

Meanwhile, Carlton Group's Carlton Exchange continues adding non-performing small-balance hotel mortgages to its real-time, online bidding opportunities. The platform allows would-be buyers to customize and bid on what Carlton refers to as "bidder-defined pools" of offered assets.

Regional banks likewise continue engaging specialty loan-sale agents to market varying sizes of distressed small hotel mortgage portfolios. For instance, Baylake Bank just engaged AZ-Garnet Loan Sale Advisors to sell a handful of notes with combined balances of $18 million, secured by flagged limited-service hotels in the Green Bay, Wis. area.

As Stolly observes, banks have become more motivated to shed defaulted loans - and local hospitality real estate entrepreneurs see the time as right to buy. Banks' capital ratios are improving - as are collateral values - which is prompting more banks to dispose of distressed assets and reinvest proceeds into new loans amid low capital costs.

Likewise, CMBS bondholders and their fiduciaries have generally concluded that note sales in many cases will be the most effective means of maximizing recoveries related to distressed hotel loans, Stolly explains. And servicers are particularly motivated to sell small-balance loans, as they're compensated for managing the assets on the basis of outstanding balance.

Nor do note-holders exactly relish prospects of operating hotels, a more specialized and labor-intensive category than the primary income-property food groups. And it also helps that the consensus emerging in recent months is that hospitality fundamentals (and property values) appear to have bottomed out, leaving more likelihood of upside than downside ahead.

Again, this is a category best left to investors boasting specific operational experience - or who can at least bring in related expertise. Bidders registering for this week's JLL/REDC auction mostly have hospitality operational experience, Stolly confirms, adding that buyers tend to already operate properties in the same marketplace as the assets being sold.

And they're necessarily buying with cash in the prevailing credit environment. Indeed 95 percent of auctioned hotel loans sell via all-cash transactions, Stolly notes. "It may actually be closer to 99 percent. The debt market is still pretty much shut for small, limited-service assets."

It's also become pretty clear that plenty of specialists have cash to invest and are ready to pounce. This is the first time the JLL/REDC team has limited an auction to one property type, and buyer demand seems so robust Stolly envisions more single-category auctions ahead.

He's even anticipating that strong bidding will boost the average recovery rate relative to previous, more diversified NPL auctions. So far this year, loss severity rates (measured as discounts from par) on distressed hotel notes are comparable to other collateral categories, i.e., in the low- to mid-40 percent vicinity.

In other words, specialty investors continue targeting internal rates of return in the high-teens to low-20s as they resolve the distress (typically via foreclosure or deeds in lieu), implement management efficiencies, and improve revenue streams.

While savvy operators are comfortable with prospects at prevailing pricing, they also realize hotel property investments carry no shortage of risks. Economic hiccups can reverberate quickly in terms of guest demand - not to mention the event-related havoc terrorism and other concerns can wreak.

Indeed, the recovery route in the hospitality sector tends to be far more bumpy than other income-property categories. For example the probability of hotel industry expansion, as calculated by e-forecasting.com and STR, had been close to 100 percent all year before suddenly falling to near 70 percent in September.

That's the kind of risk investors will have to consider as more distressed assets come to market in coming months. Standard & Poor's reports that nearly 15 percent of securitized hotel mortgages are 30 days past due, and by some counts another 1,000 hotel properties in California alone are destined for default.

As for Stolly's assessment as the World Series continues: "I'd say we're in the top of the fourth inning."