Tuesday, June 23, 2009

Bed Bugs
The second hotel chain in as many weeks has run into major problems. Last week Extended Stay Hotels filed for Chapter 11 bankruptcy and this week Red Roof Inn defaulted on $367 million of mortgage debt. Both Extended Stay and Red Roof were bought by their current owners in 2007, at the height of the commercial real estate boom. Including the $367 million in defaulted mortgage debt, Red Roof has $1.2 billion of total debt. There are forces at work against the hospitality industry, including tight credit markets (this is especially tough for deals done in 2006 and 2007), and the recession that has lead to higher vacancy rates and lower Revenue Per Available Room (RevPAR), a primary hotel industry metric. In addition, there were way too many hotel rooms built between 2004 and 2008, and the limited service niche in which Extended Stay and Red Roof operate may have seen the most rooms built.

I don't know the specifics of the Extended Stay or Red Roof acquisitions, but I would guess that the financing was based on pro forma projections that included ever increasing RevPAR (2% to 3% per year), stable occupancies and stable expenses. The debt was also made in an easy credit environment with no expectations of a change in the finance markets (steady growth in RevPAR and net income would lead to higher valuations that would allow the borrowers to easily sell the hotels and repay the debt or refinance the debt).

In more hotel news, the swank W Hotel in San Diego, and the luxury resort St Regis in Orange County were both given back to their respective lenders. Again, both experienced high vacancies and lower RevPAR, and the owners were unable to make their debt payments. The W Hotel was bought for $96 million in 2006 and had a $65 million mortgage. The owners, Sunstone REIT, say the hotel is worth much less than the $65 million mortgage. The St Regis story is similar, declining RevPAR does not allow the owners to support the current mortgage payments.

There was clearly overbuilding in residential real estate. In general, there was not the same boom in commercial real estate - there was just too much money to be made on the residential properties. Hotels, in my opinion, were the exception. There were way too many hotels built (again, all based on linear pro forma financial statements). Combine this with the ridiculous financing and it's a wonder that more hotels are not joining Red Room and Extended Stay in default or bankruptcy.

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