Capital has been parked on the hotel industry’s sidelines since this time last year. Staring down the continued chaos of COVID-19, it might as well turn off the engine: M&A activity in the U.S. hotel sector is likely to remained gridlocked for at least six months to a year.
Contributed by Mary Scoviak
It’s hard to drive a deal pace when there’s nothing to buy. Even with estimated hotel industry losses of US$400 million a day since March, according to STR and Tourism Economics, the combination of bankers’ forbearance and federal stimulus measures has kept all but a few hotels off the block.
Any hopes that a continued hard line by CMBS lenders would speed more assets to market foundered as Q2 wore on. Although hotel delinquencies had risen 2% from May to June (11.49% of all property type CMBS delinquencies), Trepp Analytics took a closer look at servicer and watchlist notes, along with other materials, to get a clearer picture of CMBS forbearance. What they found, as of early August, was that CMBS lenders had granted US$16.6 billion in relief, two-thirds of which went to hotel loans. The data showed that hundreds of additional hotel borrowers currently have requests for forbearance under review. Not all of those requests will get approved, but there won’t be an RTC-style liquidation sale either.
The scarcity of hotels combined with even more scarcity on the debt side has disincentivized buyers and sellers.
“Public company values have decreased 40% to 60% since February. However, the asking price for individual assets has not changed materially since owners are still focused on pre-COVID-19 values. The bid/ask gap is too wide,” said John Pritzker, founding partner and director, Geolo Capital, San Francisco.
Still, there are points of entry into the hotel market in 2020. “In the immediate term, it’s a debt play,” says Chad Crandell, managing director/CEO of asset management company CHMWarnick, Beverly, Massachusetts.
“There’s so much private equity with no place to go.” added Michael Cahill, CEO and founder, HREC — Hospitality Real Estate Counselors, Denver, Colorado. “Buying opportunities won’t come until after Q1 of 2021, and maybe not for a year. Investors need to get some money [placed]out in the interim.”
To the rescue
With a lot of hoteliers nervously eyeing life after first-round forbearance and SBA loans expire, it’s no surprise there’s an uptick in rescue or runway capital as a home for early adopters. This is a different play in the context of coronavirus. It’s not just overleveraged or badly run companies that are struggling to stay afloat — though they’re obviously the ones most likely to move into special servicing before the end of the year.
“A lot of small management companies were profitable in February. Now they’re losing money and are cash-crunched,” said Anthony Sherman, founder and principal, Terrapin Investment & Management Corp., Aspen, Colorado.
Rescue capital plays directly to the broad market of hoteliers who need help to cover debt service and operational costs. However battered by the pandemic, these borrowers aren’t ready to exit.
“Most companies and single asset owners who may find themselves stressed or slaughtered in this market are going to jump through a lot of hoops, make calls to their equity base, negotiate concessions and standstills with their lenders, cut operating costs and so on before they throw in the towel and become subject to predatory vulturism,” said Homi Vazifdar, CEO, Canyon Equity, Larkspur, California.
The potential to help hotel borrowers bridge the liquidity gap hasn’t been lost on the investment community.
“Although it’s still premature, we expect there will be more opportunities in distressed debt situations,” Pritzker said. “The CMBS market is under duress and the number of assets that are entering special servicer status (a sign of financial distress, which sets the stage for bankruptcy) has increased with each month following COVID-19. Lenders have boosted loan loss reserves, which suggests that the stage is being set for debt workout activity.”
HREC is currently firming up plans for a two-year runway capital platform that will market available runway capital providers to borrowers. Eastern Union unveiled its Distressed Notes Initiative in May and Broe Real Estate Group (BREG), an affiliate of The Broe Group, debuted its US$250 million rescue platform in June.
Many of the platforms coming to market have a narrow focus. For example, CHC Hotel Capital “launched a direct lending arm to help hotel owners maintain control of their assets, keep debt service current and cover operating losses from the severe market downturn until business recovers,” according to a company statement. Loans will be US$250,000 to US$10 million and will cover all debt service and operating deficits. While the main targets will be limited- and select-service, full-service hotels will be considered “on a case-by-case basis.” BREG is prioritizing preferred equity and joint ventures in the Southeastern, Southwestern and Western United States.
Pre-COVID-19, Driftwood unveiled a mezzanine lending fund in January as one of three new GP vehicles that will deploy an estimated US$3 billion over the next five years (the others are for acquisition and development). Its new mezzanine lending program will focus on loans from US$3 to US$50 million range, said Chairman and CEO Carlos Rodriguez, Sr. in a statement when the funds launched. More are on the way.
Though the risks are higher, the potential rewards could justify them as a lucrative while-you-wait option. After conducting interviews with more than 35 private equity providers in July/August, Cahill estimated a 13% to 15% immediate return on preferred equity and 20% IRR in 24 to 36 months when the owner refinances or sells, or just “slightly lower” returns on mezzanine debt depending on how much debt the hotel is carrying.
Strict borrowing terms
For borrowers, the price tag will be higher as well. CHC Capital’s program lists an interest rate of 12% to 15% on a loan with a five-year term on a value estimated at less than 70% of pre-COVID-19 value a 1% origination fee and a 1% exit fee. The prepayment is 18 months minimum interest.
They can also expect investors will insist on being more hands-on. “Investors will want more control given the uncertainty and higher-risk of loan-to-own,” Crandell said. Silent partners are a thing of the past. Deals being negotiated involve preferred equity, seats on boards of directors and the right to get the investor’s money out before other equity. There are also pure mezzanine deals and other bridge options, especially to help borrowers with bank loans where forbearance is more expected than with CMBS lenders, according to industry insiders.
“Hoteliers don’t want to sell, and they don’t want to go into special servicing. It’s expensive and time consuming,” Sherman said. “They’re trying to raise cash from current investors to stay current [on loan repayments] until the situation improves. But, they also know they need cash if they want to stay in business.”
Paying a short-term premium to get past the next two to three years might look appealing compared with losing everything. Owners and operators will have hard decisions to make over the next two quarters as banks likely tighten forbearance to offset their own pandemic-related loan losses and further government stimulus relief may be too little, too late or not happen at all.