PHOENIX — The full brunt of the commercial mortgage-backed securities (CMBS) crisis has yet to strike the struggling hotel industry. The warning from Joel Ross, principal of New York-based Citadel Realty Advisors, came Wednesday during a panel discussion at the 16^th annual Lodging Conference taking place at the Arizona Biltmore. “You haven’t seen anything yet,” said Ross in sizing up the current level of distress.

The delinquency rate on CMBS hotel loans 30 days or more past due reached 18.92% in August, up from 6.15% a year earlier, according to real estate analytics firm Trepp LLC. The $13.3 billion in delinquent hotel loans accounts for 21% of all delinquencies across property types. Another $4.4 billion in lodging loans are current but in special servicing.

CMBS servicers, who can extend, modify or liquidate securitized loans, have been reluctant to take write-downs, pointed out Ross. That’s partly because in many instances the special servicers own the non-investment-grade, or lower-rated pieces of the bonds. As such, they would be the first to take a loss in the event of a loan default.

But pressures are mounting to abandon the so-called “extend and pretend” approach, explained Ross, who helped create the first Wall Street hotel CMBS program in conjunction with Nomura in 1993. “Everybody has dragged this out as long as they can. I personally believe that next year that game is starting to be over. But that is why not much [distressed property for sale] has shown up yet. It’s there, and guys are dying. But nobody wants to blow the whistle. But we’re getting to a point where the whistle is going to get blown and that’s next year, I think. “

Inside the numbers
To illustrate what many CMBS borrowers are up against, Ross uses a hypothetical example. Let’s say a hotel borrower in 2006 received an $8 million loan and had $2 million in equity on a $10 million property. Assume the property is now worth $6 million in the wake of the recession, and that two years from now its value will climb to $7.5 million, a 25% increase.

When the borrower goes to refinance the $8 million loan upon maturity using a debt-service coverage ratio of 1.3 or 1.4, he is going to end up with a loan amount of approximately $5.3 million, said Ross. “So you are in the hole for $2.7 million, except there is another little problem. It’s been five to six years since you’ve done a PIP (property improvement plan).”

Assume the PIP costs $8,000 a room on a 120-room property, or a total of $1 million. “Now you are in for $3.7 million to bail yourself out of this,” said Ross. “Forget about the $2 million you lost when you started this whole thing. That’s what we’re facing — exactly that. And where is the average guy going to come up with $3.7 million? Forget it. It can’t happen.”

As more borrowers find their situation hopeless they will give their troubled hotels back to lenders and special servicers, said Bill Hoffman, president and CEO of Trigild, a San Diego-based company that offers receivership, operations management, and disposition services.

Tale of two markets
One audience member said that he was perplexed by the discussion on the demise of the CMBS market at a time when some hotels in Philadelphia and San Francisco have sold at prices above the senior mortgages on the properties. He wanted to know if the wave of attractive buying opportunities will primarily be in the secondary markets.

There is a massive bifurcation occurring in the office, retail and hotel investment sectors today, explained Ross. “If you are the owner of a major office or hotel in New York, Boston, Los Angeles or San Francisco, you can get a 10% premium over what you thought you should get, and there are multiple buyers.”

The bottom line is that investors are willing to pay a premium for cash-flowing properties in major markets. But Ross was quick to add that the average capitalization rate for hotels, or the return to the investor based on the purchase price, will be on the rise in 2011.

Alan Tantleff of FTI Consulting in New York and a panel member, echoed those sentiments. “There is a premium being paid for scarcity value. People have a lot of money and they’re sitting on it right now,” emphasized Tantleff. “The private equity funds have raised a lot of capital. Their returns are lousy. If they are going to pick up [a hotel asset] at a 5% yield, it’s actually better than giving the money back.”

Hoffman emphasized that hotels in major metros are not immune to distress, with the exception of perhaps New York. About 75% of the properties on Trigild’s watch list — some of which could become the company’s next receivership assignment — are three-, four- and five-star hotels. That includes markets such as Las Vegas, San Francisco, Los Angeles, and Phoenix, noted Hoffman. “We’re seeing a couple high-end hotels close their doors.”