The key issue in the bankruptcy proceedings involving a debtor entity that owned two hotels was the value of the hotels, which would control the amount of the main creditor’s secured and unsecured claims. The valuation date was October 2020, a point when the effect of COVID-19 was keenly felt, particularly in the hospitality industry. The court, drawing on expert opinions from both sides and straddling the value divide, found a legally sound valuation needed to be based on the premise that the debtor was planning to keep hotels in operation. Further, any valuation based on the income approach needed to be based on projections that accounted for the revenue damage caused by COVID-19.

Backstory

In 2017, the debtor entity bought two hotels in Bloomington, Ind.: The Comfort Inn and the Holiday Inn. At the time, only about 1,000 hotel rooms were available in the city. In contrast, at the end of 2020, there were about 2,900 rooms. Meanwhile, the city’s population was relatively static, as was the rate of visitors. 

COVID-19-related government shutdowns in the area began in March 2020. One of the debtor’s 50% owners, who was a witness at the valuation against hearing that is the subject of this court decision, testified that, before COVID-19, the debtor never missed a payment to the bank, which held perfected first liens against for about $7.5 million as of August 2020. The shutdowns had serious negative consequences for the hotels’ financial performance. In October 2020, the revenue was $1.9 million lower than in October 2019, the co-owner said.

Bloomington is a college town. The evidence showed that, once COVID-19 was recognized as a global and national health threat and government orders required people to limit their social interactions, Bloomington saw students leave and pursue online education. Further, sports-related events and other college activities came to a halt for the rest of 2020. This standstill is likely to continue for a good part of 2021 until vaccination brings about a turnaround.

As for the hotels, even before COVID-19, there was a noticeable reduction in revenue (for the Comfort Inn, about 30% from 2018 to 2019) owing to the dramatic increase in the supply of hotel rooms in Bloomington. 

On Oct. 7, 2020, the debtor filed for Chapter 11 bankruptcy under subchapter V. However, the court, sustaining the bank’s objection, found the debtor did not qualify for subchapter V. Instead, the case was to proceed as a standard Chapter 11 bankruptcy.

The debtor filed a reorganization plan under which the debtor would not dispose of the hotels but would retain and operate them. Also, to determine how to treat the bank’s secured and unsecured claims under the plan, the debtor filed a valuation motion. The issue in front of the court was the fair market value of the hotels as of the valuation date. Or, as the court put it, “what would a willing buyer, under no compulsion to buy, pay for the Hotels in the condition which these Hotels existed at the Valuation Date?” 

Applicable law

The valuation issue arose under 11 U.S.C.S. § 506 (“Determination of secured status”), which says:

An allowed claim of a creditor secured by a lien on the property in which the estate has an interest, or that is subject to setoff under section 553 of this title [11 USCS 553] is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor’s interest or the amount so subject to set-off is less than the amount of such allowed claim. 

Regarding valuation methodology, the statutory provision only says the value is to be determined “in light of the purpose of the valuation and the proposed disposition or use of such property.” 

However, under controlling Supreme Court law, the proposed disposition or use of the property “[i]s of paramount importance to the valuation question.” Where the debtor contemplated the use of the property that served as collateral, the property was to be valued under the replacement value. See Associates Commercial Corporation v. Rash, 520 U.S. 953 (1997).

Similarly, in a follow-up decision, the 9th Circuit has found that “[w]hen a Chapter 11 debtor or a Chapter 13 debtor intends to retain property subject to a lien, the purpose of a valuation under section 506(a) is not to determine the amount the creditor would receive if it hypothetically had to foreclose and sell the collateral.” See First Southern Nat’l Bank v. Sunnyslope Hous. L.P. (In re Sunnyslope Hous. L.P.), 859 F.3d 637 (2017) (en banc).

The court in the instant case said it would equate “replacement value” with the fair market value of the hotels on the valuation date in an “as is” condition.

The court heard from valuation experts for both parties and heard from the co-owner of the debtor. It considered all the opinions for its valuation. It also noted that all witnesses agreed that the hotel’s ability to generate net revenues for the owners was “the principal factor driving the market value of the hotel.” This is what investors focus on when buying and selling hotels, the court noted.

