It is no secret that COVID-19 has negatively impacted commercial real estate across all asset classes, but arguably, no sector has suffered greater harm than hospitality and lodging assets. The economic devastation wreaked on the hospitality industry by the global pandemic beginning in March 2020 spared no hotel owner-operator, with both business and leisure demand down year-over-year by approximately 50% on average.
Besides the obvious fear of the coronavirus, what else happened to impact hospitality and lodging assets more severely than office, retail, multifamily, self-storage, and mixed-use assets? And, what does this mean for lenders and loan sales in 2021? When will hotel lending resume?
First, hospitality assets have inherent volatility based on average daily rates (ADR) and occupancy resetting daily versus other asset classes in commercial real estate, whose rent factors reset monthly or annually. The negative effects of daily or weekly (e.g., extended-stay hotels) rent resets in bear markets are more pronounced with hotels.
Conversely, this also implies the probability for a quick recovery, as occurred after 9/11, is minute. Of note, the events of 9/11 were security threats that were addressed through enhanced airline passenger screenings, which subsequently resulted in a nearly immediate rebound in consumer confidence and in personal and business travel to previous levels. COVID-19 is a health threat that is in process of being resolved through vaccinations, but it will likely take time for consumers to regain enough confidence for personal and business travel to return to pre-pandemic levels.
Secondly, while room supply increased in 2019 and 2020 with the proliferation of new brands by major franchisors and new construction projects coming online in markets arguably already saturated, demand literally evaporated overnight beginning in March 2020 based on governmental shutdown orders. Occupancy for a majority of hotels plummeted to less than 10% capacity at the onset of the pandemic, based on special servicing data, far below the marginal cost to operate profitably as a going concern.
At the same time, macroeconomic indicators reflected skyrocketing unemployment, affecting almost 15% of the labor force, with structural, frictional, cyclical, and even voluntary dislocation in the hotel market. The structural dislocation first occurred in retail with the rise of e-commerce, but it eventually spilled over into hospitality, with many hotels permanently closing and repurposing for a higher and best use, such as multifamily housing or even land value.
Frictional dislocation occurred with the furloughing or permanent termination of employees as hotels sought, and continue to seek, to reduce payroll and operating expenses based on lower occupancy demand. Frictional dislocation is inextricably intertwined with voluntary dislocation, given that there was a perverse moral hazard incentive for hotel employees to simply not work in 2020 based on increased unemployment benefits.
For example, an employee earning $15 per hour for a 40-hour work week would earn $31,200 per year pre-pandemic. Post-pandemic, the same employee could earn $280 per week in base unemployment plus $600 per week in supplementary unemployment benefits, which annualized to $45,760 per year. Although these enhanced unemployment benefits were temporary in nature and were subsequently reduced, they nonetheless strained hotel owner-operators in hiring or retaining talent in an already challenging labor market.
All of these events created the negative externality of a rise in prevailing wages, payroll, and operating expenses for hotels, which further decreased net operating income (NOI). In addition, the hotel industry is currently in a cyclical dislocation, with the winter season being traditionally slow, though there are expectations for increased occupancy demand during the 2021 summer season, given distribution of the COVID-19 vaccine currently underway. Yet, this does not factor in the potential for an increase in the federal minimum wage to $15 per hour, from $7.25 per hour, which is being discussed on Capitol Hill and would further harm the hospitality industry.
Thirdly, due to the increased economic insecurity introduced by the pandemic, consumers continue saving as opposed to spending, and businesses continue to curtail expenses, primarily in the areas of travel and discretionary spending. In fact, many businesses have permanently shifted to a remote work style and have no plans to revert to pre-pandemic travel activity. The ramifications of this shift in behavior and preferences can only be negative in nature for hotels, at least in the short to medium term. What happens in the long term, more than five years from now, is largely unknown—and avoiding this uncertainty should be an impetus for lenders selling hotel loans in 2021.
A key metric in evaluating hotel performance is revenue per available room (RevPAR), which is the product of occupancy multiplied by ADR. The extent of RevPAR decline over the past year has varied greatly by market and segment, with the worst afflicted hotels being located in primary and secondary markets, having in excess of 125 rooms, and operating in the full-service, upscale, luxury segments. The afflicted segments with the least RevPAR decline are in tertiary markets, have fewer than 125 rooms, and operate in the economy, midscale, and extended-stay segments.
Unfortunately, the recovery to pre-COVID-19 performance levels will be protracted for all segments and largely agnostic to location, although larger properties in major metropolitan statistical areas (MSAs) that rely on group and convention business may be even slower to recover. The booking window for group and convention business is typically at least 12 months out, and, notably, the current lack of future bookings does not suggest an imminent recovery.
