The long-term problems underlying the commercial mortgage-backed securities limited-service hotel sector have finally come to fruition recently, market observers say, as the carry-through of actual defaults and last week's downgrade of the Fairfield Inns-Marriott International CMBS credit rating by Standard & Poor's Ratings Services have been a cause for some alarm.
Despite the fact that property markets are doing quite well overall, the always-volatile hospitality sector has been particularly problematic recently, as an oversupply in the level of development of new hotels has "[exacerbated] the cash flow problems of existing properties," said Peter Kozel, an S&P analyst. Because of this, several deals that have a significant lodging component have either been put on CreditWatch negative or downgraded.
Last week, S&P lowered to B' from BB' its rating on Asset Securitization Corp.'s $12.49 million mortgage passthrough certificates 1997-MDVII class B-1 and B-1H. The classes had been placed on "CreditWatch - Negative" on Sept. 3. The downgrade reflects the continuing operating performance decline of the largest loan, Fairfield Inns, which represents approximately 33% of the total outstanding principal balance. The Fairfield hotels are managed by Marriott International and contain 6,672 rooms.
Additionally, another CMBS deal, Donaldson, Lufkin & Jenrette Securities Mortgage Acceptance Corp. 1997-CF1, a cross-loan of 10 limited-service hotels, contains collateral that is currently in default. In that transaction, the borrower transferred the properties to a previous employee without the lender's consent, and that employee filed the properties into bankruptcy. There is currently a stay on the properties, and the special servicer is trying to have the stay lifted and have the properties foreclosed on.
This morass of liability for the hospitality sector has led market participants to remain wary about the future of this type of real estate. "It's counterintuitive and, in a sense, disturbing, mainly because the credit markets are supposed to be so wonderful at regulating the flow of capital and making sure that supply and demand in the property markets are always balanced," said S&P's Kozel. "I think this is something people ought to reconsider. It does say to you, I better investigate the points I'm basing my positions on.' People have been warned."
A Matter Of Supply And Demand
A significant ramping up in hotel development during the mid-1990s led to an oversupply that has glutted the industry and caused the operating performance of properties such as Fairfield to deteriorate, Kozel said.
Because of this, the pressure on the properties gets so great that room rates must be lowered due to an impetus to maintain a sky-high occupancy rate. Additionally, if the number of rooms increases 10%, for instance, more staff must be hired to take care of the rooms, causing tremendous cost pressures and a bidding-up of wages.
"This limited-service sector is significantly overbilled, and property markets development get drawn to the peak level of demand, typically," Kozel added. "Supply continues hitting the market until signals are sent out to developers and lenders that there must be a slowdown. And, in the lodging sector, that signal of oversupply is sent out slowly; room rates seem not to fall as quickly as the imbalance between the supply and demand would indicate."
As a result, the debt coverage ratios on the underlying mortgages deteriorate, causing a downgrade and making the CMBS a more risky investment.
Though a reduction in the supply of new rooms is underway, some markets may well be oversupplied already. This appears to be particularly true for geographic regions that did not participate in the economic expansion of the 1990s or that have recently experienced an abrupt slowdown in their rates of economic growth.
"The pace has slowed," Kozel admitted, "but three or four years of strong growth and supply - including increased competition from the upscale full-service hotel sector - will lead to some dicey questions over the next couple of years in regard to credit problems for these limited-service hotels."
And it is easy to understand why investors are nervous about this sector. In an office property, the average lease is between five and six years; for apartments, it is perhaps two and three years. "For hotels, it's about eight hours," Kozel said.
In addition to short leases, an economic downturn often portends that travel budgets get clipped. "Companies go for their travel budgets first, so hotel gets hurt the worst," he noted.
"I believe it is going to be a spotty situation for the hospitality sector going forward, even in a healthy economy. But it will be even more serious if there is some sort of downturn."
Already, S&P analyst Larry Kay has been receiving calls from concerned investors about the two high profile limited-service downgrades and defaults. "Fairfield is a major player, and its loans did represent a good portion of the principal balance. So I wouldn't be surprised if more calls come in regarding this credit," he said.