Hospitality Restructuring in the COVID-19 Environment
By Francis (Frank) Nardozza Chairman & CEO, REH Capital Partners, LLC | February 28, 2021
This article was co-authored by Troy Taylor, President, Algon Group
The fallout from the COVID-19 pandemic has presented unique challenges to the hospitality industry in its efforts to recover from a disastrous year amidst a very uncertain industry outlook. Hospitality and travel are often hit earliest and hardest when major catastrophes occur, such as natural disasters, war and civil unrest, economic downturn, and now, the pandemic.
Unlike after the terrible events of “9/11,” there is even more uncertainty now as to how long it will take for hotels to reach full recovery to pre-COVID-19 levels of operation. Expect a long and slow transition from the current state of “we have a problem” to the future state of “all clear.”
There may be several false starts to the industry recovery due to numerous peaks and troughs in the COVID 19 case curve and a slower than expected rollout of the COVID-19 vaccines. Some segments of the industry, in particular business and convention related business, will have a later start and take longer to recover than leisure/tourism related segments. In reality, business travel may take years to recover as some companies choose to have far fewer travel related in-person meetings versus the less expensive and less time-consuming online meetings.
Additionally, some portion of business travel may permanently be eliminated. Convention business, with its long lead time to bookings, is expected to take years to recover, probably starting in 2022 at the earliest, and stretching out to late 2023 or 2024 before a full recovery to Pre-COVID 19 levels occurs. This is partly due to the “wait and see” approach that many companies and associations are taking in planning and booking large meetings and conference events.
Business at virtually all US hotels stopped on a dime in early March and, while some properties re-opened mid-summer, occupancy and ADR have been down significantly at almost all hotels in 2020. Worse yet, the industry has been hit hard with a double-whammy of drastically reduced revenues on top of additional operating costs due to new COVID-19 related safety protocols, and government mandated occupancy restrictions. While many lenders have been amenable to forbearance related deferrals of debt service and PPP funds have somewhat helped hoteliers to reduce cash deficits, the time to sit on the sidelines and wait for a long-term solution to present itself is rapidly coming to an end.
When embarking on a loan restructuring, it is important to recognize that there are numerous types of senior lenders with differing motivations. In this article when we refer to “Lenders” we mean regulated entities such as banks and insurance companies. Other types of lenders include credit companies, real estate opportunity funds, mezzanine/junior capital providers and CMBS lenders. Borrowers may face unique challenges in seeking and securing debt relief, depending on the type of lender involved.
Despite the ongoing uncertainly, if a debt restructuring is in the cards, it should be undertaken as soon as possible. Multiple scenarios must be considered, many of which may involve substantial cash infusions and/or debt modification. Make sure that there is enough “dry powder” cash available before committing to a restructuring plan. The chances of executing a successful debt restructuring increase if you can avoid some of the most common restructuring mistakes:
1. Understand that the Lender is not your friend
Lenders will always act in (what they believe) is their best economic self-interest. Do not expect special treatment because of a long-standing relationship with your individual banker who may have originated your loan or who handles your on-going banking relationship. Most lenders have separate, independent loan workout teams to handle these matters.
2. Not being proactive
Doing nothing and waiting for the market to fix your problem is a sure-fire strategy for financial ruin. Every month that you wait wastes precious resources that are needed to create a real solution.
3. Putting good money after bad
Lenders’ willingness to defer debt service will end soon, if it has not already done so, and they will pressure you to commit whatever cash you have towards servicing or repaying their loans. However, and this is a crucial point, if you do not have a global and viable restructuring plan to get you to the other side of the problem, you are just throwing your money away.
4. Unjustified optimism
Thinking that the industry’s complete recovery is just a vaccine away is a risky and dangerous turnaround plan. After a solid year of horrible hotel operating results, we still have many Lenders that have not written down or cleaned-up their bad loan portfolios. What will happen to valuations when foreclosed assets start hitting the market in mass?
5. Wasting time, money and effort negotiating short-term fixes
Forbearance agreements are, in many cases, short-term band-aids that provide a false sense of accomplishment. The net result is that typically you will give up your legal rights and the Lender may give you little of value in return. Again, when negotiating a solution with Lenders, it must be a complete, global solution that permits you to realistically bridge the gap to future profitability.
6. Thinking that you can fix it yourself
Hiring professionals that do this all the time is the best way to send a message to your creditors that you are serious about addressing the problem. Trying to get it done yourself, possibly with some assistance from your accountant and/or general practicing attorney, is often a prescription for disaster. You have your plate full in these difficult times just dealing with day-to-day asset matters and operations.
Professionals who do this as their main line of business will know what Lenders really can or cannot do in a restructuring. They can insulate you from unpleasant discussions so that you might be able to do business with these banks in the future. The fact is that bankruptcy can be worse for the Lender than the troubled debt situation itself and this is an important negotiating tool.
What to Do
First, have a thorough review of your situation by specialized legal counsel, including a fresh review of all agreements with special attention to default provisions such as guarantees, “bad-boy” carve-outs, and triggers of covenant defaults. The circumstances could be vastly different now versus when those documents were originally negotiated.
