COVID-19’s impact on the hotel industry has been devastating. According to STR, the operating results for the week ending May 2, revenue per available room dropped 76.8 percent compared with the same week a year earlier. In addition, HVS published an article in mid-April that presented three levels of projections of the hotel industry performance for 2020. Its midrange projection for the US hotel industry was for break-even earnings before interest, taxes, depreciation and amortization, meaning, the average hotel would be unable to generate any cash to service debt or fund capital needs. To make things worse, according to STR, the U.S. reached the highest number of hotel rooms under construction on record in March of 2020.
There are many experts writing about what travel will look like in the second half of 2020 and beyond. The reality is that no one really knows, but almost everyone agrees that there will be less of it for the next several years. Changes to travel demand based on virus spread prevention and demand changes because of a weakened economy will mute demand for a sustained period of time. Lower travel volume coupled with a substantial increase in hotel room supply will create an exceedingly difficult situation for hotels and their lenders.
A revenue problem is ultimately a debt problem. The reality will be that many hotels are simply carrying too much debt to survive based on the new reality of roomnight demand. Assuming that the degraded hotel industry metrics are not a transitory blip on an otherwise rosy forecast, hotels must work with lenders to create a permanent solution to the problem. Depending on many factors, often the only sustainable solution for the hotel and its ownership group is a reduction in the debt load. The new reality is that many hotels are now worth less than the hotel’s debt, and the lender has already lost money on the note. In fact, once the bank has evidence that the asset is worth less than the note, they are obligated to write down the value of the note on their books. In times like these, often none of the lender’s legal options to recover the full value of the note will work.
Two Common Solutions for Overleveraged Real Estate
U.S. banking regulations facilitate several types of debt forgiveness for nonperforming loans. The most common process is called a bifurcation. In a loan bifurcation, the note is divided into two parts, part A and part B. The amount allocated to part A is a note based on the amount of the loan on which the property can perform. Part B is the amount of the remainder of the note. The property is obligated to pay on the part A note only. What ultimately happens to the part B note is a matter of negotiation.
Another solution is a discounted payoff. If a hotel owner can secure financing from a different lender for part of the note balance, the existing lender may take the money in full satisfaction of the note.
So what should hotel owners do if they have too much debt on their hotel?
1. Address the problem early. Many ownership groups we talk to have exhausted all other sources of cash before they talk to their bank. Talking to your bank while you still have cash will help preserve cash that will be increasingly difficult to accumulate. Why deplete it before addressing the problem? Do not think that banks will not negotiate with you because you have personal guarantees. It is in all parties’ interests to find a negotiated solution, and that rarely involves exercising the guarantees.
2. Be ethical and truthful. A restructure negotiation will be dependent, in part, on the borrowers’ credibility and the trust between the lender and the borrower. Be sure that your accounting is complete and accurate. The truth is powerful in loan restructure negotiations, and if a lender begins to believe that he cannot rely on your representations, things will go south quickly.
3. Be realistic with the bank and propose a solution. Banks need you to come to them with a solution. There are reasons why they will not propose one. Debt reduction is often in the interests of the lender, because if properly structured, it will yield the lender more money than a foreclosure, and it can be accomplished quickly with a minimum of legal expense. Foreclosures on hotels, especially in periods of low demand, can be extraordinarily risky for lenders.
4. Don’t forget the capital budget. When doing your analysis, don’t forget that there needs to be enough cash flow after the debt restructure to fund the inevitable capital reinvestment to keep your property competitive. Failure to plan and negotiate enough concessions to allow for capital reinvestment will make it impossible to compete in the future.
5. Understand that you have a problem of economics, not a legal problem. Loan documents invariably empower banks with all the legal rights imaginable (and some unimaginable ones). However, the problem is one of cash shortfalls, and all the lender’s legal rights cannot solve the problem. Approach the bank with a solution, not with a lawyer. Your lawyer can only talk to the bank’s lawyer and inserting your lawyer between you and your lender is a certain way to turn an economic problem into a legal one.
It is important to understand that in many markets, the debt of your competitors will be restructured one way or another, because most markets now are oversupplied. Properties with high debt relative to their competitors will have a difficult time competing. Debt reduction often is done through foreclosures or bankruptcies, but in order for the reduction to produce the best result for the property owner and the lender, it should be accomplished through negotiations between owners and lenders.