CRE: Yarrow Hotel, Park City, Utah

The Yarrow, a stalwart hotel amid the glitzy lodging properties that have been built in the past decade, is scheduled to be sold at auction in a trustee’s sale in January, the most recent stunner as the upheaval continues in a Park City economy once thought by many to be largely isolated from national trends.

In September, a notice of default was filed at the County Courthouse indicating the firm had not paid what was due to the Chicago lender. According to Hart, the biggest payment on the loan — $8.2 million — was due at maturity on July 1. Until then, he said, his side kept up on the payments to the lender, Heller Financial, Inc.

Source: Salt Lake City Tribune

I mentioned the roll over problem commercial real estate borrowers are having earlier in the week. The Yarrow Hotel in Park City is another example. Unlike residential housing, it is a  norm with commercial loans to make interest only payments for the life of the loan with a balloon at the end. The balloon during normal times was not a problem because the borrower simply refinanced. Now, due to falling property values and tighter lending standards, refinancing is effectively not available (not without the borrower making huge capital infusions which often does not make economic sense). Hart Hotels has the same story as many commercial borrowers out there. They were current on their monthly interest payments but had no where to turn when the balloon payment became due at maturity.

Note that the Yarrow appears to be a 10-year loan (although I can’t tell how many extensions may have been granted by the bank) and the original face amount of the loan was $9,950,000. The balloon payment is $8,200,000 meaning that this was a longer term facility and that some small principal payment were made. So this is not a recent purchase at the top of the market nor did Hart take excessive risk by doing only a 3 or 5 year note.

So what is the problem here? The problem is the assumptions of normal with commercial real estate loans is way to loose. CRE loans depend on two assumptions. First, property appreciation. Second, that leverage ratios will not tighten. If you look back to 1999, Hart could reasonably have thought that even if they didn’t sell their project within ten years they would be able to refinance into a new loan because there would likely be equity built up in the property. Even if the property did not appreciate, Hart likely assumed they could get a loan before maturity at 70% or 80% loan-to-value. Generally, borrowers never assume depreciation and/or tighter loan-to-value covenants.

Of course, loan-to-value is just one financial test that must be met. Other financial tests such as debt service ratios (net operating income/debt service) are also breached when a hotel project struggles. However, not all projects will succeed and there will be recessions causing projects not to perform. This is part of the risk of lending. Banks do have to take on some risk when they make a loan.  Lenders and borrowers can usually work through a breach of a debt service covenant. Especially in this environment when many hotel operators are breaching debt service covenants.  On the other hand, the rollover problem doesn’t really have a good solution.

Asking a struggling borrower with a struggling property to inject millions of dollars into project is not usually reality. On the other hand, banks are working to strengthen their balance sheets for regulators and often do not have the ability to (or willingness) extend a loan at 90-100% loan-to-value (or in many cases above 100% loan-to-value). Especially when the banks often expect the prices to decline further.