ROBERT E. NUGENT, Bankruptcy Judge.
Courts value the estate's interest in property in light of the purpose for establishing its value and the proposed use or disposition of the property.
The Inn was built in 1985 (with additional buildings in 1990). It is a campus-style, limited service, extended-stay hotel consisting of several buildings with 88 total units (suites with full kitchens except for 24 studio-type units) with exterior door entrances and stair wells. It is an independent hotel carrying no brand or flag affiliation and no national reservation system. It is located near, but not visible from, the intersection of North Rock Road and 21st Street East, a busy retail and residential location in Wichita's northeast quadrant. The Inn is tucked behind a shopping center and is adjacent to a private golf club. The Inn typically caters to corporate customers who provide extended stay lodging there for their employees. These customers include the major aircraft manufacturers and Koch Industries which is headquartered in Wichita. Without a flag, the management must build and maintain relationships in the community to directly sell the Inn's extended stay concept to customers and corporate travel departments. The Inn is considered a mid-price hotel that appeals to cost-conscious guests. Everyone agrees that the hotel has deferred maintenance and needs a "soft finish," the general updating of furnishings and decor.
Donald Kennedy acquired sole ownership of the capital stock of TIAT in 2006 for $6.1 million. To finance that purchase, TIAT borrowed $5.0 million from U.S. Bank on a non-recourse note secured by, among other things, a mortgage on the property and an assignment of room rents. Previously, Kennedy had managed the Inn since 1987. He currently receives an annual salary of $110,000 and continues to manage the hotel. After a substantial drop in revenue in 2015 led to default and a looming foreclosure, TIAT filed this case. TIAT attributes its misfortune to a decline in corporate customers purchasing extended stay housing for their employees as a result of increased competition in Wichita. Post-petition, U.S. Bank auctioned TIAT's note and mortgage and SBNV, the current holder, acquired it for $1.82 million. TIAT filed a plan proposing to value the Inn at $2,161,761 and SBNV filed this motion under § 506(a) to determine the value of the collateral.
Three reports were offered and admitted into evidence. The debtor offered two opinions of James Korroch, the first asserting a value of $2,181,761 and the second a revised value of $1,298,364.
James Askew is a licensed commercial real estate appraiser and has been president of Hotel Valuation Advisors, Inc. since 2000. He specializes in hotel valuations and has appraised more than 500 hotels of varying types, including independent properties and extended stay hotels all over the United States. Askew's report relies heavily on industry market data and trend reports compiled by third party services such as Smith Travel Research (STR), the Highland Group, and PKF to develop projected growth, revenue, and operating expenses for the Inn.
TIAT asked James Korroch, a personal friend of Mr. Kennedy, to advise it concerning the value of the property. Korroch is not a licensed appraiser, but he has been a licensed commercial real estate agent for about two years. Before that, he accumulated nearly 30 years' experience as a hotelier, serving in various capacities. He co-founded Candlewood Suites with extended-stay lodging pioneer Jack DeBoer, and worked to develop nearly 70 Candlewoods before DeBoer sold the brand. His roles included management, site selection, and franchising. Korroch is also a Marriott franchisee and has developed several Marriott properties in the Midwest. He presently owns the Marriott Fairfield Inn in east Wichita and two other Marriott properties in Northwest Arkansas. He specializes in consulting with investors wanting to build or purchase hotels and is currently advising the developers of the newly-constructed Starwood aLoft property in northeast Wichita, a $20,000,000 project. Korroch's lack of appraisal certification is offset by his credibility and experience with hotel operations, and specifically with extended stay hotels in the Wichita market. He testified that he was familiar with and uses capitalization methods in evaluating hotels for himself and his clients.
The debtor's plan proposes a value for the Inn of $2,161,761.
Both Askew and Korroch purport to value The Inn on an "as is" basis. Both also agree that some level of property improvement is necessary. Askew factored a $600,000 improvement plan into his calculations and Korroch testified that a similar program would be necessary to keep the hotel in its current competitive position. Korroch testified that in his experience, hotels require periodic "soft finish refreshes," meaning that the furnishings, carpeting, wall coverings, and window treatments need to be refreshed at least every 6 years. This property requires that, too.
