Bob Bigtime knew a great deal when he saw one. Podunk City Council was convinced it was going to get professional football, basketball and baseball franchises. The $500 Million Podunk Sports Complex was going to be the greatest thing that ever happened to Podunk. Bob knew he could make a fortune by building the hotel everyone, including visiting teams, would want to stay at. He grabbed a tract of land near the site. To make sure he was the best choice for rooms, he bought a Marriott franchise and hired a high-end management company to operate the hotel for him. 

Bob raised $5,000,000 in equity and got a $20,000,000 five-year term loan from Podunk Bank to build a $25,000,000, 250-room Marriott at the site. Podunk Bank agreed to a 20 year amortization. The loan bore interest at 6%. The hotel opened January 1, 2018. The loan comes due December 31, 2022.

Guess what; Podunk didn’t get any Major League sports franchises. Hotel performance is reported based on the product of multiplying the average of nightly room rates actually charged over a year times the percentage of hotel occupancy over the year. Bob originally anticipated averaging 80% daily occupancy with an average nightly room rate of $100. This meant gross revenues of $7,300,000 a year. Instead, with the best efforts he can make, the hotel averages 50% occupancy at $75 a night. Gross revenues are about $3,400,000. Bob recognizes this is going to be his “stabilized” revenue stream for the future; perhaps increasing slightly with inflation.. 

Bob has expenses. The management fee costs him $200,000 a year. Marriot costs $350,000 a year. The employees at the hotel cost $450,000 a year, including taxes and benefits. Supplies are another $200,000, taxes at 1% are $250,000, insurance is $60,000, and he must fund an “FFE” reserve of 4% a year. That's 4% of gross revenues. In other words, $136,000 a year is going into a reserve to refurbish the hotel every five years. The upgrade costs, for a Marriott Hotel, would be about $1.2 Million dollars. 

And then the pandemic hit. The bank was good; suspending payments of principle for 2020. Principle payments will start up again in January. But at that point, Bob must make some decisions. The hotel is currently valued at a “10 cap.” Bob's advisors tell him that the stabilized cap rate for the hotel, after the pandemic ends and things get back to normal, should be about a “7 cap.” 

Podunk bank has a loan covenant requiring that the hotel have cash flow coverage of at least 1.0. Cash flow coverage for the hotel would be net operating income divided by total debt service. Bob is allowed to include investments he makes into the hotel as income. The bank wants Bob to be back in compliance with this provision by the end of 2021. 

Bob also recognizes that neither his Marriott franchise agreement nor his expensive management contracts are worth the future prospects for the hotel. Bob can enter into a new franchise agreement with Best Western for $150,000 a year. The cost to convert would be $100,000, and the cost to terminate Marriott, under the Marriott agreement, would be $200,000. Best Western only requires an $800,000 upgrade in year five.

Bob can also terminate his current management company and replace it with another management company that will only charge 3% of gross revenues. The cost to terminate the management company would be $100,000. 

Bob's advisors are telling him to get rid of Marriott and the current management company, and try to comply with the bank's requests. Bob thinks this is the right thing to do, though he knows it means he will have to put more money into the hotel to make the changes and meet the new sets of obligations. Assume that, in 2020, Bob was able to meet his current expenses and pay interest to the bank, thanks to the bank suspending principle payments. Assume he does as his advisors recommend. Assume also that the hotel returns to its stabilized revenues for all of 2021.  

Questions:

1. What is Bob’s current NOI? What is the range of the hotel’s current values? What will his NOI be at the end of 2021? What will the hotel’s range of values be then?

2. Will Bob meet the bank’s cash flow coverage ratio as of year-end 2021?

3. If Bob decides to make the recommended changes, how much will he have to invest in the hotel between now and December 31, 2022? About how much will he owe Podunk Bank at that time?