Emerging investment themes as the pandemic continues
We hope this letter finds you in good health. It’s difficult to believe that it has been three months since our last quarterly letter, and yet it’s difficult to believe it has only been three months. The current market environment seems to be simultaneously moving very quickly and very slowly. In this update, we will provide snapshots on two investment themes we like within our sector: 1. NYC hotel acquisitions / rescue capital and 2. Private debt investments.
We’re Bullish on NYC Hotels (For the First Time in ~7 Years)
For the past ~7 years Ohana has taken a defensive approach to investing in NYC hotels due to elevated supply growth that greatly outpaced demand growth. We avoided equity investments and chose instead to focus on buying select loan positions on very high-quality Manhattan hotels. We now believe the supply story in NYC will reverse and become a tailwind to performance in coming years for three main reasons: 1. COVID-19 will cause permanent hotel closures and lingering distress, 2. Pre-COVID and potential Post-COVID regulatory changes will meaningfully restrict future supply growth, and 3. A scarcity of hotel construction financing will limit new development starts.
At the same time supply is reversing, we believe demand will recover back to 2019 levels by ~2024 and Manhattan will remain a global destination for work, travel, and investment capital. As a result, we are now more bullish on NYC hotels and shifting our focus to acquisitions and rescue capital opportunities. While we expect the next ~24 months to be fairly volatile operationally, we believe that market participants who take an objective and analytical approach to asset selection and investment structuring will be rewarded.
In the immediate aftermath of the Lehman Brothers bankruptcy in 2008, New York City saw unprecedent growth in hotel supply. The growth in supply was mainly caused by a few key factors: specific zoning and permitting dynamics that encouraged hotel development over other property types, an abundance of cheap hotel construction debt from domestic and international lenders, and the 2015 enactment of New York City Local Law 50, which for four years prevented most existing hotels from converting to alternative uses.
From 2008 to 2019, total New York City hotel supply grew by 59% (a 4.3% CAGR), outpacing otherwise very attractive aggregate demand[1] growth of 47% (a 3.6% CAGR).[2] Consequently, RevPAR peaked in 2014 and then steadily declined a by -5.6% through the end of 2019.[3] Declining revenue translated into eroding profits or losses for many hotels as expenses (namely, costs for labor, utilities, property taxes, and ground rent) continued to increase. Put simply, at the end of 2019 many NYC hotels were struggling to remain economically viable, and a hotel operating at a razor thin 10% NOI margin was probably performing in the top quartile of the market.[4] But a combination of optically high occupancy rates (~86% market-wide) and optimism led owners to keep defunct hotels open and hope for better days.
Prior to COVID-19, Ohana’s view was that a meaningful number of NYC hotels were effectively insolvent due to fundamentally broken business models and/or bad capital structures. We expected that many of these broken hotels would have to be shuttered and converted to higher and better uses, and we saw early signs of this trend starting to develop in the summer of 2019 when Local Law 50, the aforementioned law that restricted conversion of hotels to other uses, expired. Soon after, several notable large hotel properties, such as the Roosevelt (1,025 keys) and the Hotel Pennsylvania (1,705 keys) were rumored to target conversion / redevelopment to different uses.
We now expect COVID-19 to greatly accelerate this trend and cause many of these hotel owners to finally surrender and permanently close or at a minimum struggle to reopen due to lingering financial distress and liquidity issues. The Omni Berkshire hotel and the W Hotel in downtown Manhattan have already publicly announced that they will be permanently closing as a result of COVID-19.
Contributing to the supply reversal in coming years will be Pre-COVID and potential Post-COVID changes to the New York City Zoning Resolution. The most notable Pre-COVID change was a December 2018 amendment to M1 zoning district regulations. Previously, hotel development in M1 zoning districts – light manufacturing commercial districts that represented a large swath of the Midtown South, Garment District, and Chelsea neighborhoods – was as-of-right. And from 2008 to 2017, nearly 25% of all new hotels in NYC were built in M1 districts.[5] However, the December 2018 amendment will require hotel developers (or converters) in M1 districts to obtain a special-use building permit from the City Planning Commission. The new special-use permit review process will be time-consuming and expensive with no guaranty of outcome, and as a result we expect the change to greatly curtail hotel development in these districts in the coming years.
Building on the changes to M1 zoning regulations, in 2019 NYC Mayor Bill de Blasio began exploring expanding the special permit requirement for hotel development city-wide. Recent NYC market chatter suggests that de Blasio’s administration is still moving forward with the proposal, which could be enacted before his mayoral term ends on December 31, 2021. Such a change would materially restrict future hotel development across the city.
Lastly, we expect the availability of construction financing for new hotels, which is highly pro-cyclical, to dry up for the foreseeable future. When construction financing for NYC hotels does return, we expect advance rates to be much lower and interest rates to be much higher, making it harder for hotel development projects to pencil.