Each appraiser recognized the influx of new hotel properties into the Northeast Wichita market. Their views of how those new rooms compete with the Inn are divergent. Korroch noted that six new properties located within a few miles of the Inn will come online in 2017 or 2018. Askew estimated an additional 428 rooms would be provided by those properties. All of the new properties are flag properties and, unlike the Inn, are single building hotels with interior hallways. Korroch argued that lenders and buyers prefer flag properties because of their access to reservation systems, corporate property support, and management. Askew concurred that flag properties have advantages, but argued that the Inn's freedom from franchise and management fees made up for the lack of franchise connections. They agreed that big box properties are more attractive to corporate customers because they are more up to date and secure. Korroch noted that by 2020, nearly 80% of all travelers will be "millennials" who want smaller rooms and larger common areas where they can "meet and greet." The Inn features larger guest rooms in the lodging buildings, but lacks interior halls and only has a small eating area in the separate registration/lobby building.
Askew's report recognizes that the Inn suffers from certain competitive disadvantages. To begin with, he notes that nationally, growth in average daily rent (ADR) as well as revenue per available room (RevPAR) will slow in the next several years.
Local pressures also weigh down the Inn's competitive advantage. Askew noted that there were 123 hotels in Wichita in April of 2016 and that occupancy was down (2.6)% year over year, driving RevPAR down (0.5)%. He selected a set of comparative properties that, while of similar size, are structurally and physically different from the Inn. Their RevPAR was down in 2016 some (2.2)%; occupancy dropped and the increase in ADR declined as well. Notably, the Inn's RevPAR had increased some in 2015, largely due to an increase in ADR that countered its loss in occupancy and attendant reduced cash flow.
Even so, Askew argued that the coming new hotel rooms wouldn't compete with the Inn because they would command a higher price point that would appeal to a different client set. He noted that, until 2015, the Inn had enjoyed higher RevPAR than other hotels in the area. Korroch countered that in a smaller market like Wichita, any added hotel rooms pose a challenge to existing assets. He described the local market as "tight" and "close," noting that the all of the properties "steal" customers from one another. He also noted that the Inn's off-street location, when compared to the newer competitors who were or will be situated at highway interchanges or busy intersections, remained a negative.
Askew suggested that even though the national and local markets' growth is declining, after renovation, and with significantly reduced expenses, the Inn's projected average daily rents would increase by more than 3% a year over a long period, making the Inn appear to be worth much more than either Korroch or CBRE thought. Korroch agrees that demand growth is cooling and suggested that the Inn's competitive disadvantages warranted increasing any capitalization rate he might establish by 100 basis points for risk.
To be sure, both witnesses faced several challenges. The Inn's accountings don't correspond to traditional hotel cost centers. None of the witnesses was provided with detailed income and expense reports. In addition, the Inn's gross revenues were fairly stable from 2012 to 2014, averaging about $2.118 million per year. But in 2015 gross revenue plummeted to $1.665 million, a 21.4% drop. The TTM gross revenue from November of 2015 to October of 2016 rebounded to $1.843 million, a 10% increase.
Korroch and Askew took different approaches to valuing the property. CBRE and Askew capitalized stabilized income while Korroch capitalized historical income and expenses for the trailing twelve months (TTM) preceding his reports. Where Askew advocated the use of "yield capitalization," CBRE and Korroch employed "direct capitalization." Briefly, yield capitalization involves projecting future net operating income (NOI) a property might generate over time, discounting that NOI back to present day by applying a discount rate, applying a cap rate derived from market data to that NOI, and deducting the cost of any improvements from the result. Direct capitalization involves determining the stabilized revenue and operating expenses for a property, based upon its history or the market, and applying a cap rate to the resulting NOI.
Askew testified that yield analysis is most appropriate for properties with single tenant usage or long term leases. He said that smaller owner operators prefer using direct capitalization because it generally reflects historical performance rather than projected performance. Korroch said that in his "community" — hotel buyers and Marriott operators — buyers look at TTM data and capitalize it rather than rely on the projections that undergird yield analysis. He stated that yield capitalization is typically used in the hotel business when prospective buyers are REITs or when entities are considering whether to construct a hotel.
