A PROACTIVE DEFAULT

On Sunday, Sunstone REIT (SHO) provided a business update and discussed an "elective default" on their W San Diego property after failing to come to an agreement with their CMBS special servicer.  The company expects to "pursue similar options with certain of its other mortgaged hotels" where the mortgages exceed the value of the property.  We expect to see other REITs and private owners follow suit and hand back the keys on many properties over the next three years, mostly on mortgages underwritten at the peak of the market.

 

Back on May 20th, SHO amended its exchangeable notes indenture to increase the permissible basket of defaults on non-recourse indebtedness from $25MM to $300MM, before triggering an acceleration of payment.  This amendment was specifically aimed at increasing SHO's ability to exercise its option to walk away from "over-leveraged" assets.  We haven't seen this type of amendment pursued by other lodging companies yet, but expect that those that have limited baskets on non-recourse defaults to pursue similar strategies in the future.

 

This particular asset faced a more extreme situation than most hotels.  Deteriorating fundamentals in the San Diego upper upscale hotel market assets and increased supply created one of the worst hotel environments in the country.  Still, the W San Diego outcome provides another data point on the fallacy of using "NAV" to support valuations.  The confluence of the supply/demand issues led to the determination by SHO management that the asset was permanently impaired.  It no longer made sense to fund the negative cash flows of this asset ($4MM of interest expense vs 2009E EBITDA of $2MM).  Interestingly, the mortgage still had 8.5 years left before maturity and an attractive rate of 6.25%, so this was truly a proactive default.  

 

Sunstone acquired this asset in 2006 for $96MM or $372k per key and handed the keys to the lenders at $252k per key.  They concluded that the asset was worth "much less" than the $65MM mortgage on it.  Generating just $2MM in estimated EBITDA, the company made the accretive choice surrendering this asset at 32x EBITDA.  We're not sure how much less SHO thinks this asset is worth but we would guess somewhere in the $30MM range is more reasonable, a staggering 70% below where it was acquired just 3 years ago.


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