Defaults Decline in California Hotel Market

(Mark your calendars for RealShare Orange County, August 18 in Newport Beach, and for RealShare Hotels 2011, September 15 in New York City.)

IRVINE, CA-Rising room rates and improved occupancy are relieving pressure on hotel owners and lenders, but foreclosures continue to climb as banks now have stronger financial reserves. These are some of the conclusions in the latest report from locally based Atlas Hospitality Group on California’s distressed hotels, which foresees that the number of California hotel foreclosures will increase at least through the end of the year, while notices of default will continue to fall.

Atlas founder and president Alan Reay tells GlobeSt.com that although hotel foreclosures were up 91% in the second quarter (to 191 from 100) compared with the second quarter of last year, “We think that the decline in notices of default shows a more accurate depiction of the current state of the California hotel market.” The number of hotels in default in the second quarter, 287, was down 24% from the second quarter of 2010 total of 378 and was down 18% from the total of 350 in the first quarter of this year.

Reay explains that defaults have been declining for a number of reasons. For one, “California’s rate and occupancy improvements are relieving pressure on both hotel owners and lenders,” the Atlas report states. With revenues up, particularly in the better markets, “There is a psychological factor,” Reay says. He explains that owners of troubled hotels are more inclined to reach into their pockets to remain current on their mortgages if they see that rising property values have restored some of their equity, or are likely to restore it in time.

Another factor that has reduced defaults is that banks have been more aggressive in selling loans than anyone anticipated. “We thought that they might sell some of them, but not to the extent we’ve seen,” Reay says.

In a small percentage of cases, the buyers of notes are the borrowers themselves, but in a larger percentage of cases private equity buyers are acquiring the loans. These private investors, because they bought the notes on a good basis, “are able to go back in and either offer a discount to the borrower, or rework the loan with the borrower.” So, instead of going to default or foreclosure, many of the troubled loans are getting worked out.

Yet another factor in the decline in defaults is that some lenders continue to operate under forbearance agreements with borrowers. In cases where values are rising, this has been working out in favor of both the borrowers and the lenders.

Nonetheless, despite the decline in defaults, Reay says that foreclosures are rising because lenders now have the financial reserves to be able to foreclose and sell the properties at today’s market values. In the past, values were too low and the lenders’ reserves were too low for this to happen.

To illustrate how the market has changed, Reay cites the example of the 258-room W Hotel in San Diego. Sunstone Hotel Investors, an Aliso Viejo, CA-based REIT, walked away from the $65 million mortgage on the hotel in 2009, after which it was foreclosed on. At the time Sunstone gave the keys back, the hotel was appraised at $29 million. Recently, however, the hotel sold for $56 million.

“When you talk about full-service hotels in quality markets, we are now almost back to 2007-2008 peak pricing, which has a trickle-down effect to the secondary markets, too,” Reay says. He expects that rising revenues will continue to lift the troubled hotels, although he adds a caveat: “Considering what has happened in the stock market in the past two days, if revenues were to decline, we could have a different situation.”

The Atlas survey shows that 478 California hotels were in default or foreclosed on in the second quarter, down 4% from the first quarter. Most of today’s foreclosures are in secondary markets and involve limited service hotels as opposed to top-tier assets. Going forward, Reay says, the lenders would still most prefer to work out troubled loans with borrowers if they can. Their second choice is to sell the troubled loan. That leaves foreclosure as their third and least-favorite choice.