Both Askew and Korroch agreed that renovations of at least $600,000 are needed. TIAT's plan does not provide for these renovations, but proposes to make some renovations as cash flow allows. They agreed that it was appropriate to deduct a 4% replacement reserve before capitalizing the Inn's net income. Both concluded that the highest and best use of the property is continued operation of the hotel. Both concluded that the gross revenue figure for year 2015 was an anomaly and have disregarded year 2015 results in their value calculations. Finally, both concluded that the cost approach was not an appropriate valuation method given the Inn's age. They considered the sales comparison approach, both to extract capitalization rates and to check their income-based value results. Although Korroch only considered a single comparable sale, the extended stay Marriott Town Place Suites (Marriott), all ten properties in Askew's comparative set are affiliated or branded hotels, not an independent hotel like the Inn.
Askew's $5.330 million opinion of value is derived from a yield capitalization of ten years' projected stabilized NOI. It assumes a $600,000 renovation in the first year. He chose the yield capitalization method because the Inn's NOI is not stabilized. That requires him to project income and operating expenses in the future to derive a stabilized NOI.
Askew emphasized several positive factors to the property. They include the Inn's presence in a "desirable neighborhood," near major commercial and retail development and close access to arterial highways. He projects that executing a $600,000 property improvement plan would add 20-25 years of useful life for the hotel.
But, Askew also projected a drop in market RevPAR of -2.2% and a drop in occupancy of -3.9% for 2016. What makes Askew's appraisal report less persuasive are his observations about this hotel and this submarket. He acknowledges the increasing market supply of hotel rooms in Wichita, noting that 482 new rooms will come online in the near future. But he concludes that these incoming competitors won't negatively affect the Inn because of their higher room rates. Still, several of these hotels are located close to the Inn. One such hotel in development, the Starwood aLoft, is across the street from Koch Industries' headquarters. Koch has been one of the Inn's principal customers.
Askew also concluded that the Inn's operating expenses exceed average operating expenses of the hotel market in general, including those of the Marriott, Korroch's only comparable sale. Askew projects a future operating expense reduction of at least 20 percent from the Inn's actual historical operating expenses. This decrease alone adds about $400,000 to NOI, in turn triggering a $3.7 million dollar market value swing, despite Askew's testimony that he didn't know whether reducing expenses would lead to decreased revenues.
Askew projected a 3.15% ADR increase for years 4 through 11 notwithstanding flat occupancy in his stabilized projections. He chose the yield capitalization income method because it is said to adjust for variable revenue streams by normalizing and discounting them. He relied on three local comparable sales to support his $5.3 million value. Each sold for between $68,000 and $98,000 per unit or room. By comparison, at $5.3 million, the Inn would bring $60,000 per unit. Each of Askew's comparable sales involve newer, branded, big box hotels. They include Korroch's only comparable sale, the Marriott. The other two are not extended-stay hotels and none of the three is a campus style property like the Inn.
Askew testified that smaller hotel owner-operators use the direct capitalization method when they buy because they don't trust the yield capitalization method. It is too speculative or reliant on predictions. He also said that yield capitalization is typically employed in pricing properties with predictable space usage like single tenant usage or long-term leases such as office buildings, retail centers, and other properties. Askew also said that selecting the appropriate capitalization rate involves considering the site location, the condition and design of the property, and competition in the area even though his rebuttal report questioned Korroch's adjustment of the Marriott capitalization rate based on precisely these factors.
Using direct capitalization, Askew established an alternative $5.2 million value to the Inn by applying a 10 percent capitalization rate. As with his yield capitalization analysis, Askew's NOI projection is much higher because he applied market average operating expenses in assuming that the Inn's actual operating expenses can be stabilized at approximately 78.1% of gross revenue (before reserves). The Inn's actual operating expenses were as much as 99% of gross revenue in 2015, the final full year before filing, and were never lower than 85% (2013) in any year between 2012 and 2016. Using market numbers, he opines that the Inn's stabilized NOI is approximately $537,000. Note that the Inn's actual current trailing twelve months' NOI figure (through October 2016) is $165,719 (before replacement reserve). As he noted on cross-examination, the market expense averages are calculated based on hundreds of hotels, only a few of which may be similar to the Inn.
Testifying on rebuttal, Askew responded to Korroch's corrected direct capitalization evaluation
Askew concluded that a reasonable investor would bid assuming that the Inn's operating expenses could be normalized to market averages. It is true that the Inn falls at the high end of the expense range of the hotel market, $11,593-$19,757 per unit.
