Wednesday, January 20, 2010

‘Tranche Warfare’ Erupts as Property Owners Slide Into Default

Posted on Bloomberg by Nadja Brandt and Jonathan Keehner:

When Lightstone Group bought Extended Stay Hotels Inc. in June 2007, it relied on more than $7 billion in debt financing to complete the $8 billion deal just weeks before the leveraged-buyout market imploded.

Today, Extended Stay’s creditors are battling each other after the company filed the largest bankruptcy case by a U.S. hotel owner. A company reorganization plan, which includes financing from Centerbridge Partners LP and Paulson & Co., may be challenged by a proposal from Starwood Capital Group LLC that is backed by some so-called mezzanine lenders.

Infighting among lenders with different classes of debt, called tranches, is on the rise in the hotel industry and throughout the $3.5 trillion market for commercial real estate loans after property prices fell more than 40 percent from their peak in 2007. Commercial mortgage defaults more than doubled to 3.4 percent in last year’s third quarter from a year earlier.

“I expect that we will see a lot more of this tranche warfare as you are seeing in the Extended Stay scenario,” said Patrick Campbell, principal at Greenwich, Connecticut-based Wheelock Street Capital LLC, a private-equity firm focused on real estate.

Underlying the conflicts are complex financing arrangements made at the top of the market, according to David Broderick, a partner in the real estate group of law firm Allen & Overy LLP in New York. Those deals divided lenders into multiple tranches, with varying degrees of seniority and risk.


‘Binary Relationships’


Mezzanine loans, which became more prevalent during the market’s peak in 2006 and 2007, got their name because they rank in the capital structure between secured debt such as mortgages and ownership equity, sharing attributes of both. They are seen by investors as riskier than a first mortgage and have higher interest rates.

“Borrowers and lenders had a more binary relationship a decade ago,” Broderick said. “Creditors in these complicated structures no longer have similar economic interests, especially with so many lenders underwater.”

Delinquencies on loans packaged into commercial mortgage- backed securities rose to a record high of more than 6 percent in December, according to Trepp LLC, a New York-based seller of commercial mortgage data. There were about $60 billion of CMBS that were in so-called special servicing for a workout or resolution at the end of September, data from Fitch Ratings show.


Bankruptcy Claims


Extended Stay, which Lightstone bought from New York-based private-equity firm Blackstone Group LP, filed for bankruptcy in June, citing decreased business-travel spending.

The case, in federal bankruptcy court for the Southern District of New York, has been complicated by creditor lawsuits, including claims that the Chapter 11 filing was a effort to push out junior debt holders and transfer control of the Spartanburg, South Carolina-based company. Mezzanine lenders Deuce Properties Ltd. and Line Trust Corp., both incorporated in Gibraltar, said in a June lawsuit in New York Supreme Court that Cerberus Capital Management LP and senior lenders were trying to take over the chain’s 680 properties.

Peter Duda, a spokesman for Cerberus, a New York-based hedge-fund and private-equity firm, declined comment.

“I think it’s fair to say these kinds of issues will come up more and more as additional CMBS cases are filed,” said Jacqueline Marcus, a lawyer for Extended Stay at Weil, Gotshal & Manges LLP in New York. She declined further comment.

Michael Beckerman, a spokesman for Lakewood, New Jersey- based Lightstone, didn’t return a message seeking comment.

“We’re proceeding with our action against the senior lenders who supported the original term sheet filed by Extended Stay,” said Stephen Meister, a lawyer for Line Trust and Deuce Properties.


Competing Plans


Now, Starwood Capital, the investment firm run by Barry Sternlicht that is owed about $266 million by Extended Stay, has put forward its own plan for the bankrupt chain, backed by some junior creditors.

Starwood, based in Greenwich, Connecticut, said its proposal will ease “widespread dissatisfaction” among Extended Stay’s creditors by providing a new $600 million equity investment, court filings show.

Starwood may end up competing with Extended Stay’s own plan, which includes $400 million in new financing from Centerbridge Partners and Paulson & Co., the hedge-fund firm run by John Paulson.

