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This is a minor story about the foreclosure of a hotel in San Diego but it says a lot about the state of commercial real estate right now.

Sunstone Hotel Investors, LLC (NYSE:SO), a publicly held California REIT has said it will surrender its ownership in the W Hotel San Diego after attempts to restructure its securitized debt failed. Sunstone bought the hotel for $96 million in 2006 and has $65 million of debt on the property.

According to the Wall Street Journal, the hotel has failed to generate sufficient cash to cover its operating and interest expenses since 2007. Sundstone estimates that the hotel is worth substantially less than the outstanding debt on the property.

A couple of things pop out at me.

First, Sunstone bought this property in 2006 and apparently it was cash flow positive for only one year. The world didn’t fall apart all of a sudden in 2007, in fact it was actually 2008 when travel and lodging started to tank as a result of the recession. It sounds for all the world as if Sunstone badly overpaid for the hotel, probably assuming as did so many other investors that valuations had no where to go but up. A classic case of buying at the top and ignoring fundamentals.

Second, Sunstone now maintains that the hotel is worth less than the outstanding debt. Since they paid $96 million for it and now contend its worth less than $65 million we’re talking about a decline in value somewhere around or north of 40%. That hurts.

This is a perfect example of the issues facing the commercial property market. Assets were purchased at valuations that precluded positive cash flow. The rationale for the transactions rested on unrealistic assumptions of future rents and financing and ignored any sort of stress scenario. The upside was unrealizable and the recession has imposed a downside that was never anticipated.

Accordingly valuations have plummeted and there isn’t a good way out. Even if financing were plentiful, in this environment there is no solution short of injecting significantly more capital and writing off a chunk of the debt.

Let’s assume that the hotel is worth $60 million and you could find a lender to finance it at a 75% LTV. In that case Sunstone would need to pony up $15 million and the existing lender would have to take a $20 million haircut. So Sunstone would have $46 million invested in a property that is worth $60 million. Probably not something that’s going to deliver an acceptable ROI.

Look for this to become a common theme for the next couple of years. Lenders are going to get tons of commercial real estate back from the owners. In many respects, this will be one of the best opportunities to buy commercial real estate in decades.

Source: Sunstone Hotel Investors: Classic Case of Buying at the Top and Ignoring Fundamentals