Westfort Advisors

The regional hotel market, in particular, received a significant boost in 2020, following the easing of lockdown restrictions; the “staycation” market remained strong throughout 2021, with unprecedented trading performance in select coastal and countryside locations.

2022 may prove more of a challenge, with overseas travel restrictions loosening and possible pent-up demand for foreign holidays impairing domestic demand. Notwithstanding this, recent PwC Research indicates that 37% of people still plan to holiday within the UK in 2022. On balance, we would expect similar performance in 2022 to 2021 for these regional locations.

The return of events, conferences and meetings will have a direct impact on regional hotel recovery. Larger events with longer planning cycles may take further time to recover, especially if uncertainty persists around potential restrictions. Business travel, in general, could potentially stabilize at a lower level than 2019, due to the widespread adoption of teleconferencing and tightened business travel policies.

The London hotel sector has suffered a lack of both international tourism and domestic business travel. These have combined to make for an exceptionally difficult trading period. The luxury hotel market in London has seen occupancy as low as 18%, which is in part down to the absence of high-spend tourists from the USA and the Middle East. Mid-market and budget hotels have fared best from domestic tourism demand. Despite the ups and downs over the years, London hotels have traditionally bounced back, with trading reaching new heights.

Despite the positivity from forecasters, the hotel sector still faces major concerns as a result of inflation. Inflation has increased sharply in the UK, reaching 4.2% in November, the highest figure in almost a decade. The hospitality sector is suffering as a result and further exacerbated with supply chain disruption and labour shortages.

In terms of capital values and yields, the hotel market was one of the worst impacted sectors from the pandemic. Valuations are currently down by over 10% from 2019 levels and prime yields have increased by 25-50bps, according to a report from Invesco. This reflects the size of the impact on operating performance, as well as the increased uncertainty over future performance and restrictions.

Over the course of the year, we have seen growing confidence in the sector, with investors looking to take advantage of the reduction in values. This is particularly the case for prime hotels with fixed income leases, which provide more certainty of income than is offered from hotels on management agreements. As such, in the UK, yields on prime hotels dropped by 10bps in London Hotels and 40bps in the regions.

In general, in order to benefit from a quicker recovery as travel continues to return, investors favour hotels operating in the leisure market and in areas where new supply will be limited. This reflects the performance so far, with pent-up demand for holidays being quickly realised, and a much slower recovery expected for corporate travel. Corporate travel is also more likely to be restricted in the long run by the evolving working practices caused by the pandemic.

The hotel sector has become an increasingly important sector in CRE lending, with debt origination to hotels growing by 141% since the GFC. While this used to be primarily domestic bank territory, with UK banks having a 62% market share in 2004, this has now evolved to a much more mature and diverse lending market.

Lenders significantly raised pricing during 2020 lockdowns, as a result of the marked increase in risk. A report from Bayes Business School found hotel senior lending margins increased from 270bps at the end of 2019 to 349bps in H1 2021, showing the increased perceived risk in the sector. They also looked for more protection with targets on Interest Coverage Ratios (ICR) rising from 1.8x to 2.2x, with some lenders requiring 4x for managed hotels that do not benefit from strong brand association.

While banks and insurers remain the largest lenders in terms of total exposure, holding 92% of outstanding debt as of June 2020, in terms of new loans they effectively retreated from the sector last year and have yet to re-enter. We expect this to change in the coming six months, (assuming no regression with respect to Government Covid guidance); albeit at a very conservative leverage.

Traditional lender preference will be for well-located hotels within gateway cities or strong tourist towns that can demonstrate post-pandemic performance i.e. occupancy/ADR/income levels that are trending up and indicate continued recovery (albeit may not be reaching pre-pandemic levels). Lenders will generally require four years of trading history, in order that they can underwrite future performance and take a view on VPV – hence there is a general preference for hotels with HMAs as opposed to lease contracts. Leased hotels will be considered, but the tenant will need to be investment grade.

