And initially it seems like a fire sale liquidation of a failed hotel is a poor alternative to suspending operations until the hotel market returns to some sense or normalcy. Many lenders will be shocked to learn how dramatically hotel values can crash -- literally over night -- once a hotel is closed. Here is some food for thought.

Closing down hotel operations to staunch the negative cash flow. As more hotels fail to earn enough gross revenue to cover operating expenses, underwater borrowers are giving the keys back to lenders. They are leaving it up to the lenders to decide if they want to advance operating shortfalls to keep the hotels open. Increasingly, frustrated lenders are thinking of suspending hotel operations to stop the negative cash flow. This alternative to a liquidation sale is deceptively attractive. It can look like the best of two evils before you dig down to do the hard present value analysis.

Record hotel failures and record hotel closings. The hotel lawyers of JMBM's Global Hospitality Group® believe that this recession will bring several thousand hotel failures. In contrast to past economic cycles where most hotels continued to operate through receiverships, foreclosures and bankruptcies, it looks like things may be different this time.

We foresee a record number of hotel "closings" -- situations where the hotels cease ongoing operations as hotels. Someone "turns off the lights." The hotels "go dark." They are closed down and "mothballed" because neither the defaulting borrower nor the lender will pay the shortfall in cash necessary to meet payroll, utilities and other operating costs to keep the hotel open.

How closing a hotel can be the biggest mistake you make . . .

As discussed below in greater detail, there are two warnings we give lenders confronted by this challenge:

• The decision to close an operating hotel may be the worst decision you can make! (and someone is likely to be second guessing your decision with the benefit of hindsight)
• You are probably better off with a fast "fire sale" disposition of an open hotel today than mothballing the hotel. Because in most cases, the day a hotel closes, it will be worth less than half the value it had the day before.

Rule #1 for lenders: If you are thinking about closing a hotel, you need to run a present value and holding cost analysis.

Weigh your alternatives carefully. If you cannot afford to keep the hotel open, you may be better off with a liquidation sale. Here is a recent case study.

A recent case study

Just a few days ago, a lender pulled back from brink . . . and just in time!

In a distressed scenario becoming increasingly common, a lender recently found itself with a hotel in Hawaii where the borrower defaulted and a receiver was appointed. The hotel was not producing enough income to meet payroll, utilities and other operating costs, and was unlikely to do so in the foreseeable future. The lender's initial decision was to stop advancing cash to meet necessary working capital and close the hotel. They wanted to mothball the hotel.

But then, the lender got some good advice and did a comprehensive situation analysis. They asked for both a cash flow and a present value analysis of two alternatives. Alternative #1 was the ugly option of keeping the hotel open by making new advances to fund the shortfall to meet operating costs for 3 years. Alternative #2 was the expedient option of closing down the hotel to "stop the bleeding." It was a good thing the lender did the analysis!

The analysis showed that the best alternative was clearly keeping the hotel open. Why? Because the hotel was worth more (if it stayed open) at every point over a projected 3-year hold, AND because it cost less to supplement the negative cash flow to maintain operations than it did to close the hotel. A closed hotel generates no revenue, but still has expenses for security, insurance, property taxes, property maintenance and the like. Let's look at this in some more detail.

What does every hotel veteran know about closed hotels that you need to know, too?

If you weren't working with troubled hotels in the early 1990s, you may wonder how you could possibly be better off making a fire sale disposition rather than mothballing the hotel.

Here are 8 bad things that happen when a hotel closes:

1. The day a hotel closes, most professional hotel brokers, appraisers and investors will tell you that the hotel will be worth less than half the value it had the day before.
2. When you close a hotel, the franchise and management arrangements will terminate. It may be difficult or impossible to secure as good a brand again. It will at least be very time consuming and expensive for someone to secure a major flag. There is likely to be litigation over breach of management and franchise agreements and cloud over the property's ability to reopen without some right of first refusal to the original operator and brand.
3. Closed hotels are vulnerable to vandalism, vexatious litigation and high-profile public relation disasters.
4. The cost of holding a closed hotel (which generates no revenue) often exceeds the cost of supplementing the negative cash flow from a losing hotel operation. A closed hotel still needs security, insurance, temperature control and systems maintenance. Property taxes continue to run.
5. Property and liability insurance may be impossible to obtain on a vacant property, or may be prohibitively expensive. Security can also be very expensive depending on the nature of the property. Most municipalities will not permit landscaping to be deferred. Communities will picket, protest and sue boarded up eye sores. Utilities must normally remain on for fire and life safety reasons, and if boilers, chillers, plumbing and other systems aren't flushed or maintained, they may soon need complete replacement. Lenders may have to choose between running air conditioning in tropics or heat in winter environments to avoid the necessity of replacing frozen pipes and rusted equipment and to prevent mold and ruined wall paper, carpets and soft goods.
6. The cost of starting up or reopening a hotel is substantial. The larger the hotel, the greater the time and cost of reopening -- refurbishing, relicensing, re-contracting for brand and management, rehiring and training employees, repositioning and marketing the hotel, ordering supplies and inventories, replacing liquor licenses and amenity agreements, and refilling the empty pipeline for future business.
7. Closing a hotel may forfeit entitlements, trigger governmental backlash and have a devastating impact on related components in the project.
8. Investors will also want a price concession cushion for the risks in trying to overcome the negative image of a closed hotel. They know it takes a lot of time and money, and may not succeed. (See the accompanying infamous story of the iconic Bellevue Stratford Hotel in Philadelphia at www.HotelLawBlog.com.)

There certainly may be cases where a careful present value analysis demonstrates that it makes economic sense to close an operating hotel rather than operate it at a loss for an unknown period. But we think that a third alternative is likely to be even more attractive than closing a hotel through a protracted downturn and slow recovery. In most cases, a sale of an open hotel at a realistic market price will be preferable to mothballing the hotel.

What does it all mean?

Conclusions and situations will vary. But we believe, as a general matter, prudent lenders will run a proper cash flow analysis, sharpen their pencils, and find some interesting results.

Other articles on State of the Hotel Industry

Other recent articles that relate to the state of the industry paint a pretty consistent picture of data and trends. Here are a few links to articles for your convenience:

• Hotel receiverships, bankruptcies, restructurings, workouts, turnarounds and opportunistic investment
• Hotel Lawyer Marta Fernandez: The Labor Pains of Hotel Closings Optimal Strategies for Full or Partial Hotel Closings
• National implications from the latest hotel industry Survey
• Conditions for hotel industry "RESET" may be coming into alignment
• Hotel foreclosures on track to set new records in California and elsewhere.
• Special servicers: Busy now? Realpoint says work will double by year end! Implications for all CRE loans.
• Hotel delinquencies predicted to exceed 8% by year end. Red Roof defaults on $361 million in loans. Are there lessons for hotel lenders and investors in the latest California market report?
• PKF says 2009 worst year in lodging history. Robust recovery likely but years away
• What lies ahead for the hotel industry? When do values bottom? When do they recover?
• Hospitality Lawyer at the 2009 NYU hotel conference
• Hospitality Lawyers present JEWELS from Meet the Money® 2009
• Hospitality Lawyer Insights
• Hospitality Lawyer: The "amazing relationship" between GDP and hotel room demand. When the recovery comes, what will it look like for the hotel industry?
• Closing that hotel may be the worst money-saving idea you ever had! Lenders, here's why mothballing a hotel can be a very bad idea.