March 3, 2020

COVID Insights Series

COVID-19: What we know, our response, and what to expect next

As we’re sure many of you have been following in recent days and weeks, COVID-19 (or the “coronavirus”) has spread across a number of countries throughout the world.  Concern about the impacts the virus could have on public safety, consumer behavior, global supply chains, and general economic health has led to significant capital markets volatility and a surprise rate cut by the Federal Reserve.  In the real estate sector, all property types have been impacted as market participants assess the impact to occupancy rates and leasing activity.  Publicly traded REITs that own office buildings, retail shopping malls, seniors housing, industrial warehouses, and hotels have all experienced sharp declines in their stock prices. 

As the situation has unfolded in the past month we have been actively monitoring our owned and collateral properties as well having daily conversations with on-the-ground operating teams, hotel owners, operators, lenders, brokers, and borrowers.  We’re writing this letter to pass along some of the early intel we have, much of which is still anecdotal in nature.  As information coalesces going forward we hope to provide you with deeper insights into data trends we are seeing.  And we also hope to have more robust data to compare the impact of COVID-19 to other similar contagion events such as Zika, H1N1, and SARS. 

What’s happening in the U.S. hotel sector so far?

  • Large cities that rely on city-wide convention business and corporate travel are suffering an out-sized negative impact
    • San Francisco has been significantly impacted with the cancellation or postponement of several city-wide conventions (e.g., GDC, Facebook, Google), resulting in tens of thousands of room nights being cancelled during March and April
    • Houston, Chicago, Orlando, Denver, Anaheim, San Jose, the Greater Seattle area, and San Diego have had large conferences and city-wide events either cancelled, postponed, or converted to online virtual events.  One early theme throughout these cancellations seems to be conferences with a large proportion of international attendees
    • Corporate business travel has slowed given companies’ concern for employees as well as the potential liability involved with mandating employees to travel
    • Reduced corporate travel is having a knock-on effect in cities that also rely on corporate bookings to fill rooms Monday-Thursday
  • Other markets feeling an out-sized impact are overseas fly-to resort destinations that receive a large percentage of their business from overseas travelers – these destinations include Hawaii, which had two reported cases in Waikiki, and the Caribbean, where the tourism-heavy Dominican Republic recently reported its first case
  • On the potentially positive side, relocation bookings could help mitigate some of the above dynamics.  We have heard of groups / companies trying to relocate overseas conferences back to the U.S. (and presumably restrict participation to U.S.-based attendees).  We are also hearing of guests who had booked overseas spring break or summer vacation trips looking to relocate to U.S. destinations

How are on-the-ground hotel teams responding?

  • Operationally speaking, most hotels have standard operating procedures in-place to address contagion situations, and they are rolling those procedures out as a precautionary measure
  • Hotel sales teams are actively communicating with groups evaluating whether to book an event and are also spending time with groups that have already booked an event at a property and that are evaluating whether to cancel their event.  As part of this process, hotels are reviewing group contracts for termination and cancellation fee provisions, and are actively working with groups to determine whether events can be moved to later in the year.  Hotels that are expecting a near-term decline in revenue are evaluating staffing levels and other cost control measures in order to manage through the business disruption

How have capital markets responded?

Hotel Asset Sales / Equity:

  • As of right now, most folks seem to believe that there is a low likelihood of permanent impairment in asset values.  However, there will clearly be a near-term disruption in cash flows, and as potential buyers try to determine the magnitude of that disruption pending sales have been negatively impacted
  • We have heard of a couple of large sales transactions that were in the latter stages of negotiations that have been put on hold.  We have also heard of several sales processes that have seen little to no impact on the number of offers or the prices being offered, but it could still be early
  • We expect most property owners to delay sales processes barring some sort of idiosyncratic dynamic (e.g. an owner has a cash need or a near-term loan maturity they cannot refinance for some reason)

Debt Financing:

  • So far, interest rates have been less impacted than we would have expected (but we expect this to change)
  • A surprise 50bps rate cut from the Federal Reserve pushed 1-month LIBOR to ~1.02% (as of March 4th), it’s lowest level since May 2017.  The 1.02% rate compares to 1.76% at December 31, 2019 and ~2.50% in the summer of 2019.  Many floating rate bridge loans on transitional assets have now hit their LIBOR floors meaning further cuts to base rates will not pass through to the borrower
  • Interest rate spreads in certain channels (namely CMBS) have widened as of March 2nd the net effect with the lower LIBOR is probably only ~10-20bps of total rate increase
  • As the CMBS channel has momentarily been less reliable for hotel financing, banks and private debt funds are expected to step in, although their interest level will depend on how they think about current exposure to hotels and their cost of capital will be higher
  • An accommodative Federal Reserve has already given folks some breathing room and will likely take additional actions in the coming weeks, which will cause interest spreads and total return math to continue to evolve

Where do we see this heading?