The future business plan and capex requirement will be a core focus in this regard. One consideration will be the proportion of income derived from F&B; with 20% being the common, maximum threshold. Brand will generally be a secondary priority versus underlying trading performance, although any form of income guarantee from the operator (assuming strong financial standing) will be meaningful. The Sponsor will generally need to be highly credible, with a demonstrable track record of managing hotel investments. Equity distribution will be restricted based on business plan performance (i.e. cash trap covenants and mechanisms). Most will require strong interest cover ratios, although amortisation will not necessarily be required, given the growth business plan and the relatively conservative base on day one. However, all the above is of-course contingent on the prevailing Government advice with respect to Covid and anything that could have a future impact on the hotel/leisure sector.

Given this withdrawal of the largest lenders in the sector, there have been two key reasons that have kept the sector reasonably stable and liquid over the last 18 months.

Firstly, we have seen that lenders have shown remarkable forbearance on existing loans, with respect to covenant breaches and extensions of loan maturities. This was due to a variety of factors including Government and regulatory pressure, an understanding that there were very little borrowers could do to control the situation and the fact that in the middle of the pandemic, most lenders would not want to be taking these assets on to their books. We are now seeing lenders re-evaluate their position and start to apply pressure on borrowers. This has left some previously stable businesses in situational distress as they try and find their footing in this new market.

Secondly, while the traditional banks have retreated almost completely, we have seen a rise in activity from non-bank lenders, i.e. mainly debt funds, who have been able to step in and refinance loans held with banks or to finance new acquisitions. These lenders will look for higher returns than their bank counterparts, however, they are willing to look at a wider variety of assets and structures, as well as offering higher leverage and speed/certainty of execution to justify their pricing.

The higher leverage on offer is particularly important in circumstances where values have dropped significantly or when looking to increase returns on value-add strategies. Alongside this, we have also seen a lot of activity from challenger banks, who are nimbler in the current market and have the appetite and expertise to underwrite operating risk. These challenger banks tend to sit in between the traditional clearing banks and the debt funds, both in terms of leverage and pricing.

Below, we lay out some of the themes we have seen in recent months when financing hotels:

As a result of the marked change in market conditions, we have seen a number of opportunities where sponsors are looking to purchase and reposition or modernise assets, through extensive capex plans and through changing the hotel operator. Westfort Advisors has successfully sourced debt terms with acquisition or refinance and capex facilities both in the UK and Europe, with debt funds keen to support value-add business plans. Lenders will require a well-thought-out and credible business plan and an experienced operator with a strong track record.

One particular trend we have seen is the increasing negotiation going into loan mechanics and interest reserves, and the flexibility that has been shown by non-bank lenders in order to offer a product that will both keep borrowers accountable against the business plan and at the same time provide sufficient headroom for market fluctuations without defaulting. We have seen this come in the shape of delayed covenant testing, guarantees, borrower and lender funded interest reserves and special pandemic related clauses in the covenant testing. Whilst there is a hive of activity in Europe in tourist countries such as Spain, Portugal and Greece, many lenders are cautious of the legal environment in these countries should they have to enforce. As such, many are only willing to consider deals with a double LuxCo structure to protect them in a downside situation.

As previously mentioned, regional hotels have benefited from a quicker recovery in the UK as lockdown measures were lifted. This was in no small part down to the fact that international travel was restricted. While this has led to regional hotels outperforming their big-city counterparts in many instances, the feedback we have seen from some lenders is they see this as a short-term bounce and one that is not necessarily sustainable as international travel continues to return. Given the time horizon of senior loans is typically 3-5 years, these lenders remain more comfortable with hotels with strong fundamentals in established city centres.

The increased uncertainty has seen lenders turn to familiar names in order to give themselves and their credit committees more confidence in the credibility of business plans and performance going forward. A report from Bayes Business School found 78% of lenders preferred to finance hotels with a franchise or renowned brand image. As such, those looking for finance in the sector, are incentivised to look to partner with or sign-up big-name brands to increase their chance of raising funds.

In conclusion, financing in the hotel market remains achievable, albeit more expensive than before the pandemic. Borrowers are also having to look outside their traditional bank finance in many cases, especially when looking at anything other than extremely core, long-let assets. One potential concern to watch out for will be when refinancing is required for loans that mature over the next year. Whereas last year many lenders were willing to offer short term extensions, now that the market has returned to some form of normality, there will be more pressure on borrowers. Where values remain lower, this may cause issues and many borrowers may have to adjust and move to more expensive non-bank finance.