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MILWAUKEE-A recent study by Robert W. Baird & Co. Inc. paints a rather bleak picture of the hotel CMBS debt universe. The locally based firm found that 11.2% of outstanding lodging CMBS has a trailing 12 month (TTM) debt service coverage of less than 1.0x. On top of that, another 19.3% has a TTM debt service coverage between 1.0x and 1.5x.

“The volume of CMBS debt where the assets are not covering the debt service surprised me,” remarks David Loeb, senior research analyst and managing director at Robert W. Baird. “We expect there will be perhaps another six quarters, maybe more, of negative comparisons. So the trailing 12-month numbers are going to get worse, not just until RevPAR turns positive but until we see margins turn positive. That may take more than a point or two [increase in] RevPAR.” The firm maintains its underweight recommendation for the hotel sector in light of its analysis.

Another worrisome development is the amount of CMBS that is set to mature in the next decade. Nearly $30 billion of hotel CMBS debt is on track to mature through 2012, with another $35 billion set to mature between 2015 and 2017. Of those amounts, $7.7 billion carries a TTM debt service coverage under 1.0x, raising the potential of a surge of defaults.

“There really is no mechanism in place today to refinance all of that debt,” Loeb says. “It just doesn’t exist. That will create defaults at maturity, but it may also put upward pressure on cap rates.”

Loeb estimates that CMBS accounts for between a third and a quarter of all outstanding hotel debt. Most of the debt is held by banks, insurance companies and non-bank financial institutions, but “CMBS is a pretty big number on its own,” Loeb notes.What could make the situation even worse for holders of CMBS debt is the fact that special servicers charged with overseeing troubled loans have less leeway in restructuring the debt.

“Banks, insurance companies and non-bank financial institutions have a great deal of flexibility in how they deal with those mortgages and borrowers,” Loeb points out. “CMBS special services have very narrow rules. It’s much easier to work out a loan with a traditional lender than it is with a CMBS lender. After all, it’s not the originator of the loan you are working with. They are far out of the picture, and the REMIC rules are very tight about how you can modify these loans.”

Loeb says that in the public lodging world he normally covers, the companies are more conservatively financed. Not so for hotels owners who used CMBS debt. “There must be a tremendous amount of pain relative to leverage in the private world and that will lead to more defaults and foreclosures long before maturity for some of these loans.”

The biggest hurt will be felt by holders of CMBS debt and those buyers who overpaid for lodging assets. However, Loeb asserts that all owners of lodging properties stand to suffer when the tidal wave of distressed assets up for sale. “As a result of the way the industry is financed today and what happened with cash flows and therefore what is happening with values,” Loeb says, “we may see cap rates rise because of the glut of assets coming to market. All owners of hotels may see the value of their investments decline.”

And make no mistake, the properties that back CMBS run the gamut from mid-scale properties to the top of the luxury market. “This type of mortgage origination was done across the spectrum,” Loeb states. “It’s all types of hotels. The distress is more focused on the larger transactions and the higher-end hotels, primarily because we’ve seen a bigger drop in the cash flow at the higher-end hotels. This is the issue that people will be talking about in the hotel industry for the next five years, maybe longer. Unless we see some sort of RTC-style mechanism where the government is involved in the resolution of these mortgages, it’s going to be messy and for a long time.”

If there is one savior on the horizon, it could be the public markets. Some of the more well-capitalized public companies, such as Host, Diamond Rock, LaSalle and Sunstone, are in a position to pick up some of the distressed assets. Or pools of these assets could be packaged for sale on the public market. “Public capital,” Loeb predicts, “is one of the most likely sources to heal the wounds from this financing phenomenon.”

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