Description

The Denver Convention Center is a 1,100 room hotel in downtown Denver (surprise) that also serves as the nearest lodging for the city's premier convention center. The hotel opened in 2005 and encompasses about 1.2 million square feet. It was built at a cost of about $300 million and is managed by Hyatt. The property we should be concerned about is really only the hotel because your debt service comes from the hotel and your mortgage is on the hotel and not the convention center itself. The equity in the property is effectively owned by the City of Denver, so you have a strong AAA equity sponsor with a long-term perspective on the value of the hotel (both in terms of cash flows to the city as well as the value of the hotel to the city's overall economy).

In evaluating the credit, I looked at three sources of value. First, there is the underlying hotel itself on which you have a mortgage. The hotel also benefits from a property tax waiver, which should mean that the property gets a higher multiple than peers on a per room basis (though not on an EBITDA basis since property taxes are not generally added back to get to EBITDA). Second, the city has agreed to make an annual allocation payment from certain sales and excise taxes for the benefit of the hotel's creditors. Third, there are several restricted cash accounts such as debt service reserves that are being held for the benefit of the creditors. In order to value the bond, we approached the hotel valuation as representing the residual after the restricted cash for debt service and the allocation payments from the City of Denver, which is a AAA credit.

While the restricted cash does not represent an asset producing cash flow for debt service, it is a claim that would be readily available to creditors. Including only the accounts that are identifiable for the benefit of bondholders - the senior debt service fund, the debt service fund, the senior special debt service fund, and the redemption fund - gets us to $41.5 million of restricted cash set aside for creditors. In considering the credit, we have included the value of this cash but ignored the other $37.8 million of restricted cash that has been set aside for other uses such as future capex. In reality, some or all of this other restricted cash could be used to reduce operating expenses for the hotel and free up additional hotel cash flow for debt service should it prove necessary.

The allocation payments, known as Economic Development Payments, are considered a "moral obligation" of Denver City and come from specific tax revenues. The city has covenanted that the Mayor will include the Economic Development Payments in his budget and these have traditionally been seen as non-negotiable allocations by cities because their exclusion would effectively shut the city in question out from raising additional allocation-backed debt. For this reason, allocation backed bonds have historically been considered very safe instruments and tend to take on their issuer's credit rating. The allocations that the city has agreed to make will grow from $8.75 million in 2011 to $11 million in 2018 and then continue at $11 million until 2040. To value these allocations, we first calculated their duration (12.8 years) and then chose the reference bond (20-year UST). We valued the allocations at a yield equal to 100% of the reference treasury based on a small premium to the Denver GO credit, which is currently trading at 90% of the reference treasury. On this basis, we believe that the allocation payments have a present value of approximately $173 million.

To value the hotel itself, I looked at a variety of comparable companies, including H, HST, MAR, HOT, and IHG on an EV/EBITDA basis. The average trailing EBITDA multiple is 15.5x, suggesting that the Denver hotel is worth about $375 million. On a per room basis, private market transactions have been taking place at about $300,000 per room, which means that the hotel would be worth $330 million. Given the hotel's excellent condition (recently built), its property tax waiver, and its substantial meeting, restaurant, and common spaces, we think this is a conservative value per room. Using the average of these valuation metrics, we come to a value for the hotel of about $350 million.

The face value of debt outstanding is $344 million excluding the unamortized premium and the market value at 77% of par is $265 million. Subtracting the $173 million of value attributable to the annual allocation from Denver as well as the $41 million of restricted cash for the benefit of creditors implies a value of the debt attributable to the hotel of $130 million at face value and $51 million at market prices. This represents a LTV of 37% at face value and 15% at market prices and you have a first mortgage on the hotel and underlying land. I believe this should be considered an investment grade mortgage credit of "A" or "AA" and that the appropriate interest rate is somewhere around 110% of treasuries. If we look only at the cash flowing allocation asset and ignore the restricted cash accounts, the implied leverage against the hotel is 49% at face value and 26% at market value. I believe this would also be considered an investment grade mortgage credit but of "BBB" or "A" quality and that the appropriate interest rate is somewhere around 120% of treasuries.

Including our valuation for the allocation payments, hotel mortgage, and restricted cash, we believe that a valuation based on a yield of 110% of the reference treasury is appropriate for this credit or a YTM of 4.9% and a price of 101% of par. This represents 31% price upside to our purchase price of 77% of par. In order to invest in this bond as a credit investment rather than a rates investment, we suggest swapping debt from fixed to floating paying about 4.2% for a 20-year swap, which has a similar duration to the Denver hotel debt. This leaves us with a 2.8% spread to collect over the remaining term of the bond (all of which we believe can be captured through price appreciation) and similar price upside based on the bond's credit.

Catalyst