IRVINE, CA-The number of California hotels in default or foreclosure increased during the third quarter, but an even bigger story may be lurking in the shadows—the shadow inventory of properties that are in trouble but have yet to hit the default market. Alan Reay, president of Irvine-based Atlas Hospitality Group, tells GlobeSt.com that his firm’s research suggests “a huge shadow inventory of distressed deals that are yet to hit the default market” could be up to 1,000 hotels in addition to the 529 in default or foreclosed already. California’s total hotel count is approximately 10,000.

A newly released Atlas survey of distressed hotels in California shows that the 529 in the state represent a 10.7% increase from the second quarter 2010 and 71.2% increase over the third quarter of 2009. The 529 figure includes 119 properties that are in foreclosure, up 71.2% over the third quarter of 2009, and 410 that are in default, up more than 58% from the third quarter of last year.

The trends are not all downward, however. The number of foreclosed hotels selling to new buyers ticked up in the third quarter, a trend that Atlas expects to continue through the fourth quarter and accelerate into 2011.

Reay cites two major factors causing the increase in sales of foreclosed hotels: Lenders are realizing the difficulties in running an operating business like a hotel, and are deciding to sell verses hold; and buyers are willing to pay higher prices than before.

In turn, Reay cites three major reasons that buyers are willing to pay more: the general consensus that we have turned the corner economically, RevPAR that is increasing in almost every single market in California, and “the perception that we have hit bottom and now is the time to buy.” A secondary factor is that financing is coming back into the market, although it is not as readily available as it once was.

On the foreclosure front, Reay predicts that most of the activity will be in the smaller and limited-service hotels as opposed to the large luxury resorts. “The luxury resorts lenders are absolutely loath to put the properties into foreclosure because it gathers a lot of bad publicity, and if the lender ends up foreclosing, they are hurting themselves because business into those assets books two to four years in advance,” Reay says. The largest hotel in the state to be foreclosed on was the 512-room Holiday Inn in San Jose.

On the flip side, it’s very costly to maintain the small hotels, so lenders would like to sell the loans, but more of them are willing to take the properties via foreclosure and put them on the market now, Reay explains.

Special servicers are moving a bit more aggressively in selling off their loans than the regional banks are, according to Reay, but the banks now are finding that the forbearance agreements they have been working under with hotels for six months to a year aren’t solving the problem. “That’s why we’ve seen an uptick in notices of default, because these properties have reached six to 12 months on their forbearance agreements and the banks believe they need to take action,” Reay says.