A feature in today’s Wall Street Journal chronicled the bankruptcy of the storied 1,640 room Palmer House Hilton—a 150-year old landmark in the heart of downtown Chicago. It was presented as a victim of the Covid, but in fact it is a casualty of the hand-to-mouth, debt-entombed economy fostered by 30 years of Keynesian central banking.
The Palmer House Hilton has been one of Chicago’s grandest hotels for more than a century. Charles Dickens and Oscar Wilde were guests. Frank Sinatra serenaded diners at its supper club. The hotel for many years attracted the wealthy, powerful and famous. Liberace and Louis Armstrong played at its Empire Room nightclub, while U.S. presidents from Grover Cleveland to Bill Clinton stayed there. Conrad Hilton purchased the hotel in 1945 and made it a flagship of his empire.
But today, the property faces a bank foreclosure and has become one of the most potent symbols of the troubled hospitality industry during Covid-19.
Well it might. In 2005 Palmer House was purchased by a leveraged real estate outfit called Thor Equities for $230 million, of which an estimated $180 million was debt and $50 million was equity. Thanks to the Fed’s deep falsification of interest rates and the resultant financial market boom, by the pre-crisis top in 2007 Thor was ready to flip the property for a big gain on its sliver of equity, as indicated by this quote from Thor Equities founder at the time:
“We said, ‘Holy cow! This is gold,’ ” the firm’s chairman and founder, Joseph Sitt, told the Wall Street Journal in 2007.
Alas, Thor missed the cash-out window before the recession closed down property speculation, but no matter.The Fed proceeded to make debt even cheaper during the era of QE. So Thor subsequently refinanced the property with double the debt at $420 million, which financing included a first mortgage of $333 million and $94 million of mezzanine debt.
That permitted it to pay off the original debt, fund a $173 million renovation program and take out a hefty dividend, too. It also meant that it had $256,000 of debt per room—an implicit bet that occupancies and room rates would stay high forever and that cash flows would never be in doubt.
And through 2018, the bet paid off. At that time, the Palmer House was appraised at $560 million, meaning that the implied equity value after the $420 million of debt was $140 million, representing a 180% gain on Thor’s original equity investment plus the interim dividends.
That’s the way things rolled during the weakest recovery in US history: The Fed’s juice obviously went into the inflation of financial asset values—including hotels—-which assets were promptly leveraged up to the hilt.
In this case, JPMorgan was the first mortgage lender, but far be it from JPM to get stuck with a $333 million single-property mortgage on its books. Instead, the mortgage was sliced and diced and securitized into bonds with an ample fee to JPM for its troubles, and then sold to desperate, yield hunger asset managers who were being starved on the meager yields available in the UST and investment grade markets. Thank you, Fed.
In this manner, especially in the commercial sector, loans were converted to bonds, making more room for new bank originations and therefore even more leveraging of rising asset values.
Then came the Covid, of course, followed by a crash of occupancies and cash flows, and a 45% reduction of the Palmer House’s valuation to just $306 million. After April, the securitized bond and mezzanine holders didn’t get their interest payments, Thor’s equity value was wiped out and the debt on average was worth just 72 cents on the dollar, at best.
Accordingly, the agent for the securitized bond holders, Wells Fargo, filed the foreclosure action, taking its fees along the way, as well.
Needless to say, the Palmer House is no aberrant outlier. The entire hotel industry was heavily leveraged in this manner, and there is now a rapidly building default crisis, as the yield-chasing fund managers, who had gorged on securitized hotel paper, find themselves on the short-end of the industry’s vaporizing cash flows. As the WSJ further noted,
Investors hold some $87 billion of debt backed by hotels that has been converted into commercial-mortgage-backed securities, according to Trepp. Nearly a quarter of all lodging loans that had been converted into securities were in default this month, compared with only 2% in February.
Needless to say, bond mutual fund managers are getting marked-to-market good and hard by their now fleeing yield-seeking investors, while insurance and private portfolio managers vainly look for buyers of deeply impaired paper for which bids are far and few between.
After all, these deals were predicated on ever rising RevPARs (Revenue per available room night) and downside cases that did not look remotely like the industry cash flow disaster depicted below.
Indeed, the peak hotel season is now already over, yet RevPAR was down by 48% versus prior year over the Labor Day week, thereby ending the season lower than had been the case during the July 4th holiday. Now comes the fall flu season, tales of second waves of Covid from the MSM and a near certainty that the Palmer House is just the first in a long-line of bankruptcies in the hotel sector.
But here’s the thing. We don’t give two hoots about the professional fund managers who are now getting their just desserts. But what we are not loathe to point out is that on the way to the top of the bubble, it was the money moving classes—investment bankers, private equity investors and their medley of vendors—- who skimmed the fees and collected the leveraged dividends and capital gains from these debt pyramids.