The COVID-19 pandemic wreaked havoc across the real estate portfolios of investors and lenders, perhaps most disastrously in the hospitality sector. A recent American Hotel & Lodging Association report shows the industry lost approximately four million jobs since 2019, and predicted business travel (the largest source of hotel revenue) will recover slowly from current virtually non-existent levels starting in the second half of 2021, but will not fully recover until 2023 or 2024. The predictions for leisure travel are a bit more optimistic, especially with the largely successful vaccine rollouts. The timeline for recovery generally remains unknown, but we believe that as we emerge from the COVID-19 era, new financing again will become available for new transactions, albeit perhaps with some new features based on these recent experiences.
General consensus is that unlike the pre-2008 Great Recession period, underwriting for hospitality assets leading up to the pandemic remained relatively disciplined. Accordingly, many in the industry believe the unique effects of the pandemic have not been exacerbated by over-leveraging based on inflated cash flow projections and over stimulated projections by investors and lenders during the pre-pandemic period. Nevertheless, the effects of the pandemic have created great uncertainty regarding the short- and long-term prospects for many hospitality properties, including the proper valuations of properties as investors and lenders evaluate their portfolios. And while many in the industry expected at this point there would be a wave of distressed hospitality assets on the market being offered at deep discounts to 2019 valuations (the properties themselves and/or the debt encumbering them), the reality is there has been a relative dearth of such discounted opportunities.
One reason for this may be the multitude of capital chasing such opportunities. Another primary reason for the absence of such a “wave” seems to be a general willingness of lenders and servicers (especially in the earliest stages of the pandemic) to be patient with borrowers, especially those whose properties were solid performers pre-pandemic. The earliest accommodations typically were forbearance arrangements ranging anywhere from three to nine months. As those short-term arrangements burned off, many investors and lenders have reached longer term modifications. This process has required lenders and servicers not only to re-assess the assets and the sponsorship, but also the “guardrails” of the loan structures put in place at origination. We expect some of the issues addressed in the more recent longer-term substantive modifications of existing loans to manifest in the terms of new loan originations as we hopefully exit the COVID-19 era.
Debt Service Reserves
Many recent loan modifications require the borrower to establish a debt service reserve (sometimes anywhere from six to 18 months) to provide the lender with security for the unknown period it will take for hospitality assets to recover and re-commence generating positive cash flow. New loan originations occurring before the industry shakes off the effects of the COVID-19 era seem likely to require upfront establishment of similar reserves, and even after the current effects of the pandemic are over, lenders may continue for some period to build in a funded reserve to cover unanticipated shortfalls in cash flow (i.e., perhaps a “fear of the unknown reserve”).
Many modifications of existing hospitality loans have required substantial principal paydowns, in an attempt to bring the loan amount in line with loan-to-value ratios, based on perceived reductions in valuations (which may not prove to be accurate given pricing in some recently reported trades). Many existing loans were interest-only for some or all of the original term, with amortization non-existent, or only towards the end of the original term or during extension terms. As was the case post-Great Recession, we anticipate new originations for some period will require debt service to include amortization much earlier in the term (even Day 1), at least until the market stabilizes. We also may see more “rebalancing” tests which may require interim/periodic paydowns (see further below).
The issues caused by COVID-19 required lenders and sponsors to review the scope of liability provided under non-recourse carve out guaranties. Many of the COVID-19-induced loan modifications have required borrowers and guarantors to take on additional recourse — e.g., liability for repayment of PPP loans; replenishment of FF&E and other reserves which lenders allowed to be put to other uses (see below); liability for obligations to third parties (franchisors, managers), etc. For sponsors who continue to believe in the long-term recovery and viability of their properties, the added recourse often is viewed as a small price to pay. In re-examining their guaranties, lenders often were reminded of limitations on recourse agreed to at origination, especially those which limit a guarantor’s liability for failure to pay taxes, insurance premiums, mechanics’ liens and similar items to the extent there is available cash flow to pay such items — a not so happy limitation from the lenders’ point of view when shut down orders and travel restrictions resulted in no or negative cash flow for many properties. While such limitations on recourse will continue to be consistent with the concept of these being considered “bad act” guaranties (i.e., recourse only for things under the sponsor’s control where it acted improperly), lenders in new originations are likely to take a harder look at whether they will grant such limitations.
