LOS ANGELES-Talk about a paradox: Downtown Los Angeles is home to the largest hotel to go into foreclosure in California in 2009, a 469-room Marriott, and yet it's also home to the largest new hotel opening up in the state this year the 1,001-room JW Marriott at L.A. LIVE. What gives?

 

Actually, the new hotel opening in the midst of one of the worst downturns in the history of the US hotel industry is less of a paradox than it might seem. Says Alan Reay, founder and president of Irvine-based Atlas Hospitality Group, "It would be more of a paradox if they started construction on the new hotel at the same time as the other hotel went into default."

 

The Atlas president explains that it's easy to understand how a new hotel is opening during one of the worst economic downturns in US history. Large projects like the new JW Marriott, which will share space with the Ritz-Carlton, Los Angeles and the Ritz-Carlton Residences at L.A. LIVE, typically take about five years from initial planning to finish.

 

"They started construction in 2007, which was pretty much the peak of the market," Reay says. "The dilemma that developers have, not only for hotels but for other product types, is that if you start in a boom time you may be opening in a down time, and vice-versa."

 

Reay's company, which is a hotel industry consulting and brokerage firm, has chronicled the ups and downs of the California hotel industry for more than 15 years. Its latest report on distress in the state's hotel industry, and its outlook for sales, predicts that the number of hotel sales in California is bound to increase this year and will probably double. That does not mean that Reay is offering an upbeat forecast.

 

Reay tells GlobeSt.com that sales are almost guaranteed to increase this year because so few closed last year that 2009 marked a new low in statewide hotel sales and because lenders who have been reluctant to foreclose on and sell hotels will finally start to shed some of the distressed properties this year.

 

The Atlas report on distressed hotels shows that the number of foreclosed hotels tripled in California in 2009. The number of foreclosures, 62, is only part of the story. The Atlas report also shows that the number of hotels in default nearly quintupled, from 53 to 307, and the number of rooms that have been foreclosed on grew nearly eight-fold to 4,468.

 

If those aren't staggering figures, the Atlas analysis reveals that fully 10% of the state's 10,000 hotels are either already in trouble or heading for it: "We estimate that, even though we have 370 deals in foreclosure and default, close to 1,000 to 1,250 are probably operating under forbearance agreements with their lenders," Reay tells GlobeSt.com. Of the loans that are in default or foreclosure, 81% were originated between 2005 and 2007, which means that hotel owners who borrowed during that time are those most likely to default. Since there was a total of 2,500 loans done during that period, "25% of the entire hotel supply in California is pretty much in a precarious position," Reay says.

 

Exactly what will unfold during 2010 depends on what lenders, CMBS special servicers and buyers decide to do this year. Reay says that one of the most surprising statistics uncovered in the Atlas survey was that only two of the 62 hotels that were foreclosed on in 2009 were financed via CMBS loans. Reay says that's because the special servicers responsible for the CMBS loans are either confused about what to do or reluctant to foreclose and take title to hotels, for a variety of reasons. "This is new territory for the CMBS special servicers," who have never before been forced to contend with a spate of defaults, Reay says.

 

Why aren't the special servicers taking action on the troubled loans? They are not like banks, which can foreclose and then provide financing to a new owner. "With the shortage of financing out there, if the special servicers foreclose and there is no financing available, they have to take a huge hit," Reay says. As a result, they continue delaying, much as many banks continue to delay action on troubled loans in what has become one of the new buzz phrases of the downturn: "Extend and pretend."

 

In addition, not only are the hotel assets themselves defaulting, a number of the special servicers have their own financial problems and may be in danger of going bankrupt. One that already went bankrupt was Capmark Financial Group, whose loan origination and servicing businesses were acquired by Berkadia Commercial Mortgage LLC, which is owned by investor Warren Buffet's Berkshire Hathaway Inc. in partnership with Leucadia National Corp.

 

Even though Reay expects the number of hotel sales in California to double this year, the number will remain below average and prices will remain depressed, he says. Atlas has not issued its 2009 hotel sales totals yet, but for the first half of 2009, the total was 49, versus 100 in the first half of 2008. The pace of transactions surpassed 300 per year during the boom years, but a more typical pace is about 200 to 250 sales per year.

 

Buyers of the largest hotels will most likely be overseas investors like those who have already acquired the W Hotel in San Francisco [http:///news/1448_1448/sanfrancisco/179708-1.html] , the Wyndham in Costa Mesa and others, according to Reay, who says that Asian investors in particular are shopping for US hotels because of the depressed prices and the discount inherent in the weak dollar. Buyers for smaller properties will likely be private investors, including those who already own hotels, many of whom have cash on hand and can also get financing of up to $5 million through the SBA.

 

Another factor likely to drive hotel sales higher is that banks will start to realize that they are better off foreclosing and selling their hospitality assets rather than trying to hang onto them until prices rise. "Banks are generally going to run higher expenses and lower income than entrepreneurial operators," Reay says. Eventually they are going to realize that selling at today's prices makes more sense for them than trying to hold on and wait for higher prices, the Atlas founder and president says.