GlobeSt.com: Who is investing in distressed hotel debt? What are the returns?

Nichols: Opportunity funds and hedge funds are taking the opportunity to invest in distressed hotel debt. These funds have realized that even though the upside is capped, if the loan is paid at par, there is still a good risk-adjusted return with a low loan to value ratio. Ultimately, the investment can still be profitable so long as the debt is priced properly. And some hotel REITs are also looking at purchasing distressed debt as a way to acquire the property secured by the debt.

GlobeSt.com: What is the future hold for the hospitality industry?

Scheinberg: The good news is that, if we are in the early stages of economic recovery, the hospitality industry is in a position to be the first to recover. Rents are elastic and hotel owners have the ability to quickly adjust room rates to meet current demand. Nonetheless, it will be interesting to see how underwriting takes into account the potential for traumatic world events. Investors' underwriting a "problem year" into their financial models may be part of what is creating the "bid-ask" spread between buyers and sellers.

Nichols: Hotels are the canary in the mine when times are tough but the harbinger of spring when times are good. However, it is unclear when business travel, which has decreased drastically, will pick up again. And, in this cycle, there is nervousness that business travel may never return to the level that it did before.

GlobeSt.com: How are workouts now being negotiated with lending institutions?

Nichols: Though lenders generally are allowing borrowers to extend so long as they are not in monetary default, this may not be true for many hotels. Even at very low interest rates, many hotels are unable to cover interest that accrues on the sizable debt secured by these hotels. In this down market, this means that hotel owners often need to bring a lot of cash to the table to pay down debt in order to obtain a loan modification.

GlobeSt.com: How is the industry handling the financial restructuring?

Scheinberg: Of course, as with other property types, so long as the borrower can meet debt service and the lender has confidence in management, lenders seem willing to provide short extensions… Substantive modification, such as a principal or rate reduction, typically require the borrower to bring cash to the table. One thing that makes hotel workouts interesting is that there can be another player at the table; brands or management companies are sometimes participating by helping their owners with loan workouts.

Nichols: If the brand is not fully protected in its SNDA [subordination, non-disturbance and attornment], it has its own motivation for ensuring that the hotel owner is not foreclosed on. If the property owner is foreclosed on, and the SNDA does not adequately address the brand's right to stay in place as the property manager, the brand could essentially lose its hotel. Under the right circumstances, brands therefore could be motivated to temporarily relax brand standards, or even contribute cash or reduce fees, to help make loan modifications feasible and ensure the brand's right to continue managing the hotel.

GlobeSt.com: How are laws affecting distressed assets changing on a state and national level?

Scheinberg: On a local level we are noticing that entitlement periods are being extended so that developers who have obtained entitlements but do not wish to start construction can wait out the market for a longer period of time before losing their entitlements. On a national level, there is proposed legislation in Congress to relax FIRPTA [Foreign Investment Real Property Tax Act] withholding in an effort to attract more foreign capital for US real estate.

Nichols: Also, the Internal Revenue Service's issuing of Revenue Procedure 2009-45 in 2009 has given REMIC's [Real Estate Mortgage Investment Conduit] greater flexibility to modify a loan or otherwise extend a loan's maturity date prior to an actual default. Under Revenue Procedure 2009-45, the servicers of a REMIC have greater latitude to determine when a default is "reasonably foreseeable." This allows the special servicer of the REMIC to step in prior to the borrower actually defaulting on the loan so the borrower can negotiate a workout or other modification.

GlobeSt.com: What are some relevant legal and tax issues in distressed debt investing?

Scheinberg: Borrower's and their constituents have real concerns with cancellation of indebtedness (COD) issues. Under new IRC Section 108(i) (part of the 2009 stimulus package), COD incurred in 2009 or 2010 can be deferred until 2014 and then included ratably over five years. However, one point often overlooked is that this deferral is conditioned on the borrower maintaining ownership of the property; if there is a disposition by, for example, sale or deed-in-lieu, the deferral is lost and the COD would have to be recognized in the year of disposition.

Nichols: Avoiding the inadvertent recognition of gain is also an important tax issue when purchasing distressed debt. For instance, if a loan purchaser acquires a $25-million loan for the discounted price of $15 million and afterward makes some type of "significant modification" (as determined under the tax code) to the loan, the loan purchaser is treated as exchanging the unmodified loan for the modified loan. The loan purchaser may have taxable gain if the issue price of the loan, as modified, is greater than the loan purchaser's adjusted basis in the unmodified loan (i.e., the discounted price paid by the loan purchaser). This is phantom income: taxable income with no current cash associated with it.

Along those same lines, one debt purchaser I know of (not a client) purchased a loan at a deep discount, secured by a partially completed project, and extended the loan in consideration for the guarantor investing funds to complete the project. The modification to the loan was a "significant modification" and the loan purchaser was surprised to find out that it had immediate taxable income to the extent that the loan, upon modification, had an issue price that was more than the purchase price paid by loan purchaser.

GlobeSt.com: What are the legal aspects of workouts, restructurings, defaults and bankruptcy?

Scheinberg: Some interesting transactions are being done under Section 363 of the Bankruptcy Code with the "stalking horse" purchaser cutting a deal with the trustee or debtor-in-possession and then that deal is put out to bid. It is important for the initial "stalking horse" bidder to negotiate for a break-up fee and minimum bid increments. Not only does this compensate the stalking horse for making the first move, but it encourages meaningful bids greater than the initial offer plus the break-up fee.

Nichols: Other potential purchasers of assets in bankruptcy may look at a stalking horse as providing some comfort as to what the asset is worth. It allows potential purchasers who are uncertain as to the exact value of the property to feel more certain that the property is at least worth the stalking horse's bid and may encourage them (for better and worse) to forgo expensive due diligence.

GlobeSt.com: What are some issues relating to inter-creditor agreements and how do you avoid inter-creditor litigation?

Scheinberg: An important issue for anyone involved in a distressed situation is to examine the notice requirements in inter-creditor agreements and determine compliance with the notice provisions and other legal requirements. For example, junior creditors can have cure or pay-off rights that might impact the ability of a lender to sell a loan, the rights of a borrower to affect a restructuring or the rights of a loan buyer to realize on the asset or affect a workout. As one complicating factor, a bankruptcy filing by the borrower or a creditor party to an inter-creditor agreement can raise interesting issues as to when notices can be sent and as to the effectiveness of notices that were sent.