Key metrics

The debtor’s co-owner explained some of the principal pricing metrics in valuing a hotel. They are occupancy, average daily rate (ADR), and “RevPar,” which is occupancy times ADR.

Further, he said, the STAR report or survey provides hotel owners with information on how a hotel performs relative to its competitors. He explained that the STAR report showed that, for December 2019, the Holiday Inn had a 26.2% decline in occupancy and the Comfort Inn had a 28.5% decline in occupancy. The pre-COVID-19 decline, he said, was due to the big increase in the availability of hotel rooms and a lack of increase in the demand in Bloomington.

The debtor’s co-owner also noted the term Property Improvement Plan (PIP), which requires licensees of hotel brands to “freshen up or more fully rehabilitate a licensee’s hotel property.” The co-owner explained that neither of the subject hotels was currently contractually obligated to satisfy a PIP. A sale of either hotel also would not necessarily require a PIP for the brand to approve a buyer’s assumption of the brand’s flag. 

The co-owner said the Holiday Inn license agreement was to expire in May 2022. The Comfort Inn license was to expire in 2028. Both agreements can require the debtor to perform an upgrade and/or renovations. 

Under the debtor’s reorganization plan, the hotels were required to set aside capital reserves of 4% per year from 2021 through 2023. For the years 2024 and 2025, the owners would have to make a $300,000 capital contribution and borrow $1.2 million to make capital improvements to the hotels.

The co-owner testified that there were no plans for 2021 to renovate the hotels. Renovations, such as they were planned, would not begin until 2023. 

The Holiday Inn currently was worth about $2.4 million by the co-owners account, whereas the Comfort Inn was worth about $1.3 million to $1.4 million. The co-owner testified that neither hotel would be able to reach 2019 RevPar levels for the next three to five years.

Debtor’s valuation expert

The debtor also testified against an experienced hotel appraiser who had testified in bankruptcy and state court proceedings about 20 times.

This expert interviewed the debtor’s competitors and brokers and reviewed industry publications, particularly the STAR reports. He also visited all the competing hotels he had identified in the hotels and the subject hotels themselves. He noted the Holiday inn was a full-service hotel, whereas the Comfort Inn was a limited-service hotel.

The debtor’s appraiser noted the disruption the pandemic has caused for the hotel industry. For many properties, RevPar declined by 50%, he found. However, he also noted the debtor’s hotels had shown significant revenue reduction before COVID-19, from 2018 to 2019, because of a dramatic increase in the supply of hotel rooms in Bloomington.

He also found the STAR report showed that, in December 2019, the Holiday Inn had a relatively high ADR but relatively low occupancy. This meant the hotel rooms were overpriced. He said the Comfort Inn performed better than the Holiday Inn but RevPar was down by December 2019. He said that COVID-19 devastated revenues for both hotels in 2020. He also said that industry experts expected it would take between three and five years for revenue to return to pre-COVID-19 levels.

He completely disregarded the cost approach. He found the sales comparison approach was “imperfect” because it was not possible to locate comparable sales nearby or near in time.

He decided to use the income capitalization approach. And he found RevPar was the most important metric in his valuations. A high ADR likely would push down the occupancy rate and vice versa, he noted. Therefore, “RevPar is more important than artificially elevating its components, ADR or occupancy.”

The debtor’s expert’s valuation showed the Holiday Inn had a fair market value of about $3 million and the Comfort Inn was worth about $1.5 million. The total value of the hotels was about $4.5 million.

Bank’s valuation expert

The bank’s expert was highly experienced. He was a certified appraiser and member of the appraisal institute (MAI). He said most of his practice focused on valuing hotels. In the past five years, he said he had appraised between 115 and 150 hotels per year, 65 in Indiana alone. However, he had never testified in litigation.

The premise of his valuation was that the hotel would be sold on the appraisal date. The sale, he assumed, would require the buyer to renovate the hotels per the terms of the applicable PIP. The total cost, he assumed, would be $3 million and would come out of the capital reserves and a capital contribution.