Altogether, we believe NYC hotel supply could be as much as 10% lower (~12,500 rooms taken out of stock) in 2024 than it was in 2019, and the net demand differential[6] could be run-rate positive for the first time in a decade (a positive net demand differential is a generally bullish indicator whereas a negative net demand differential is a bearish indicator). If aggregate demand recovers to 2019 levels by 2024, which would put it -12% below its Pre-COVID trend-line[7], then market RevPAR and hotel revenue would be 11% higher than in 2019. Returning to the example hotel mentioned above that was operating at a razor thin 10% NOI margin Pre-COVID, an 11% increase in revenue would translate to a staggering 110% increase in NOI vs. 2019 levels so long as expenses can be kept in check (and we believe they can be, depending on the asset and business plan). At a constant cap rate Pre- and Post-COVID that increase in NOI would result in a doubling of asset value, and a leveraged investment could realize a very attractive MOE / MOIC.
We expect the next ~24 months to be volatile operationally in NYC. The COVID-19 pandemic will result in additional health and safety measures, such as social distancing, reduced occupancy, and more frequent cleaning. At the same time, the hotel labor unions in NYC are negotiating for a temporary reduction in required housekeeping productivity and unlimited unpaid time off. The city will almost certainly suffer a pronounced budget deficit and tax revenue will come into sharp focus. As a result, property tax and hotel occupancy tax increases will need to be monitored. These measures will likely lead to temporary increases in expenses and will need to be factored into underwriting analyses. But we see medium-term benefits as labor costs and other costs normalize.
We also remain cautious on the near-term outlook for hotel demand in NYC. Despite the aforementioned tailwinds, we are currently underwriting a 4- to 6-year recovery in RevPAR (depending on the property) to be conservative and ensure a margin of safety. And we are focused on assets where we can leverage our in-house operating expertise to identify opportunities for expense savings and other value-add initiatives.
We believe New York City will remain a global destination for workers, travel, and investment capital, and our expectation for a reversal in the hotel supply story makes us excited about the investment opportunity in NYC. We look forward to updating you in the future on specific opportunities we are pursuing within this theme.
An Overview of Recent CMBS Dynamics and Why Our Credit Focus is Shifting to Private Debt
Like much of public credit, CMBS bonds are traded Over-the-Counter (“OTC”) where daily market pricing is quoted by Dealers (mostly banks) and not listed directly on an exchange. However, unlike corporate bonds and loans, CMBS trading is generally not “traceable”, meaning executed trades and holdings are not required to be reported publicly. Market participants rely on conversations with Dealers involved in recent trades, as well as Dealer-published daily quotes to help establish “market” pricing. Pricing in the CMBS market tends to be fairly stable because bonds are secured directly by real assets.
The primary holders of CMBS are generally large balance sheet money managers and yield buyers looking for sleep-at-night credit investments. These prospective buyers generate alpha through thematic selection (e.g. weighting towards industrial, coastal resorts, or sunbelt real estate) rather than “bottoms up” underwriting of individual credits. These participants also typically utilize large amounts of short-term leverage with very generous terms (up to 90-95% LTV for the most senior debt) from repo lenders.
The COVID-19-induced market panic heavily disrupted, what turned out to be, a very delicate balancing act in the CMBS market centered around: 1. Stability of real estate fundamentals and performance, 2. Availability of market information from Dealers, and 3. The availability of cheap repo leverage.
Market disruption caused by the sudden change in real estate fundamentals due to COVID was exacerbated by a number of significant technical factors. Existing owners were suddenly forced to deleverage, creating a vicious cycle of margin calls / forced selling leading to lower prices, which lead to even more forced selling. At the same time, Dealers exited their role as market makers as they cut risk and were forced to protect their CMBS inventory, which further decimated liquidity in the market. Market participants were then forced to reckon with the fact that they did not know what they were holding and were potentially facing another GFC situation where they relied too much on ratings agencies and leverage to generate returns. At the market trough, spreads widened out 3-4x of what they were Pre-COVID with even AAA Conduit CMBS temporarily widening from ~75bps to over ~325bps during March.
For a real money buyer like Ohana, the huge dislocation in the CMBS market was an opportunity to be compensated generously for solving liquidity issues and buy bonds secured by very high-quality hotel real estate that we knew really well at very attractive discounts. CMBS holdings shifted from levered yield buyers to unlevered real money buyers who were making high conviction bets due to expertise around underlying assets and operations. Even as Ohana deployed capital into our CMBS strategy, we were fielding calls from panicked CMBS holders who were desperately trying to gather basic information on their assets.
Unfortunately, many holders simply ended up holding onto their securities choosing to fight repo lenders and accountants rather than stick to their risk guidelines and realize losses. While we were hoping for a longer price dislocation with significant value erosion, the Fed responded swiftly.