Korroch stated that the Wichita hotel business here is extremely close and competitive. He recently acted as buyer's broker for the sale of the Marriott Town Place Suites property and believed it was the most comparable sale from which to extract a capitalization rate. The Marriott and the Inn regularly compete for the same customers. He based his opinions on the financial information Kennedy provided him. When he issued his April opinion of value at $2,181,761, he included the TTM revenue and expenses ending March, 2016 to establish the NOI of $298,000 that he capitalized at 13.8%. Korroch's assumptions about the Marriott sale were erroneous because he'd used its 2014 results to establish its NOI rather than 2015. There were arithmetic errors in the opinion as well. Plus, he assumed that the Inn paid a franchise and management fee. It pays neither. Instead, Kennedy receives a salary that is accounted for in general and administrative expenses.
When SBNV pointed out those errors in its motion in limine in December of 2016, he revised the opinion.
CBRE established a direct capitalization value of $2.2 million for the Inn that is based on a stabilized NOI of $282,650,
We turn to determining which of these methods and outcomes best "fits" what 11 U.S.C. § 506(a) contemplates: determining the value of SBNV's interest in the debtor's interest in the property in light of the purpose of the valuation (allowance of SBNV's secured claim and plan confirmation) and the proposed use or disposition of the property (retain, refurbish, and continue to operate as a hotel).
Proper application of § 506(a)(1) requires that the value of the Inn be determined as of the hearing date and as it exists ("as is") today, since TIAT intends to retain the property, continue to operate it as a hotel, and use the income from operations to fund its plan of reorganization.
While fully crediting the experience and technical expertise both value witnesses brought to this hearing, the Court believes that even the best appraisals are, to some degree, educated guesses about the value of the property. Where the value experts land is often a function of the methods they apply and the data to which they apply them. Here, the parties have presented two competing appraisals with values ranging from Korroch's opinion of value of $1,298,364 to Askew's appraisal of $5,330,000. I am not required to simply choose one or the other.
Accordingly, I can give such weight to those portions of each appraisal that enable me to reach a determination of the Inn's fair market value while disregarding those portions that I find less persuasive.
Section 506(a) doesn't impose a specific standard or method of valuation, but several courts have considered what methods of valuation are appropriate in hotel cases.
The 210 Ludlow court called the direct capitalization of income method the "default method" for determining value under an income approach while stating that yield capitalization is "generally restricted to use only in cases where there is an unstable market or where new construction is involved."
Nearly all of the wide delta between Korroch's direct capitalization at $1,289,364
Askew's projected future operating expenses in forecast year 1 are $15,192, a significant cut. Askew says the bulk of that should come from labor costs. But this discounts the lack of a national reservation system and brand marketing. Without that, the Inn must work to develop personal relationships with corporate and business demand generators — a sales and labor intensive approach to generate occupancy and room revenue that is certainly not cost-free. Moreover, even during years 2012-2014 when NOI was relatively stable, the Inn's operating expenses ran above industry norms, averaging 88.39 percent of gross revenue and never below 85 percent of gross revenue in any of those three years. It may simply cost more to run an old hotel. Expenses cannot be immediately reduced by nearly 17% without negatively affecting the quality of service and, in turn, reducing gross revenues, particularly in the current competitive environment.
As Korroch suggested, a stabilized income stream that reflects the hotel's historical performance is more likely what a buyer might use to determine what to bid for this hotel. His opinion was based on the TTM ending in March of 2016 (the "March TTM"). He testified that use of the TTM ending in October 2016 (the "October TTM)" would have been timelier. If § 506(a) valuation is to be done as of the date of the hearing, the October TTM is the appropriate place to start. Rather than apply Askew's market average expenses, I would deduct expenses of 88% of gross revenue, the operating expenses average for the years 2012, 2013, and 2014, a far more stable period in the hotel's history than 2015 or 2016. Because the debtor books depreciation as an operating expense, depreciation should be added back to net income and a replacement reserve of 4% be subtracted before determining NOI. This calculation is shown below:
Korroch and Askew also differed on appropriate capitalization rates for the direct cap calculation. As noted in In re Hotel Associates, L.L.C., the capitalization rate is "dictated by market forces and the prospective investor's perceived risk in investing in or purchasing a given property."
Applying the 10.8% cap rate to the stabilized NOI for the twelve months trailing as of the end of October, 2016, I conclude that the fair market value of the Inn, as is, is
As previously ordered, SBNV has 14 days from the date of this order to make a § 1111(b) election.