The bank’s appraiser agreed the income capitalization approach was the best. He said sales comparisons tend to be subjective, particularly when one compares different markets. Hotel buyers, this expert noted, do not generally rely on sales comparisons.

The bank’s expert agreed with the opposing expert that RevPar was the most important metric for valuing a hotel. He also noted that customers sometimes have loyalty to a hotel brand because they receive points for coming back.

This expert did not review the debtor’s reorganization plan, which discussed the debtor’s intention to keep the hotels operating. 

The bank’s expert’s valuation found that the Holiday Inn on the valuation date was worth $5.5 million and the Comfort Inn was worth $2.7 million. The total value of the hotels, and therefore the bank’s collateral, was $8.2 million.

The court notes wrong base assumptions

At the beginning of its analysis, the court noted that the bank’s expert based his valuation on the mistaken premise that the hotels would be sold. Therefore, even though the expert was “imminently qualified,” his appraisals were “defective, at least for this Court’s § 506(a) valuation.” 

The debtor’s plan noted the debtor would retain and operate the hotels and case law “instructs this Court to value the Hotels at replacement value,” the court said. It went on to say that the defects in the bank’s expert’s valuation were “significant” as they lead to the assumption that the buyer would be required to spend a collective sum of $3 million to satisfy PIPs. The debtor had no capital reserves for either property and the debtor’s reorganization plan did not contemplate a capital call for years to come. The mistake carried forward in that the hypothetical buyer’s improvements pushed the expert’s occupancy and ADR numbers upwards, “thereby pushing his discounted Income Capitalization valuation all the higher.”

The court said it would give less weight to the bank’s expert’s valuation, more weight to the debtor’s expert’s valuation, and some weight to the co-owners valuations.

Overly optimistic projections

In performing its valuations, first of the Comfort Inn, then the Holiday Inn, the court first considered the experts’ projections. Regarding the Comfort Inn, the bank’s expert “divines a 10-year anticipated cash flow and applies to those NOI’s a discount rate of 11.5% and a terminal cap rate of 9.5%.” The result was an “as is” valuation for the Comfort Inn of $2.7 million.

The court said the expert’s occupancy and ADR growth rates were “unconvincing and overly aggressive.” It pointed to the “dramatically increased competition in the Bloomington market,” which occurred pre-COVID-19, and the devastating effects of COVID-19 on the life of the town and the hotel industry. The court said it believed ADR and occupancy rates would not achieve stabilization for four or five years. The bank’s expert’s projections were “overly rosy.”

In contrast, the debtor’s expert offered “more probable” projections. However, his 12% discount rate and 10.5% terminal cap rate were “a bit too pessimistic.” The court also rejected this expert’s sales comparison analysis, noting he made too many significant adjustments and subtracted a “Lease-Up Discount,” which the court said he did not define or explain in the report. However, he did explain the meaning of the discount at trial.

The sales comparison approach, the court found, was not particularly useful. “RevPar is what counts and it is the components of RevPar (occupancy × ADR) which drives [the experts’ valuations] and which also drives this Court’s valuation determinations,” the court said. 

The court decided the Comfort Inn was worth about $1.8 million.

The court next valued the Holiday Inn. It said it would disregard the sales comparison analyses of both experts. 

Regarding the income approach, the court again found that the bank’s expert offered “performance estimates” for the overly optimistic hotel. Occupancy rates and ADR would not be stabilized in three years, as the expert assumed, the court noted. 

The debtor’s expert against NOI projections for both hotels was more reasonable than the opposing expert’s projections, the court said, considering the “keen hotel competition” in the area and the “long-term revenue damage caused by the COVID-19 pandemic.”

The court concluded the Holiday Inn was worth $3.9 million. The debtor’s expert proposed a value of $3 million, and the opposing expert a value of $5.5 million. The co-owner said the hotel was worth only $2.4 million. The court noted this witness was “very knowledgeable and credible,” but his valuations were “too light.”

In conclusion, the court found the bank had failed to meet its burden to show that the hotels, collectively, were worth $8.2 million. Looking more at the debtor’s expert’s valuations, the court found the hotels’ total value was over $5.7 million.