The hotel and lodging industry has been hit hard by the coronavirus pandemic. S&P Global Ratings recently published a report stating that a “solid recovery isn’t likely” until 2023, predicting that hotel revenue will recover marginally in 2021 but will likely remain 20% to 30% lower compared with 2019. A full recovery to pre-COVID-19 levels isn’t expected for another few years.
While there is certainly light at the end of the tunnel with the announcement of a COVID-19 vaccine being widely available to the general public around April, hotels will continue to face significant operating deficits, rapidly depleting reserves and a lack of capital markets liquidity for the next one to two years.
Kenneth Herzberg is founder and managing partner of Redpoint Capital Advisors LLC and Redpoint Special Ventures LLC, based in New York.
However, a relatively niche financing mechanism has been increasing in popularity over the past year called Commercial Property Assessed Clean Energy (C-PACE). C-PACE makes it possible for commercial property owners and developers to obtain low-cost, long-term financing to recapitalize their properties if they have recently completed (or currently have underway) eligible construction that improves the building’s energy or water usage. The C-PACE program allows eligible costs to be paid for through tax assessments in the same way other public benefits like sewers, water lines or roads are paid – through a 20- to 30-year, non-recourse tax assessment.
While C-PACE traditionally has been used to fund energy-saving retrofits, gut rehabs and new construction projects, the current public health and economic crisis has shifted the use of those funds toward recapitalization of ongoing or recently completed new construction or energy-efficiency related capex projects.
Currently 25 states have active C-PACE programs, and 20 of those allow “retroactive” financing for recently completed projects. Lookback periods vary but can extend up to 36 months from CO.
Through C-PACE recapitalization, property owners and developers can access low-cost, long-term, non-recourse financing up to 35% of a property’s value with no payment for 24 months to replenish reserves, provide working capital and reduce senior loan payments – bridging hotel properties to stabilization. Proceeds may be used to fund construction cost overruns, replenish operating reserves, cover existing lender debt service, and pay down existing leverage.
This financing mechanism can provide immediate liquidity and a much-needed bridge to stabilization. Below is a sample impact of a C-PACE recapitalization project.
Case study
COVID-19 creates US$8.6 million gap to stabilization at a new hotel. C-PACE funds US$12.8M, fully bridging the property to 2023.
Property: 180-key, 3-star hotel opened June 2019. Prior to COVID, it had not yet reached stabilization.
- Total construction costs: US$50 million
- Construction debt: US$30 million (60%)
- Projected value at stabilization: US$64 million
Significant operating shortfalls: In April 2020, occupancy levels dropped to 20%. Though occupancy increased to ~60% during June, the property faces a significant budget deficit to reach post-COVID stabilization.
- Cost overruns and operating reserve deficits to date: ~US$5.0 million
- Projected senior lender debt service due through 2022: ~US$3.6 million
- Sponsor owns and operates 12 hotels; while experienced and well-capitalized, COVID-19 has stressed the finances of its business
At least US$8.6 million will be needed to comfortably bridge the property to stabilization.
Challenging borrowing environment: Most of the sponsor’s banking relationships have stopped lending against pre-stabilization hospitality assets. While an equity raise may be possible, timing and success aren’t certain and any equity raise would dilute existing partners and likely erase any financial upside for the sponsor.
Potential recapitalization options:
- Upsize construction loan: No lender appetite
- Distressed/mezzanine debt: Limited market; 14% to 20% cost of capital
- Preferred equity: 12% to 14% cost of capital with current pay coupon required
- Equity from existing LPs: Overexposed to hospitality; potentially possible but challenging and dilutive
- New equity raise: Challenging, very expensive promote, dilutive
Financing Profile US$12.8 million in C-PACE financing funds most acute property needs:
- US$5.0 million of cost overruns and operating reserves
- US$2.8 million paydown of the senior loan
- US$3.3 million of senior debt service reserves to cover 24 months
- US$1.7 million of C-PACE capitalized interest reserve to cover 24 months
C-PACE program qualification
- Property must be constructed within eligible lookback period
- Construction must meet construction code requirements
- Property must be in active C-PACE district (24 states and District of Columbia are active)
A typical C-PACE transaction can close in four to eight weeks, depending on existing deal participants and availability of financial information, appraisal and energy audit, if needed.
Senior lender considerations
C-PACE increases property leverage and is repaid through a tax assessment, but its non-accelerating structure and “silent” nature in a foreclosure allow many senior lenders to successfully underwrite the tool into their transactions. Over 250 unique senior lenders have consented to C-PACE projects across the country.
It’s important to note that only current and past due C-PACE payments can be enforced through a tax lien and are senior to a mortgage lender’s claim; the full principal balance can never be called due, unlike a traditional mortgage. In addition, senior lenders can foreclose on the property in the same manner as if they were the sole financing on the property; there is no “workout” as with mezzanine debt or equity providers which leaves senior lender in the driver’s seat.
C-PACE also provides immediate liquidity by reimbursing sponsors for completed eligible projects providing proceeds structured for senior lender comfort and dedicated to operating reserves, debt service reserves, construction cost overruns and/or partial debt paydown. The mortgage lender receives notice and cure rights with ample time to bring the C-PACE current given that a tax lien foreclosure/sale typically takes 12 to 24 months or more.
For hotels located in qualifying states, C-PACE recapitalization can help them buy time to ride out the economic volatility resulting from COVID-19 and create a win/win strategy for hotel property owners and mortgage lenders.