Night Falls on New York's Zombie Hotels

Includes: BEE, CHH, FS, HLT-OLD, IHG, L, MAR
by: Jeffrey Bernstein recently published some quotes from a seminar they held in early June on the hospitality market. The outlook voiced was sobering to say the least. Richard Warnick of the eponymous Warnick + Co., a hospitality advisory company, said "Up until this point in time, most of the defaults have been technical defaults. We're now moving rapidly into significant monetary defaults on loans. The question is whether lenders take those properties back or try to work with borrowers."

According to a article, "Last month, 13 hotel loans totaling $596 million defaulted. These included the $190-million Pointe South Mountain Resort in Phoenix, the $117-million Loews Lake Las Vegas in Las Vegas, and the $100-million Dream Hotel located in New York City."

Now, Urban Digs readers know that the New York City Hotel market is one of the strongest in the country, if not the world, in terms of occupancy (New York City Hotels Going From Foist to Woist). However, you also know that even very tight markets can suffer in a demand recession, and it doesn't help if a bunch of new supply is coming to market as it is in New York City (Hotel Hell - The Zombies Cometh). I thought I would give a little update on the New York City lodging market, since the last time we checked in (chuckle-inducing word play intended) back in March. At the time my outlook was negative and I believed that industry estimates for the New York City market would have to come down.

Lest I give the impression that New York City languishes alone in its lodging lethargy (alliteration added for emphasis) business in the U.S. overall has fallen out of bed. Recently, Smith Travel (NYSE:STR), which had been among the more optimistic seers in its predictions for lodging fundamentals, significantly cut its forecasts for the U.S. industry overall. STR now predicts that RevPAR (Revenue Per Available Room - a combination of rate and occupancy) will decline 17.1% in 2009, versus a previous estimate of a 9.8% decline.

I recently checked in with John Fox at PKF Consulting, who follows the New York City lodging market for his firm. According to PKF's current forecast, New York City RevPAR will decline 30.8% in 2009 (versus a prior estimate of down 26% in March). Now let me walk you through the financial implications of such a decline in top line for the brand new hotels in New York City that have been delivered over the last couple of years. Hotels generate net operating income margins (Revenue less all operating expenses and FF&E reserves, but before financing costs) of 25% to 40% depending on the level of service they provide. Higher end hotels, with all their amenities and services, carry higher expenses and lower margins, although their sales per square foot can be phenomenal. New York City Hotels probably tended to the higher end of this spectrum, if not exceeding it, due to their very high occupancy rates. (New York hotels are running as much as 25 percentage points higher than the rest of the U.S., where hotels were achieving a pitiable 57.7% occupancy as of last week).

I would note, however, that at the same time, due to the prior extreme tightness of the New York City market and hoteliers' success in pushing up rates, the decline in rates in New York has been much more severe than in other markets. According to PKF, in May 2009 (most recent data) rates were down about 30% year to year in New York City; in comparison STR reported the nationwide rate decline in May to be 9.8% year to year.

Now hotel expenses have a considerable fixed cost element, despite the fact that some are literally shutting down floors so they don't have to clean them, while others simply bring forward normal maintenance or upgrade cycles to achieve the same reduction in capacity/expense. As a result of the lower revenue applied over an only slightly reduced expense base, a 30% decline in revenue can easily translate into a 50% decline in operating income (used to service debt). There is one saving grace, however, hotels, due to their reputation for volatility in operating results, were not financed at nearly the egregious leverage levels at which other real estate assets were in the past cycle. Lodging properties were more often leveraged at the merely imprudent 65% to 70% level as opposed to any higher. So let's take a not so fictional 100- room hotel financed with $44 million from a European bank (name withheld to protect depositors), or $442,000 per room. (Please note that despite the small number of iconic hotel sales in New York City at over $800,000 per key, very few hotels have ever sold in the market for more than $500,000 per key.)

The debt service by my reckoning would be almost $4 million annually on a 30-year perm loan issued at a great rate. If said hotel ran at an average $350 per night room rate and 90% occupancy (peak New York City type numbers) the hotel would generate $11.5 million or so in annual revenue and potentially $5 million in annual operating income. Cut to 2009, and room rates down 20% plus, with occupancy off 7 points or so. Revenue declines to around $8 million and with margins being cut from 45% to say 30%, net operating income declines to around $2.5 million per year, give or take. You can see where I'm going with regard to servicing the $44 million in debt......fogeddaboutit!

According to Fox of PKF, they see RevPAR in New York City declining 1.2% again in 2010, with the first increase in RevPar not coming until Q2 2011. Because although demand should start to rise in mid-2010, there are still 10,000 rooms expected to come on in New York in 2009 and 2010. Yup, that train has already left the station. Fox reminds that Q3 is seasonally weak for the New York City market and may be the time when we start to see the recent default by The Dream joined by some additional nightmares. Will bankers work with borrowers? I don't know, but it would be quite comical to see a few carrying bags out to taxis.....Oh Bellhop!