  • In the immediate term we see an escalation of the aforementioned dynamics.  We expect that the business disruption will continue to develop during the next 30-60 days with cash flow being temporarily impaired across the hotel space.  Some hotels will be more impacted than others.  The severity of impact will depend on the profile of assets and the markets in which they are located
  • City hotels that rely on corporate travel and city-wide conventions will continue to be most impacted.  Markets with already weaker fundamentals such as New York City and Chicago will feel some pain
  • U.S. consumers will enjoy a near-term boost from lower gas prices, low interest rates, and deferred spending.  Translating these dynamics into hotel performance, we believe that U.S. leisure-oriented hotels and resorts (especially resorts that are driving distance to a major city) are best positioned to benefit from a recovery in economic fundamentals and spending later in the year

How are our investments performing?

  • As many of you know from prior conversations, our philosophy and approach within our space is to prepare for the downside and try to be surprised by the upside.  This approach helps us in times of dislocation and uncertainty
  • It is too early to fully quantify the potential impact at our owned and collateral properties.  We have begun to see reservation cancellations at our owned properties, but we are not seeing wholesale cancellations of business.  Certain conferences are still proceeding and leisure guests continue to arrive at the hotels and continue to book
  • In addition to having daily calls and weekly meetings with on-the-ground operating teams, we are actively monitoring an array of data including web traffic patterns as a potential leading indicator.  We have also begun active outreach to our borrowers to understand what they are seeing at their properties
  • While we expect near-term disruption to cash flows, we believe that our owned and collateral properties are reasonably well-positioned to weather the disruption.  We have limited exposure to city hotels that rely heavily on convention and corporate travel business.  None of our collateral properties are located in overseas fly-to destinations
  • This situation is a good reminder for why we have been defensively positioned the past five years with a highly targeted approach to investing in very high-quality assets at an attractive all-weather basis
    • The majority of our investments during the past five years have been in the credit space at 20%-40% discounts to market value of assets.  The borrowers are generally well-capitalized and the capital structures are, by design, not overleveraged.  All of the loans remain current on monthly debt service.  However, if issues do arise for any particular property we take comfort from the fact that we have the internal capabilities and debt structures to quickly step in and take over operations (or to effectively force a sale of the property so that our debt is paid off)
    • Our recent acquisitions have been oriented towards opportunities where we were able to acquire very high quality real estate at an attractive all-weather basis, take a very conservative approach to projecting cash flows to provide an additional margin of safety, and use smart leverage strategies – namely using moderate leverage and taking advantage of floating rate loans that provide a natural hedge as base rates (i.e. LIBOR) decline in this type of scenario. 

Potential investment themes:

  • We currently believe that people in our space (and other asset classes and businesses) are not adequately pricing in the risk that irrational behavior will likely worsen in the near-term as more confirmed coronavirus cases are reported.  We are preparing for additional volatility, uncertainty, and scarcity of alternatives to provide investment solutions across the capital stack at attractive risk-adjusted returns
  • We believe the majority of opportunities will present themselves during the next 30-90-day period when uncertainty is at the highest and we are preparing accordingly with outreach to brokers and owners of high-quality properties.  Should the virus impact last beyond 90 days, we anticipate a continuation of attractive opportunities
  • As of right now we generally anticipate this dislocation playing out as a disruption to cash flow, not a permanent impairment in asset value.  We believe our thesis remains intact that investing in high-quality well-located assets in supply constrained markets will support attractive short-term and long-term risk-adjusted returns.  And we believe these types of assets will be quickest to rebound in a return to normalcy
  • There are some key practical considerations that will also impair near-term transaction volume – namely fewer capital providers (buyers, lenders) traveling to see properties and fewer international participants.  And we expect certain “tourist investors” to the hotel space to sit on the sidelines in the near-term
  • Our early investment themes include:
    • Refinancing attractive properties at an attractive basis that have near-term liquidity considerations (e.g. maturing loans) where borrowers are price takers
    • Refinancing newly built properties at a significant discount to physical replacement cost
    • Distressed-for-control or motivated selling situations in markets already dealing with weaker fundamentals (e.g., NYC, Chicago) or acquiring construction loans on built properties
    • Secondary acquisitions of publicly traded CMBS debt on attractive hotels and corporate unsecured debt on hospitality businesses
    • Providing rescue capital or bridge capital to buyers / owners of assets

Please refer to disclaimers for important considerations.