Funding and Use of FF&E Reserves
In response to the sudden lack of revenue caused by COVID-19 shutdowns and travel restrictions, most lenders and servicers were willing, even in the earliest of forbearance agreements, to waive the requirement of making deposits to FF&E reserves for defined periods, and to allow funds already in such reserves to be used for working capital, debt service and other expenses. Of course, deposits to FF&E reserves typically are based on a percentage of gross revenue, so waiving the requirement to make deposits for properties generating little to no revenue was not such a huge accommodation on its face by lenders (and by franchise and management companies, who also had to waive the deposit and use requirements). Nevertheless, it did not necessarily follow from that “easy give” that existing FF&E reserve dollars, which also constitute security for the loan, would be allowed to be re-purposed. Being allowed to re-direct those dollars, especially early on in the pandemic, provided much-needed breathing room to sponsors and facilitated the measured response of most lenders in working with sponsors on longer term solutions. Although we have not seen this yet, new loans may include built in mechanisms which may allow for flexibility in certain circumstances to re-purpose FF&E reserves (but with a replenishment requirement, likely backed up by recourse). We also may see a concept of minimum deposits to the FF&E reserve which are not solely tied to gross revenues (which also likely would be backed up by recourse), so the lender’s interest in having cash security for the loan is protected.
DSCR and other Financial Covenants
Some loans with required debt service coverage and similar covenants which are tested periodically have been modified to waive entirely or delay testing to allow for recovery from the effects of COVID-19 on the property. Often a paydown of the loan, at modification or soon thereafter, is required in exchange for this accommodation, to provide greater security for the lender. Although loans with such covenants often already include an ability for the sponsor to paydown the loan (sometimes without any prepayment premiums) in order to satisfy such covenants, the pandemic has demonstrated the importance for sponsors to obtain the right to “rebalance” or paydown their loans in order to avoid default of such covenants.
Special Loan Servicing Fees
Post-Great Recession, CMBS lenders and servicers became more explicit (and, some might say, aggressive) in providing for payment by borrowers of special servicing and similar fees whenever a “transfer event” occurs, resulting in the loan being brought under the active management of the special servicer to address default and workout situations. While these fees arguably were intended to cover the increased costs associated with the resources brought to bear to handle a troubled loan, even some special servicers have admitted (off the record at least) that these fees often served as an impediment to discussing substantive solutions for hospitality loans. The flexibility of special servicers in determining whether a “transfer event” has occurred, whether it can merely “consult” with the master servicer regarding proposed modifications, and even whether it can elect to charge less than its full special servicing fees, are dictated largely by the terms of the applicable pooling and servicing agreement. We anticipate these most recent experiences will result in a re-examination of these processes and fees to facilitate responsiveness to whatever the next crisis may be.
Although it may seem obvious, detailed cash management regimes in loan documents have little value when there is no cash to manage; nevertheless, we expect this to remain a feature of many hospitality loans. Also, although segmentation of the industry — full service, resort, select service, boutique, etc. — has been common for years and is a factor in loan underwriting, the ongoing recovery from the pandemic is demonstrating that not all hotels in the same class of service are created equal, with “drive to” destinations recovering more quickly, and with an uncertain recovery timeline and future for central business district hotels and conference center hotels, many of which were steady cash cows before the disruption in airplane and business travel. Maybe one of the biggest, and yet also seemingly obvious, lessons is the importance of communication between sponsors and lenders/servicers as disruptions and troubles of any kind manifest; as a general matter, those sponsors who attempted to get in front of their lenders (often much harder to do with servicers) seem to have fared better than those who were less proactive, for whatever reason.
While the pace of vaccinations and the re-opening of cities across the country are increasing and helping aid the recovery of restaurants, hotels, resorts, and other hospitality properties, it remains unclear when full recovery will arrive. Many business leaders speculate there will be pent-up demand for business travel to resume, much like we already have seen pent-up demand in some markets for leisure travel by folks weary of being at home for months; however, others speculate that business travel, and thus the need for business-oriented hotels, will recover very slowly, given continued illness concerns and the demonstrated ability to continue to function, via Zoom and otherwise, without even leaving the house, let alone one’s office. Some hotels are being and may continue to be re-purposed as condos, multi-family apartments, student housing, and other uses. But all in all, we believe that while some existing financing will continue to require modifications until full recovery, new lending in the hospitality sector also will recover, with sponsors and lenders theoretically wiser from COVID-19’s effects on the industry.
Chauncey M. SwalwellPartner