In most cases it is also advisable to engage a financial advisor, well versed in hospitality restructurings, who can provide a realistic and unemotional assessment of your financial situation and prospects for your hotel(s)’ recovery, and help you develop an effective strategy to address your specific situation. You must arrive at a cash flow projection to determine how much cash burn you will need to sustain ongoing operations. It is crucial to use realistic occupancy and ADR assumptions.
Likewise, it is important to assess realistic cash requirements, even if the hotel is temporarily closed for business, to cover maintenance, security, property taxes, insurance, and other fixed costs. One suggestion is to prepare both a base case and alternative case cash flow projection covering the next two to three years under an “as expected” and “more conservative” market recovery scenario.
After the Great Recession of 2008-09, in most cases, it took 18 months to two years for hotel occupancy to fully recover and two to three years for ADR to fully recover; however, that was not after starting with virtually no occupancy or below 30% occupancy levels like many hotels are currently experiencing. Be conservative in your estimates because coming up short on your bridge funding plan can lead to a worse outcome.
Owners of larger projects with complex capital stacks will need to understand and address the competing agendas of the various lenders that may have a seat at the table. A fully secured senior lender may not be willing to extend more credit, but a subordinated lender may have a greater need to invest fresh capital to protect their collateral position. Determining the best strategy for the hotel owner may be strongly impacted by the dynamics between differing classes of lenders.
Before deciding on a course of action, a frank analysis of the situation is necessary to determine if there is enough residual equity for the hotel owner to protect before any new capital is deployed. Hotels that were highly leveraged pre-COVID-19 and were hit particularly hard by the COVID-19 pandemic may already have their owner’s equity completely wiped out and be too far underwater for salvaging, absent material concessions from other stakeholders, including lenders. Hotels under construction when the pandemic hit pose a unique challenge that will be defined by where they are in the development cycle.
Next, determine what type of capital is available to fund immediate and on-going hotel cash needs, including how much and at what price. Various types of bridge financing, including mezzanine and preferred stock, are available, but generally at a much higher cost of capital than existing senior debt. The incremental cost of new capital combined with an extended and uncertain recovery time could erode much, if not all, of the owner’s residual equity. Real Estate Opportunity Funds will be active in making loans; but, if your problems are worse or take longer to resolve than expected, these lenders will have little flexibility and could be more interested in a “loan to own” strategy that ultimately eliminates the current owner.
The CMBS market has been especially hard hit by hotel loan defaults, but with far less flexibility for loan restructurings because of the complex hierarchy of loan investor classes and seemingly unbendable requirements of complicated loan trust agreements. Once a loan goes into default or seeks modification, a special servicer takes over. In many cases, special servicers are not afraid to foreclose on assets, like banks and insurance companies might be, because they possess the necessary know-how, capabilities, and experience for owning real estate and hotels through their other lines of business.
A Lender’s treatment of a troubled loan is greatly impacted by the actions of government regulators. Also keep in mind that virtually all hospitality loans in most Lenders’ portfolios are having problems right now. Regulators have not yet put pressure on Lenders, but that could change at any time now as it becomes clearer that this is not just a three- or six-month problem. Waivers, deferrals, covenant relief and additional debt could all but dry up quickly. Lenders do not want to own your hotel, but CMBS lenders will. A tighter regulatory market will accelerate forced bank sales of hotel loans, likely to Opportunity Funds, who will put immense pressure on both junior debt and owner’s equity, in many cases wiping them out.
Concessions from your existing lender may be necessary for raising new capital. If existing equity holders can invest additional funds into the property, that should be only done in conjunction with “right sizing/re-pricing” any debt that is senior to the new capital.
Analyzing the Impact of a Potential Chapter 11 Bankruptcy Filing
Determining whether a bankruptcy, or the threat of bankruptcy, is possible and appropriate will greatly impact negotiations with creditors. Chapter 11 is an expensive and time-consuming process for all parties, including lenders. The bankruptcy courts have significant discretion which creates an uncertain environment that most lenders would prefer to avoid. Lenders are often more willing to make concessions and provide flexible alternatives when faced with a realistic possibility of a Chapter 11 filing. Often the threat of bankruptcy can be a catalyst to spur intransigent stakeholders to come to the negotiating table.
The structure and collectability of guaranties can greatly impact bankruptcy as a negotiating strategy. Two important points to keep in mind, franchise agreements (like all executory contracts) cannot be terminated during the bankruptcy, except by the debtor. If the debtor chooses to assume the franchise contract, they must cure all defaults before exiting bankruptcy, but then can operate with a clean slate. Also, secured lenders receive special treatment in situations that are deemed single asset real estate cases. Consult with legal counsel on these issues.
We all hope that COVID-19 will be in the rearview mirror by mid-2021. However, the economic fallout will continue for some time into the future. Virtually every hospitality loan has some level of distress and Lenders may soon begin to make blanket decisions on their overall loan portfolios, without regard to specific hotel loan situations.
Being proactive, critically addressing your financial situation, and developing a plan to bridge the difficult times is more important now than ever, and having the right advisors to assist you in this process is equally important. The name of the game is to preserve and protect your owner’s equity and, with the right approach and plan, your chances of doing so are greatly enhanced.
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