The pandemic and its enormous global impact clearly demonstrate the latent volatility of hospitality real estate. The lodging industry is perhaps the most labor capital-intensive sector of real estate, and it is unequivocally being stressed by the pandemic. National U.S. hotel occupancy has been historically consistent, with occupancy percentages in the mid-60% range, until COVID-19 took national occupancy to an all-time low of 44%. Only now in 2021 has an improvement in travel begun. Pent-up demand, plus COVID optimism, drove last-minute bookings at a pace that has never occurred in the industry. Though occupancy has yet to fully recover, average daily rate (ADR) growth has been favorable. As of July 2021, revenue per available room (RevPAR) has tracked back to 2019 levels — but will it hold?
Many pundits predict a lagging recovery well into 2024/2025; the Delta variant and other possible strains have an unfavorable impact on these forecasts. The true resilience of both the leisure and corporate traveler will be determined in the next six months. Will airports return to pre-COVID activity during the holidays, and will corporate employers resume in-person meetings?
How hotels are perceived as an investment class is being tested. Those in the sector will determine new valuation parameters for this asset class, including owners, investors, franchisors, trade partners, lenders, management companies and, most importantly, employees. The global marketplace is also impacting the industry in areas from the cost of air travel to the cost of goods. The pandemic has forced owners to examine their agreements and contracts with trade partners and lenders to survive and thrive post-COVID. In this environment, proactive asset-management of short- and long-term strategies is critical. Let’s look at some important considerations.
Working Capital and Lenders
Honesty and transparency are the best strategies in communicating with lenders. Generally, lenders do not want to assume responsibility for managing a human capital-intensive business. Being transparent with cash flow, accounts payables and payroll will only help with forbearance agreements and negotiations of revised terms.
A silver lining during this chaos has been that lenders have had no fiduciary pressure from governmental agencies in terms of compliance. The moratorium on foreclosures, coupled with governmental assistance (CARES ACT/PPP/EIDL), has allowed owners and lenders flexibility, but these are only short-term crutches. Lenders and owners need now to determine long-term strategies. Seasonality of demand (monthly/weekly) and average rate change on a daily basis are not new complexities for the industry. The impact of COVID has only educated loan officers and bank asset managers about daily operational variables. Fortunately, lenders have been cooperative since the onset of COVID. However, hotel sector delinquencies continue to be prevalent. Below are the top five delinquency rates across real estate assets as of July 2021, according to Fitch Ratings.1
The current patience of regional banks and special servicers is allowing for owners and stakeholders to have preemptive negotiations and forbearance agreements to address long-term economics.
Management and Employee Retention
The massive global disruption of the hospitality workforce is the single most important issue facing all stakeholders, including guests. When the world shut down in 2020, hotels in the U.S. laid off approximately 6.2 million employees.According to the U.S. Travel Association, prior to the pandemic direct travel jobs accounted for 6% of the total workforce, and travel-supported jobs accounted for 11%. But in 2020, direct travel jobs accounted for a disproportionate 35% of jobs lost, and total travel-support jobs accounted for a staggering 65%.
The PPP rescue has been a temporary fix for owners. Coupled with the tightening supply chain, PPP has pressured the cost of human capital. Employee costs range from 30-40% of revenue. Raising wages is not a simple solution when cash flow is tight. Many veteran hotel managers and employees had the opportunity to re-evaluate the work, life and health balance of the service sector. There is no easy solution. Yet all industry leaders recognize the vital importance of fully reengaging the workforce into the hospitality sector.
Franchise and Online Travel Agencies
Legally, a franchisor is not a partner, but when brand fees total 10-15% of revenue, most owners will agree a franchisor feels like a partner. Managers often must comply with operational standards that are not ideal, especially during a pandemic. Similar to lenders, franchisors have been lenient by deferring fees and Capex requirements during 2020. The pandemic has presented an opportunity to reevaluate brand values and potentially renegotiate such terms as fees, license terms and product-improvement plans (PIPs) that are mutually beneficial for long-term prosperity.
Other often “forgotten trade partners” are online travel agencies (OTAs) such as Expedia and Booking.com. Reportedly, 80+% of U.S. travel reservations have been made without human interaction via websites or apps. The pandemic renews concerns from hotels and airlines about fees charged by third parties that can reach 25%. The large hotel chains and owners can negotiate lower fees and have the advantage of loyalty and incentive programs. Group and corporate travel has been virtually nonexistent in 2020 and 2021, and OTAs reportedly delivered a large percentage of few bookings.
Nevertheless, OTAs will continue providing bookings. Keeping a watchful eye on room inventory provided to third parties is essential for operators. The “heads in beds“ occupancy model is not necessarily an effective economic strategy. Net ADR is more important to the bottom line. This is the time to also reconsider contracts and guarantees with all third parties.
Global Supply Markets and Consumer Confidence
The pandemic has stressed the global supply chain landscape. Supply costs and freight, coupled with the increased cost of labor, is impacting operations daily. Hotel companies and owners are seeing freight times expand to two or three times longer than what they were pre-COVID. This lets hoteliers be creative in the purchasing process, such as by finding new domestic and international supply sources. Being preemptive is essential for owners and managers.
Despite the increase in vaccinations, consumer confidence in travel will continue to be an issue. Most brands have installed health and safety protocols. Educating guests and highlighting cleanliness and health standards is imperative and sells rooms. Using third-party accreditations and the recent requirement of vaccine passports may help. The guest experience is always evolving, and COVID-19 has added a high degree of complexity to the mix.
Valuation and Outlook
Hotel valuations are generally measured by cash flow and various multiples (cap rate, discount rate, room revenue multiple), as well as reproduction costs and implicit value. The short-term impact has been obvious, as hotel sales transactions were limited in 2020 and Q1 2021, excluding the large hotel portfolios and REIT transactions. The availability of financing drives valuations, which halted in 2020. The lack of pressure from government agencies and Fed rate policy has slowly reopened financing markets as of Q2 2021. As a part of the CARES Act, late last year the SBA offered incentives for new loans, including waiving three months of P&I payments and all loan fees. The CMBS market has also been revived, and a slew of new lenders have entered. Regional banks, insurance companies and debt funds all hesitant of lodging assets are reconsidering the economics.
The advantage of lodging real estate has been the volatility of its day-to-day operations being offset by its inherent land and real estate value, despite the variability of daily operational challenges. This has been truly tested by the pandemic, which has forced owners/investors and their trade partners (employees, franchisors, third parties) and lenders to collectively work together toward a common goal of improving cash flow and valuations. A recovery of valuation is inevitable, although its timing is uncertain. As in the past, all recoveries set new investment parameters and higher valuations.