The direct and indirect effects of Fed intervention action largely solved the extreme liquidity issues in the CMBS market and CMBS has begun to recover in the past couple of months. However, other than the highest rated tranches, CMBS price recovery is still lagging the rest of the credit market, as comparably-rated performing high credits have already recovered and, in many cases, surpassed Pre-COVID levels. In contrast, most CMBS securities still trade at a discount to Pre-COVID levels.
For a highly COVID-impacted sector like hospitality, the CMBS recovery has also been strong but further lags the rest of the CMBS market. In hospitality, the public markets are reflecting a belief in medium term fundamentals (vaccine in 2021 and subsequently strong demand for leisure travel) and are fairly positive on value coverage and principal recovery for trophy Single Asset hotel credits. Further supporting the trophy hotel sector, is the fact that many of these assets are owned by top-tier sponsors with access to liquidity. So despite a poor near-term operating outlook for hotels prospective buyers’ demand for trophy hotel credit has been strong as long as they receive a modest yield premium. Said another way, the current rally in hotel debt is more reflective of technical factors like liquidity and yield buyers returning to the market rather than changing investor sentiment on the near-term operational outlook for hotels.
Given these dynamics, we asked ourselves a simple question – after the sustained recovery in bond prices during the past couple of months what’s the implied interest rate / return on a fully assembled CMBS senior mortgage loan right now and how does that compare to expected pricing for a senior loan in the private market?
To answer this question, Ohana used estimated real-time market pricing on various bond classes (gleaned from our daily involvement in and monitoring of CMBS bonds) to assemble an entire senior mortgage loan – i.e. to put humpty dumpty back together. What we found was that a ~45% Pre-COVID LTV senior loan for a luxury hotel is pricing at ~L+3.25% – L+4.00% (spot coupon of ~3.40% – 4.15%) depending on the asset and borrower profile. This price range compares to Pre-COVID pricing of ~L+1.55% – L+1.70% (spot coupon of ~3.30% – 3.45% assuming LIBOR of ~1.75%). Looking at the Pre-COVID and Post-COVID coupons we see that prospective buyers in public hotel CMBS SASB bonds are currently not demanding much more yield than they were before COVID. And a significant portion of Post-COVID spread widening can be attributed to the commensurate decline in LIBOR.
What’s also very interesting is that a new hotel CMBS SASB loan could not be originated at these pricing levels today, which indicates to us that pricing and returns are being distorted by a handful of technical factors including seasoning, credit ratings being in suspended animation, and marginal price dynamics (i.e. only small pieces of bond classes are actually trading – not the entire bond class much less the entire senior loan).
Another observation is that the recovery in pricing continues to be the most robust in the most senior tranches, reflecting the return of traditional CMBS holders and their more sanguine views on credit risk for high-end hotels. While there remain pockets of opportunities to achieve good risk-adjusted returns in the lowest tranches of hotel debt, prices continue to rise throughout the bottom of the stack as other market participants chase yield. We expect this trend to continue and opportunities in this space to be less attractive unless / until we see another round of volatility and forced selling.
In the private markets, however, many asset owners are beginning to kick off a wave of capital raising for a variety of reasons, such as the expiration of loan forbearance periods or lack of capital to fund carrying costs. We see similar dynamics to the early days of the credit cycle recovery we identified in CMBS and have identified a similarly attractive opportunity. There is currently a very pronounced gap in the hotel lending market as tourist investors – banks, leveraged private lenders, and international investors – have largely exited our sector and remain on the sidelines as they continue to work out their existing portfolios.
Capital dislocation has resulted in senior loan pricing of L+5.50% – 7.50% (spot coupon of 5.70% – 7.70%) with comparable asset quality and similar leverage to those observed in the public markets. That’s a 2.30% – 3.55% spread premium over implied public market interest rates. While public market CMBS is liquid, it is also generally ‘covenant-lite’. If anything, today’s private market lending environment is materially more restrictive (i.e. lender-friendly) than it was Pre-COVID. Moreover, the early private loan opportunities we are seeing present attractive opportunities to structure a range of reserves and fees to further de-risk the investment while amplifying the total return of the loan investment. And the lack of competition creates opportunities to originate whole loans with an eye towards selling an A-note or leveraging in the future or structuring an attractive mezzanine loan component.
Due to these dynamics, the private loan origination space for hotels currently offers highly attractive risk-adjusted returns similarly to what existed in the public markets previously.
Please refer to disclaimers for important considerations.
[1] Aggregate demand is defined here as Total Revenue $.
[2] Smith Travel Research.
[3] Smith Travel Research. While some market participants have argued that urban facility fees contributed to overstating the true decline in RevPAR, the implementation and reporting of those fees is inconsistent and unreliable. And we believe the overall impact to RevPAR is negligible next to the supply impact.
[4] Ohana opinion based on an informal survey of our data.
[5] HVS.
[6] The difference between run-rate growth in aggregate demand minus the run-rate growth in supply.
[7] Ohana estimate based on growing aggregate demand at a 2.7% CAGR (the actualized CAGR from 2014 to 2019).