The hotel industry finds itself in perhaps the most significant liquidity crisis it has ever faced. As the industry reports second-quarter numbers – with almost the entire second quarter coinciding with COVID-19-related government mandated closures and self-imposed scaling back of operations – the results for virtually all sectors of the industry will undoubtedly be both sobering and unprecedented.
A staggering number of hotels were closed for most of the second quarter. Although some hotels were temporarily repositioned for use by health care providers and other first responders, and a small number have been used as quarantine facilities, most hotels that continued to operate experienced no group or meeting business, virtually no food and beverage revenues and, in some cases, single-digit occupancy. Significant cost-cutting measures were put in place, starting with employee layoffs and furloughs followed by the cessation of non-essential services.
However, even shuttered hotels incur significant costs of ownership, such as debt service, property taxes and insurance, as well as necessary operating costs like continued employment of engineering and security personnel.
Cliff Risman is co-chair of the hospitality and leisure team at Foley & Lardner LLP.
To add insult to injury, as hotels begin to reopen, they are experiencing unanticipated incremental costs relating to the pandemic. Many previously furloughed employees have not reported back to work when asked, leading to employee search costs. New employee hiring and training costs are being incurred to teach employees new health, safety and cleaning protocols. Additional re-opening costs have also included acquisition of newly mandated cleaning supplies, equipment and personal protection items such as gloves and masks, as well as the installation of shields and other equipment and the repurposing of breakfast bars and certain gym and spa areas.
Hotels that had cash reserves and lower leverage were better positioned for these unprecedented events than others. Many hotels were able to take advantage of various U.S. government programs hastily put in place, such as PPP loans. However, even as occupancy begins the long climb upward to the record high levels experienced in 2019, the cash crunch continues to worsen.
As the pandemic started, many owners received cash calls from operators. Some, with access to cash, funded these calls. Others either negotiated revised funding amounts and timeframes or did not fund at all. To date, most operators have endeavored to work with owners to minimize expenses, but employee salaries and other necessary expenses must be paid.
Many lenders have also worked with hotel borrowers granting forbearance and payment deferrals. There has, however, been a striking dichotomy in reaction among CMBS lenders and other lenders. While most non-CMBS lenders have been accessible to, and willing to work with, borrowers, CMBS servicers and special servicers have been much more difficult to communicate with and, when reached, less likely to “play nice in the sandbox.”
As noted in a recent Wall Street Journal article, “just 20% of hotel owners whose loans had been packaged and sold to investors have been able to adjust payments in some form during the pandemic, versus 91% of hotel owners who borrowed from banks.”
With this as a backdrop, we see owners using existing FF&E and other reserves to pay operating expenses, and ceasing to contribute additional funds to these reserves – in most cases, with the consent of their franchisors, operators and non-CMBS lenders. Although a source of significant amounts of cash, and a necessary and reasonable short-term solution, these reserves will eventually need to be replenished.
Most planned and previously budgeted non-essential capital expenses have been deferred, with renovations and soft goods replacements put on indefinite hold. The brands, whether as franchisor or branded manager, have consented to these postponements and deferrals. However, at some point in the future the brands will again begin to enforce brand standards, require the implementation of property improvement plans and the commencement of capital projects. The conundrum here is that when these requirements are again imposed, the balances in FF&E and other capital reserve accounts that were raided or not funded will be insufficient to pay for these projects; but for now, as they say, this can is being kicked down the road.
Brands and independent managers are also not immune to the cash crunch. With most fees payable to brands and independent managers being calculated as percentages of various revenue streams – whether franchise fees as a percentage of gross rooms revenues, base management fees as a percentage of total revenues or incentive management fees as a percentage of some measure of profitability – managers and brands are also feeling the pain, laying off and furloughing corporate employees and cutting costs wherever possible.
Lenders that focus on hotel assets are seeing their earnings affected as debt service payments are deferred and waived. For how long lenders can weather the storm, we do not know. At some point, lenders will begin to exercise remedies. We have already started to see the appointments of receivers and the commencement of foreclosure proceedings. CMBS and other borrowers who have executed so-called “carve-out” or “bad boy” guaranties generally do not contest these actions, as any such effort could be deemed an effort to frustrate the lender’s exercise of its remedies and lead to personal liability under these guaranties.
Many industry experts predict that in the current environment, where a lender or new owner will be no more likely to increase revenues or successfully reposition an asset than is the current owner, lenders will be less likely to foreclose then they were during prior downturns, and, consequently, predict a flurry of note sales by lenders.
Veterans of the industry believe it will be 2023 or 2024 before the industry recovers to 2019 occupancy and profitability levels. That said, there are many unknowns. Will the economy experience the faster V-shaped recovery predicted by the current administration, or take years to recover to pre-COVID-19 levels? Whether, and to what extent, will there be additional government aid provided to the industry? To what extent will insurers pay the massive pending volume of business interruption insurance claims that have been filed and to date, denied by insurers?
For the foreseeable future, in the hospitality industry, like many other industries, cash will be king. Better-capitalized owners, brands, operators and lenders will likely survive, while others that are less well capitalized may not. As in prior downturns, both new and existing well-capitalized opportunistic participants in the industry may well generate outsized returns by acquiring and investing in loans, assets and operating companies at historically low prices.