Avoiding Mutually Assured Destruction in Hotel and Resort Projects in a Troubled Economy
In the current economy, many of the hotel and resort projects that are in the development phase (from pre-development to pre-opening) are facing numerous challenges to their survival. Some problems, like banks failing and being unable to fund projects that were not in default, are almost unique to the economic morass in which we now find ourselves. Many of these resort projects were originally structured as mixed-use projects with resort, retail, residential, golf and marina components. A certain balance of these components was required to make the project economically and operationally feasible from the outset and remain essential for success on a going forward basis in any scenario. Others may require creative restructuring and repositioning in order to have any chance to survive. As the structures of mixed-use projects have become more complex and sophisticated to accommodate the various project elements and divided ownership, it has become that much more difficult to formulate solutions for survival or rebirth.
The parties involved in these projects have expanded from the typical developer and lender model to include other investors, unit or parcel purchasers, governmental entities, brand managers, golf course and marina designers, contractors and operators, and other affiliation companies. The project structure likely includes agreements for joint venture, loans, concessions, purchases, leases, licensing, management, development, construction, and membership programs and affiliation agreements, in addition to the governing documents for the project. Because of the interrelationship of these various components, the project structure is susceptible to failure as a result of a default of even one of these agreements or the refusal or inability of a single party to participate in a restructuring program, either inside or outside bankruptcy. The mix of U.S. and foreign parties further challenge the design of a viable workout solution.
Under the operative project-related agreements, it is typical that in the event of a default, each of the parties has claims for varying types of damages and a right to judicial and non-judicial remedies and dispute resolution. For example, in addition to other available remedies, the lender may foreclose upon the property; the brand company may walk away from the project, thereby creating a loss of the brand and be further entitled to very substantial termination fees; the residential or hotel-condo purchasers may terminate their purchase contracts and be entitled to a refund of their deposits; and the government may be entitled to pull development permits and concessions that it may have granted. The possible claims by the parties (who learn from claims made by others, which causes increased complexity in litigation or arbitration proceedings) may include monetary damages, injunction, punitive damages, lender liability, securities violations and fraud claims. However, if each party’s strategy is to seek their own remedies, everyone loses. The project collapses and becomes either a total or near-total loss, generally resulting in massive economic loss to all parties and injury to brand companies through the association with a failed project with which the brand’s name was associated in the press, advertising and representations to purchasers. The brand also loses the location and future, long-term fees. The purchasers may lose their deposits with no property or membership benefits in exchange and may have little chance to recover their “used for construction” deposits from any viable party. The government loses potential jobs, taxes, and fees and now has a blighted project. Political opposition parties now have a failure to hang around the necks of the incumbents who approved the project and the granted concessions. Lenders are not equipped to either complete the development or operate the hotel or other components and so are reluctant to take the project back and become exposed to the potential successor developer obligations that may come with it. This is particularly the case in a market where there are no “vulture capitalists” looking to acquired failed projects.
As though all of that is not problematical enough, consider the special problems relating to abandoned, unfinished construction, from environmental issues relating to runoff from unseeded golf courses that have not yet been reclaimed by adjacent jungle areas to restarting construction with a new team where records have disappeared and uncovered construction has been exposed to weather elements for a period of time.
Strategies for Bankruptcy
If a lender (or, potentially, a construction lienor) decides to foreclose, the owner/developer may consider the strategy of filing a chapter 11 bankruptcy. This is particularly true if the owners believe that there is equity in the property. In the current market, this may amount to wishful thinking for both owner and lender. Where the owner/developer wants to interrupt the foreclosure process, the bankruptcy filing may be used to: (1) slow the foreclosure process to simply buy time; (2) obtain court-approved refinancing, such as debtor in possession financing; (3) confirm a plan of reorganization; or (4) to sell the property. Conversely, where there is no equity in the property, the bankruptcy process may also be used to “strip down” mortgage indebtedness to the market value of the property via plan of reorganization. The more likely scenario would be for the owner/developer to attempt to sell the property while using the bankruptcy process to allow it breathing time to market the property. A bankruptcy sale may be particularly attractive where there are multiple liens on the property, as the asset may be sold free and clear of liens with liens attaching to the sales proceeds and with distributions to secured creditors to be determined by the bankruptcy court. The downside of bankruptcy, on the other hand, is the expense and risk that existing equity or ownership could be eliminated, or that the project now lacks a brand and unit purchasers, thereby creating, at best, a pyrrhic victory.
Given the current economy, owner/developers of hospitality projects find themselves in default in some or all of their project agreements, if for no other reason than missing milestones, and in some projects, one or more of the parties to the various agreements, not knowing what else to do, are entering into standstill arrangements until they are able to figure out their next move. Lenders worry about successor developer and senior debt versus mezzanine debt battles, and even prosecuting foreclosures in the aftermath of the collateralized debt/securitization mess.
The Domino Effect
Is there an alternative to this “mutually assured destruction”? Maybe, but such an alternative would require creative solutions, a spirit of cooperation and must make long-term business sense. All of the parties must acknowledge that no one comes out unscathed. To the extent there is to be “economic gratification,” it will be delayed, perhaps for an extended period of time. If the project remains unfinished, the parties must cooperatively find a way to complete the project or, at least, the current phase. Condo-hotels may need to become traditional hotels, the conversion of which has many business and legal hurdles, especially if a number of purchasers have closed on their units.
Once the battles start, the domino effect begins. By the time the last domino falls, there are only losers and values relating to the project become distant memories. It may be better to think of unfinished projects and not yet stabilized properties as hot potatoes, with each party that’s a potential successor in title asking, “What do I do with it?”
In order to devise a strategy that will work for a project, it is essential that all parties be advised by experienced, creative and practical dealmakers in order to prevent huge losses to everyone. Mutually assured destruction can be avoided, and losses minimized, but it’s not a simple matter. The winners here will be parties with the foresight to put together the right team and to show up with the right attitude.