The firms, both based in New York, have agreed in principle on a $200 million equity investment and $200 million backstopped rights offering to support the hotel chain’s turnaround.

Tom Johnson, a spokesman for Starwood Capital, declined to comment. Leslie Armel, a Paulson spokesman, declined to comment, while a message left for Centerbridge officials wasn’t immediately returned.


Vacant Rooms


The hotel industry is struggling with falling occupancy rates caused by the recession. Occupancy last year through November dropped 8.9 percent in the top 25 U.S. markets as leisure and business travelers slashed spending, according to Smith Travel Research Inc. The rate probably will fall an additional 0.2 percent this year nationwide, according to Jan Freitag, a vice president at the Hendersonville, Tennessee-based firm.

About $28.2 billion in debt across 1,200 loans backed by 1,800 U.S. hotels was included on a performance watch list as of December 2009, according to data compiled by Realpoint LLC, a Horsham, Pennsylvania-based credit-rating company. Most of these loans are in default or close to default, according to Frank Innaurato, managing director of CMBS analytical services at Realpoint. Outstanding securitized hotel debt is $73 billion.


Stuyvesant Town


Earlier this month, real estate investor Tishman Speyer Properties LP and BlackRock Inc., the world’s largest money manager, missed a $16.1 million payment on Stuyvesant Town and Peter Cooper Village, the New York apartment complex they bought in 2006 for $5.4 billion with $1.4 billion of mezzanine debt and a $3 billion mortgage.

A group led by Boston-based Winthrop Realty Trust, holding about $300 million in senior mezzanine debt, last week took a step toward foreclosure by demanding payment from Tishman Speyer and BlackRock, both based in New York.

Fitch estimates the property’s value to be $1.8 billion today, making it worth less than the senior debt. Representatives of Tishman Speyer, Blackrock and Winthrop declined to comment.

Possible resolutions for the complex could include restructuring, sale of the debt or even the property itself, according to Ben Thypin, senior market analyst at New York-based research firm Real Capital Analytics Inc.


W Union Square


“One avenue for sale is an auction for mezzanine debt, which gives a way for all stake holders to participate in the transfer of ownership including bidding with money already owed in a so-called credit bid,” Thypin said. “Junior holders often have the incentive to move most quickly to salvage any return on their investment.”

That’s what happened with the W New York Union Square Hotel after Dubai World’s Istithmar investment unit, which bought the property in 2006 at the height of the market, missed a payment.

LEM, a Philadelphia-based affiliate of Lubert-Adler Real Estate Funds, won control of the 270-room property on Manhattan’s Park Avenue South in an auction last month by bidding $2 million for Istithmar’s equity interest, assuming the $97 million in mezzanine debt it didn’t already own and taking over the defaulted $115 million first mortgage. LEM was the most junior lender in the original $285 million deal.


Private Equity


In addition to its first mortgage, Istithmar financed the purchase of the W New York Union Square with $117 million in mezzanine debt. The loan was split into three tranches, with LEM’s $20 million piece the smallest and most junior.

The hotel could change hands again as the senior mezzanine lender, DekaBank Deutsche Girozentrale, considers foreclosing on LEM unless loan payments are brought up to date, said David Gutstadt, a senior vice president at New York-based Savills LLC. Savills is DekaBank’s adviser.

Rick Matthews, an LEM spokesman, declined to comment. Industry newsletter Real Estate Alert reported Dekabank’s plan yesterday.

“Tranche warfare will increase because of the capital that’s been raised targeting distressed commercial real estate,” said Thypin.

Real estate private-equity firms raised $6.8 billion in the fourth quarter of 2009, according to London-based Preqin Ltd., and more than $40 billion for the year. Sternlicht, the former chairman of U.S. lodging company Starwood Hotels, raised $930 million when he took Starwood Property Trust public in August.

“Private equity has been disappointed with opportunities available through senior debt so they’re looking to subordinated debt to get control of properties,” Thypin said.

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