The pandemic ignited an explosive shift in business and consumer behavior. Smith Travel Research and HVS, two industry forecasting firms, predict at least a 24- to 48-month recovery to pre-COVID-19 RevPAR performance. What does this bleak outlook mean for lenders and loan sales in 2021?
Hotel owner-operators range the gamut, from mom-and-pop single-unit operators to private multiunit operators that include individuals and equity funds to public real estate investment trusts (REITs). Again, not one hotel owner-operator has benefited from the pandemic, although owner-operators have varying degrees of access to capital to prop up their investment holdings. Almost every hotelier should have or did apply for government grants and loan programs, including the Paycheck Protection Program. However, these funds were exhausted in a matter of months and provided only a temporary Band-Aid to a wound requiring major surgery.
Bank lenders governed by the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) were required to forbear and accrue interest on impaired assets for two 90-day periods, which have since expired. This was a classic “extend-and-pretend” strategy to “kick the can down the road” and defer any loss, but eventually someone must pay the piper.
Non-bank debt fund and CMBS lenders were not subject to these forbearance requirements. They adopted various strategies, including suing on the note and foreclosure, but in many cases, they worked with borrowers to apply reserves toward debt service due to negative NOI and to forbear lender remedies. However, what happens when these hotels require capital expenditures or a property improvement plan (PIP) to preserve their franchise agreements when there are no funds available? The only reasonable inference is either a lender’s collateral value declines or the lender is forced to make protective advances on its loan.
With the U.S. presidential election over with, the second round of PPP loans in process of application will further delay hotel loans coming to market due to another period of extend and pretend—at least for the next six months. In Q4 2020, there was approximately $3 billion of first mortgage hotel loans for sale from debt funds, banks, and servicers. These lenders were well capitalized to incur any write-down losses and recycle their capital toward new originations on assets with a reset basis, e.g., financing discounted payoffs (DPOs).
Eventually the second round of PPP will be exhausted, and this movie will play all over again, except this time there will be forced sellers when the FDIC and OCC conduct their annual audits of insured banks. It is inevitable that some banks will fail and enter receivership for liquidation by their respective regulators. A bank with 92% of its capital structure in fixed time deposits must pay depositors interest regardless, and a non-interest-bearing loan portfolio will certainly cause an erosion of capital, a lack of liquidity, and insolvency.
Additionally, Financial Accounting Standards Board (FASB) impairment write-downs and mark-to-market accounting requirements based on a pending tidal wave of foreclosure comparable sales will further erode bank capital. Non-bank lenders have somewhat more flexibility, unless these lenders are leveraged on warehouse lines that require margin calls. However, no lender is truly “vaccinated,” and an adage of the banking business is, “Your first loss is your best loss,” as “no one wants to catch a falling knife.”
On the brighter side, it is important to analyze various hotel lending programs for signs of a potential recovery. Select lenders continue to originate SBA and USDA government-guaranteed loans secured by hotels, but at lower basis, such as financing discounted payoffs or short sales where assets deleverage. The recovery process in the hotel industry is akin to a three-course meal—it starts with CMBS lending, evolves into balance sheet lending, and restarts with ground-up construction lending.
As the securitization markets and bond investors open up to allow limited and full-service hotel collateral back into securitizations, it will then open the non-bank lenders and debt funds to reemerge in lending to newly built hotels that are ready to retire construction loans. When this occurs, only then will the spigot open for ground-up construction hotel loans in select markets.
Hotels that come out first for lending again will likely be nonconvention hotels in secondary markets with consistent occupancy demand and ADR penetration evidenced by its competitive set. Based on ongoing conversations with securitization shelf lenders, Q2 2022 at the latest is when the market should allow hotels to reenter the system of financial markets.
Obviously, both owner-operators and lenders hope that will occur sooner, but mid-2022 seems to be the temperature level from bond investors, rating agencies, and CMBS securitization shelf lenders. Furthermore, as with Fannie Mae and Freddie Mac requiring six and 12 months of debt service coverage ratio (DSCR), respectively, for COVID-19 reserves, CMBS already require office and retail loans that are being securitized to have six months DSCR for COVID-19 reserves. Thus, hotels will most likely be required to set aside 12 months DSCR reserves for COVID-19 when they get back into the system.
This structure should provide bond investors with comfort and security, since interest reserves are set aside for hotels as they continue to recover. The recovery for occupancy demand and customer segmentation will certainly be uneven across the U.S., but at least hotel borrowers are ready and willing to use funds reserved for debt service in case they are needed.
For now, a fragile asset class, one of the most important in the real estate stratosphere, will come back in roaring fashion at some point, as Americans will most certainly want to travel domestically rather than internationally. And, the traditional CMBS market, where hotel owners go for long-term non-recourse debt, will reemerge in full force, but the leverage, amortization schedules, cash out opportunities, and structure will be more conservative in approach compared to pre-COVID-19.
