For most hotels in most markets, 2001 was simply a bad year, capped off by the terrorist attacks of 9/11. However, other than the attacks, the downturn in the hotel industry was not totally unexpected. As has been chronicled by HVS literature in the past, the hotel industry, especially in the U.S., has tended to follow a 10-year boom/bust cycle, and has done so with some regularity since the end of WWII. Because of the previous downturn occurring in 1991/1992, a downturn in 2001 was due. This downturn was accompanied by both supply-side problems (too many new hotels opening) and demand (for hotel rooms) downturn. On a positive note, thanks to the comparative industry-wide restraint of hotel construction lenders during much of the latter half of the 1990s, the recent 2001/2002 downturn (expressed as a decrease in RevPAR) can be fairly equally attributed to both supply-side and demand-side problems. Such a downturn mix tends to resolve itself faster than a more heavily weighted supply-side downturn, as was evidenced in the 1991/1992 era. Therefore, it is generally expected that the return to positive RevPAR growth could occur over a shorter period of time. Currently, the highest level of default rates continues to be found in loans secured by hotel properties. Hotel default rates have climbed, due to 9/11 coupled with a less robust economy, raising the number of defaulted hotel loans (conduit, fusion, and large loans) from 12 in 1999 to 70 in 2001. Even though the recent level of defaults in hotel mortgage loans was not as severe as may have been expected or was experienced in 1991/1992, we can see that there certainly have been some. So, the question becomes: what do you do if you find yourself in the unfortunate situation of owning a hotel that is currently in default on its debt? In our last article, we mentioned that the root cause of a hotel mortgage default was essentially a lack of liquidity; the hotel is often in a downward spiral and the various parties associated with the hotel (and/or its mortgage debt) cannot or will not resolve the problem with cash. Obviously, the first thing most borrowers will do is contact their lender (or the mortgage loan servicer) and request some level of temporary forbearance or other concessions. We further mentioned that hotels, as a real estate asset class, have recently generally underperformed, as compared to the remainder of a diversified real estate lender’s portfolio. Therefore, in most cases, lenders have been willing to agree to some temporary accommodations. The focus of this article is to analyze what happens when the temporary good graces from the lender and the earnings from the hotel have not improved. Such a discussion typically centers on two topics: is the loan a non-recourse mortgage, and what is the current value of the hotel? Recourse vs. non-recourse provisions in a mortgage obviously can have a bearing on the tenor of discussions between a lender and defaulted borrower. However, typically the presence of recourse in a mortgage is often not as dire as most borrowers think, nor does it represent the panacea that most lenders would like to have. The issue obviously revolves around the borrower’s liquidity and the lender’s realistic likelihood of collecting on a personal guarantee. It is often the case that if a borrower is defaulting on a mortgage, the borrower’s general financial conditions may be poor, thus the time and expense for a lender to collect on a judgment against a borrower may not be encouraging. Still, the presence of recourse in a mortgage is an issue with which to be dealt. Most commonly, to the extent that the borrower maintains other assets, the resolution of the recourse issue often involves the borrower “buying out” its guarantee - in other words, paying an agreed upon sum of money to the lender in satisfaction of the mortgage guarantee. Usually, this is occurs either with the borrower threatening bankruptcy or under the control of the bankruptcy courts, after the borrowing entity has declared bankruptcy. The second major issue is the current value of the hotel, or more precisely, the current value of the hotel in comparison to the present principal balance on the mortgage. It is critical to identify whether or not the borrower has any real equity left in the property. The answer to this gives rise to a series of decisions that both the borrower and the lender need to make in the matter. If the borrower indeed does have equity in the property, this obviously gives the borrower a reason to stay in the deal, and also could give it better hopes in bankruptcy court, especially in its ability to get a reasonable plan confirmed. Conversely, if the mortgage balance is substantially higher than the current property value (and the borrower has no equity), then the lender is faced with some hard choices. These include “marking the loan to market,” which often could be best done by simply selling the mortgage, probably at a loss. This is not as black and white during instances in which an appraisal shows that the margin between current value and the mortgage amount is narrow. Such situations become especially unclear if it is probable that the value of the hotel might substantially rise in the future. Sometimes this issue is resolved through the introduction of a “white knight” - a new third party investor that enters the transaction. The white knight may bring cash to cure the existing default, perhaps pay down the mortgage slightly, and/or provide funds for renovation/repositioning of the property, in addition to working capital. From the existing lender’s perspective, this is often a good solution because it could give the lender the ability to restore the loan to a productive, “non-scheduled item” status. From the existing borrower’s perspective, the introduction of a white knight could assist in avoiding a bankruptcy and income tax recapture (which can often happen in a foreclosure), in addition to affording the borrower an opportunity to enjoy the rise in value from the asset (this is usually true if the existing borrower is willing to invest in this new recapitalization of the asset). Lastly, from the white knight’s perspective, by investing in this manner, it can hold a stake in attractive assets that may not be technically “on the market.” Further, depending on the level of the white knight’s investment vs. any new investment by the existing borrower, the white knight is able to strip out most of the economic upside (appreciation, management, control, cash flow, etc.). Therefore, it is often the case that this type of arrangement, if properly structured, presents a win-win-win situation for all parties involved.