It has certainly been a very challenging year for all hotels in the UK as most were forced to shut their doors for much of 2020 with occupancy down to as low as 17%, a figure which in London is expected to persist or even slightly decrease for 2021. Despite the Government support provided during the pandemic, including the reduced VAT rates for hotel accommodation and furlough scheme to support employee salaries, many hotel businesses, particularly those with leases or ground rent structures, have had fixed costs throughout the closure period that cannot be readily mitigated. Sadly, going forward, we expect that some hotel assets may no longer be viable as hotels, and might require to be repositioned to a different asset class such as student accommodation or residential. However, the hope is that after a stabilisation period many hotels should be able to return to their pre-2019 trading levels.
In 2020, the main topic hotel owners and operators discussed was financial liquidity. In some cases, this has been made more challenging by the high level of gearing, in the form of debt and rental costs, in hotel structures. One popular trend in recent years that has come back to haunt lenders is the use of highly geared ground rent structures, in which the owner of the long lease pays a significant proportion of hotel income as rent under the ground lease. These have been seen as a neat way to release equity for the sponsors through the upfront sale of the freehold in return for entering into a long lease, and the healthy performance of the relevant underlying hotels should have more than covered the ground rent commitment. However, such structures did not anticipate a pandemic forcing hotels to shut their doors, and many owners have found themselves short of the cash required to pay both the higher priority ground rent and their lenders. In some cases, lenders have been required to call on operator guarantees to ensure payment of loan interest amounts with knock on consequences for the operator's cash flow. Perhaps not surprisingly, when we speak with lenders now, they are currently very cautious about any hotel asset with a highly geared ground rent structure.
It might also take a couple of years for cash flows to improve. According to STR's February 2021 forecast for the London Luxury market, Revenue Per Available Room (RevPAR) and revenue levels are expected to get back to 2019 levels by 2024 with occupancy coming back by 2025. As none of us know how we will exit this pandemic, to some degree all such projections must be crystal ball gazing. Interestingly, such projections now predict a deeper dip in 2021 followed by a steeper climb as markets return, compared to similar projections made last year.
As we continue further into 2021, on a traffic light scale, hotels may well fall in the 'amber' category for many lenders who have traditionally financed them. In addition, not all hotel sub-sectors may be of equal interest to lenders in the short term. Some lenders we have spoken with are more cautious in the immediate term about some city hotels and perhaps more bullish about regional properties than would have previously been the case, reflecting the relative performance of regional assets during the pandemic and the boom in 'staycation' getaways whilst overseas travel has been illegal, or at best uncertain.
Another sub-sector, which perhaps has been less well known to traditional lenders in the UK (albeit already much more established in other countries), is the serviced apartment sector. This has been seen to have performed relatively well during the pandemic as a result of its COVID-secure features and as it also aligns well with the continuing trend towards so-called 'bleisure' travel and longer stay business travel. It has in the past fallen between the gaps in finance appetite, being considered neither a traditional hotel nor a residential product. However lenders are increasingly familiar with this sub-sector and we expect that as more high quality product is delivered to the market and it becomes a more institutional led investment market, finance appetite for serviced apartments will increase further. In fact, over the last few months, there seems to have been good appetite for serviced apartment/aparthotels financings in the market. For example the start of this year saw the £74m financing of Canary Wharf Group, edyn by Cain International for the development of a 279 key aparthotel development and November last year, saw the £30m financing by OakNorth Bank of Staycity's 10 aparthotels this year.
Some lenders who have historically financed traditional hotel assets have pulled back from the market quite significantly. Other lenders have advised us that their financing appetite is topping out at a lower leverage than pre-COVID (say 50/55% LTV for senior lenders) based on a post-COVID valuation. One big question mark as hotels come out of lockdown and start to stabilise is how quickly they will reach equilibrium and what the impact will be on pre-COVID values. Could values have shifted down by as much as 15 or 20% in some markets? Given the inherent uncertainty as might be expected, loan pricing has also moved out since pre-COVID. Lenders are also considering the stabilisation period required for each hotel asset when structuring new facilities and in particular when agreeing appropriate financial covenants. For example, they are considering delayed testing of leverage covenants (postponing this to say 2023, depending on the business plan) with the LTV covenant based on the new valuation, they are requiring a DSCR and cash trap in the ordinary course, and requiring say two years of interest cover to be placed into a deposit account in advance to 'solve' for the short term lack of income as hotels ramp up again. Senior lenders in many cases are also able to accept fully structurally subordinated mezzanine finance, particularly if the mezzanine lender has hotel expertise and hypothetically could step in with additional equity in a worst case scenario.
As some hotel owners approach refinancing deadlines under existing facilities, we are starting to see sales of sub-portfolios of hotel assets to provide much needed liquidity to the wider portfolio. Another approach to restablise a portfolio is to bring in new capital. A number of specialty finance lenders now have dedicated hospitality 'rescue capital' strategies, which are targeted at providing additional capital to 'cure' liquidity constraints or LTV breaches whilst hotels restablise. For some of these strategies the capital can be for opex and capex and/or to fund an interest reserve for a senior facility or to de-lever existing facilities. In addition, there are a number of niche ABL finance providers that can provide additional sources of liquidity secured against the right balance sheet assets or cash flows.
We expect that there will be a period of adjustment and ongoing short-term liquidity issues as hotels come back to an equilibrium position, however there is capital ready to support the right assets backed by the right owners and operators, to provide such hotels with much needed runway to get back to their pre-COVID revenue levels. Only time will tell, but we fully expect that hotel assets, which in many cases have had a long successful track record of performance, will bounce back strongly and financing appetite will quickly follow suit.
If you'd like to discuss any matters relating to this article or the Hotel industry please contact Omega Poole or a member of our Hotels Group.
This is the first in a series of Hospitality Matters articles dedicated to issues and opportunities facing individuals and businesses in the hospitality industry today. Click here to be added to our mailing list for future articles.