The hotel investment world was rocked last month with a high-profile Chapter 11 bankruptcy filing of two hotels operated by Illinois-based Harp Group. The filing covers a three-year-old, 580-room Radisson Hotel at the Los Angeles Airport and the InterContinental Chicago O’Hare, a 556-room luxury property that’s only been open about a year. Both properties remain open while the filing winds its way through federal court. The two properties owe a combined $278 million to San Diego National Bank and Amalgamated Bank, a lender owned by hotel workers union Unite Here.

David Neff, a partner with law firm Perkins Coie, represents Harp affiliates that own the hotel. He says the filing was a result of the downturn in the economy and difficulty the owners had in communicating with the lenders over the issue. “There were some initial discussions, but then the lenders went silent even after they sent us a default notice,” claims Neff. “We invited them to call, but they never returned the call.”

We chatted by phone with Neff to discuss the impact of the Chapter 11 filing on the rest of the industry:

Lodging Hospitality: Is the Harp filing the beginning of a wave or will it turn into a tsunami?
Neff: You’ll definitely see more bankruptcies, but not the tsunami we had in the late ’80s and early ’90s because a key feature of CMBS loans are springing guarantees that only take effect upon certain “bad-boy” acts, which include the filing of bankruptcy. [The Harp loans aren’t tied to commercial mortgage-backed securities.]

Lodging Hospitality: Can you explain?
Neff: The rating agencies required that CMBS loans be non-recourse to the borrowers or the borrowers’ principals, except under certain circumstances, which we call bad-boy acts, one of which is the filing for bankruptcy. For instance, if Ed Watkins had a company, Ed Watkins LLC, that owned a hotel and you went to get a CMBS loan in 2006-07, they’d give it to you, but you were personally on the hook for the full amount of the debt if Ed Watkins LLC files for bankruptcy. That’s a key feature in most CMBS loan documents and is the main reason why you’re going to see borrowers just giving the keys back.

Lodging Hospitality: What else contributes to the problems?
Neff: Unlike the late ’80s and early ’90s, we don’t have as many hotels managed by their owners. Instead, they have third-party management companies or they’re managed by a brand. This means owners have less of an incentive to keep their hotels because they’re not getting the cash flow. In addition, back in the late ’80s, we had hundreds of 1031 exchange buyers who were buying hotels to avoid recapture from the losses they’d taken from other real estate ventures. They still exist, but mostly in the form of tenants in common, or TICs, but not nearly in the numbers we had in the late ’80s and early ’90s.

And thirdly, to sustain a property that’s underwater, the owner has got to put money into it. So if he’s not getting cash flow through management fees, and he’s not avoiding recapture to a 1031 exchange, he has to look at the situation and say, “Does it make any economic sense for me to put more money into this property, even if I can reduce the debt on it.” And does he even have the money to put in?

Lodging Hospitality: Instead, will more owners just turn back the keys to lenders?
Neff: Absolutely, the W San Diego was just the beginning. It was a high-profile property with a high-profile borrower [Sunstone Hotel Investors], but you’re going to see that many times over.

Lodging Hospitality: Why?
Neff: Unless borrowers are willing to put in money into their projects, they’re going to have a difficult time getting a CMBS servicer to agree to a restructure.

Lodging Hospitality: What are lenders going to do with all these hotels?
Neff: It depends on the lender. Is it a troubled financial institution? Is it a CMBS servicer? Some lenders will try to dispose of the properties as quickly as possible to monetize their investment losses. Others will wait for the markets to return.

Lodging Hospitality: What about the CMBS servicers?
Neff: Contrary to the beliefs of some in the hotel industry, CMBS servicers are actually quite sophisticated in their knowledge of the hotel industry and are well advised. The problem is hotel owners lack sophistication in financial distress and don’t understand how to approach servicers. They run hotels, and they may have knowledge of the real estate industry beyond hotels, but they have no knowledge of how to deal with a distressed property. There are very few exceptions, the major one being Donald Trump, and we have very few Donald Trumps in the hotel industry.

Lodging Hospitality: As a lawyer, what advice would you give to an owner who thinks he or she may be in the same boat six months down the road?
Neff: Get good advice, whether it’s a lawyer or a hotel workout consultant, before approaching the lender because most of the initial restructuring offers made by lenders to borrowers, particularly to CMBS servicers, are ridiculous. Here’s what they say: “Cram down the loan to the current value, reduce my mortgage principal amount to the current fair market value, reduce my interest rate, take a cash flow mortgage, and I don’t have to put any money into it.”

Lodging Hospitality: Everyone’s got to share the pain, right?
Neff: If you want the reward of keeping the equity from a property that has no equity and you want the lender to share the pain, you’ve also got to share the pain by putting in more money. That’s really the bottom line, and unless it’s going to be meaningful cash, it’s a non-starter for most lenders.

Lodging Hospitality: Do you envision a rash of hotel closings?
Neff: Most of the hotels that should close aren’t the CMBS hotels. The CMBS hotels tend to be newer. When we talk about our industry being under demolished, we’re not talking about the two-year-old Hilton Garden Inn, which even though it could be in severe financial distress, you probably won’t see it closing. It’s an excellent box and not in need of any substantial CapEx. I don’t see a lot of hotel closings, and I wholly agree that shutting down a newer hotel is suicide with regard to value. As far as an older hotel goes, it may make all the sense in the world.