by RUSHI SHAH
These remain unprecedented times. Our world has suffered a 25-standard deviation, or what’s more commonly known as a black swan event. We are witnessing levels well outside any previous economic model’s scope. To put this in perspective, most risk models predict a 10-standard deviation event. During a black swan event, there is typically a total loss of revenue. When standard deviations widen this much, it exacerbates valuation declines in multiples of the overall GDP’s decline, mainly due to leverage. And wherever there is leverage, there will be pain. As a result, as a leveraged asset, hotels, and all other real estate must brace for impact.
Banks, lenders, bond holders, and other capital sources that provide debt have a limited threshold for pain. They have agreed to returns of 4 to 6 percent and cannot accommodate months and months of non-payment. While many of these lenders empathize with hotel owners’ extraordinary predicament and may be willing to grant 90 to 180 days of forbearance or payment deferrals, they must act in the best interest of their investors and shareholders. As a result, when it comes to offering further borrower relief, their hands are tied. Debt providers must do what is needed to trim their risk positions and shift the risk back to where it belongs, e.g., the original equity owners. Keeping all of this in mind, hotel owners can expect debt markets to continue to place pressure on them to either stay current on their mortgages or give back their assets once the temporary demand shift has been righted.
By definition, hotels are assets backed by overnight leases. Historically, hotels have been valued with an 8 percent capitalization rate on a trailing 12 net operating income. The market supported this type of valuation metric due to a massive appetite for yield. In the quest for yield, hotel investors were willing to discount the negative effects of overnight leases. Looking forward, in the medium term there will be a process of price discovery. In the long run, hotel valuations are likely to bounce back. Valuations may not return to previous levels, however, because the market will likely need to assign a higher premium for the risk for a hotel asset. This will translate into a higher cap rate. In other words, hotel values will continue to suffer the consequences of COVID-19 for quite some time.
Looking ahead, we can also expect debt markets, including both recourse and non-recourse lenders, to view hotels through a more conservative lens. As we enter recovery mode, debt yield, which is measured as Net Operating Income (NOI) as a percentage of the loan amount, will be higher for hotel lenders and leverage on a typical hotel asset will be lower than pre-pandemic levels.
CURRENT MARKET AND FINANCING TRENDS
We expect Commercial Mortgage Backed Securities (CMBS) markets will start originating new hotel loans sometime in 2021. Debt funds will also be back around the same time frame. The banks and other recourse lenders are likely to only lend on hotels with compelling borrowers with whom they already have a relationship. In the nearer term, hotels will be financed between 50 and 60 percent of the value at rates between 9 to 12-percent annually, using funds from hard money lenders or capital from lenders that don’t rely on leverage to fund their loans. These will be lenders of last resort.
Rescue capital financing will be in critical demand for the foreseeable future. Most rescue capital lenders require well-located and lower-leveraged assets and are willing to lend six to nine months of debt service, tax and insurance escrow, and any operating shortfall. This relief comes at a high 15-percent interest rate with terms that make it easy for the lender to take over the asset if there is any event of default.
Another major market trend is a surge in note-buying opportunities. Based on their risk models, lenders are scrambling to sell loans most likely to default later at a discount to par value now, while the loans are still performing. Although no one knows for sure when or which hotels will recover, as we move further into the future and those hotels move further down the default path, lenders realize that today’s 85 cents on a dollar discounted pricing could plummet to only 60 cents or even 50 cents on a dollar. There is roughly $350 billion of capital set aside to take advantage of note-buying opportunities. Most of this capital remains sitting on the sidelines waiting to see which loans will perform and which ones will default.
DECISIONS HOTEL OWNERS WILL NEED TO MAKE
As hotel owners navigate the next phase of recovery, they will have a lot of tough decisions to make. Non-recourse borrowers will have to decide if they want to defend their assets or give them up. One clarifying question borrowers can ask themselves is, “Do I believe in my asset in the long run?” If the answer to this question is yes, then it is imperative that the owner does what it takes to continue to satisfy the loan. That may include putting out a capital call to any partners who have previously cashed out of these properties. Another strategy may be finding rescue capital. Owners should tread cautiously, however, as resorting to rescue capital may be as the old adage says, throwing good money after bad. This is a decision that hotel owners should think about carefully.
GOVERNMENT RELIEF PROGRAMS
The federal government and the federal reserve have stepped in and offered unprecedented policy intervention during these times. We continue to see the Small Business Administration (SBA) as a strong, viable lender and both the SBA 7(a) and 504 programs remain active. Because these programs require lenders to share some of the risk with the government, banks and other SBA lenders are currently skittish about lending to hotel assets. We expect SBA lending will open once banks emerge from processing the highly administrative Paycheck Protection Program (PPP).
There is a new program from the federal reserve that may prove to be the hospitality industry’s saving grace. Known as the Main Street Lending Program (MLSP), the supplemental program provides participating banks a 95-percent backstop on new loan originations. Loans are full recourse with a 4-year term and rates from 3 to 4 percent. Early guidance suggests underwriting will be based on 2019 earnings before interest, taxes, depreciation, and amortization (EBITDA). Like most other government programs, however, the guidelines remain loose and it is still very much a work in progress. Most banks expect this program will be operational by early summer.
Hotel owners are dealing with a tremendous amount of anxiety as they navigate these ongoing and significant economic obstacles. But as society has done in the past, we will get through these dark times and find the proverbial light at the end of the tunnel. Decision-making will be easier and strategy clearer for hotel owners who address their situation with rational thinking, a risk-return mindset and pragmatic approach, and who do not allow emotion to cloud good judgement. Just like other entrepreneurs, hotel owners may find themselves progressing through psychological stages as they evaluate their situation and course of action. Those that avoid stalling in denial and instead move quickly to acceptance are likely to be most productive. Hotel owners also do not have to go through this alone. There are a tremendous number of resources, including experts in tune with market condition developments, who are ready to help with prognosis and solutions. ?
Rushi Shah is principal and CEO of the commercial mortgage and real estate investment banking firm and AAHOA Club Blue Member Mag Mile Capital. As a leader in hospitality financing, Shah specializes in structuring and placing high-leverage, non-recourse bridge and permanent debt with cash out for full – and limited-service hotels nationwide. Since joining the firm’s predecessor, Aries Capital, in 2015, Shah has structured and closed hundreds of millions in financing for all property types. Shah has held previous positions at Northern Trust and has an MBA from the University of Chicago’s Booth School of Business.