The W Hotel has been described a lot of different ways including trendy, upscale, and avant-garde.  The posh hotels chain however has shown that it is not immune in the current economy as travelers are cutting back on expenses everywhere possible.   Sunstone Hotel Investors (SHO), a REIT that owns the W in San Diego, in addition to 43 other hotels, has decided to forfeit the building to its lenders rather than pay its June mortgage payment.  Industry analysts think that more hotels could follow suit if conditions do not improve.

We know that air travel has been hurt as the International Air Transport Authority doubled (to $9 billion) its estimates of worldwide airline losses on Monday.  Obviously, consumers are flying less when possible and when staying in hotels they are more willing than ever to trade down to the midrange hotels, in order to save some coin.  That was certainly the case for the San Diego W which was acquired by Sunstone Hotels Investors near the height of the real estate bubble in 2006 for $96 million.  According to the Wall Street Journal, income from the hotel was insufficient to cover the expenses starting in 2007 and since that time Sunstone had been footing the bill.  However, after failed negotiations for a loan modification the REIT decided that it was no longer worth paying, since the loan was still valued at nearly $65 million almost certainly more than the hotel is worth.

As everyone knows, the recession has been a especially hard on real estate and by extension Real Estate Investment Trusts.  REITs have had to deal with declining property values and inhospitable credit markets for the better part of two years now.  Frankly, it has been a surprise to us that commercial real estate has not yet had more of these kinds of stories.  Sunstone’s earnings will be heavily tied to which ever direction the economy goes in over the coming quarters.  With the San Diego W, it was clear that they bought in at the worst possible time and could no longer justify paying a mortgage that was far too costly for the underlying asset’s value.  The substantial debt load on this company does not allow them to continue to pay into projects that are that far underwater and clearly not paying for themselves.

We currently have Sunstone Hotel Investors as Greatly Undervalued based on comparisons to its historically normal valuation range.  However, that being said, while this opportunity may turn out to be a great deal 2 to 3 years from now, it is simply not the right market environment to buy into SHO.  The stock has more than doubled since the market hit a low in March, but the move today highlights that there may be more trouble ahead.  The company is having to give up on one of its hotels with a great brand in a popular resort city, after sinking a substantial amount of money into the project.  Surely, this is not a decision that comes easily to the management at SHO and if they thought that CRE was on the rebound then they likely would have tried to wait it out.  Furthermore, the company was too aggressive when real estate was too expensive and now is left with a huge debt load and dwindling asset values.  For Ockham to get excited about this stock, we would like to see a reversal to the nasty revenue and earnings trends that we are currently seeing.  In order for that to happen, we will need to see both business and leisure travel pick up and with the newly thrifty America that could take some time.