Collectively, we all hope for an expedited market recovery, but there is a real likelihood the downturn could stretch through the third and fourth quarters of this year and potentially into 2022.
For now, current business levels and the second round of government relief have reduced the need for new capital. However, they are not sufficient to cover the full cash burn. In anticipation of foreclosure or a deed in lieu of foreclosure, it would benefit lenders to use professional hotel asset managers to develop a comprehensive real estate owned asset plan now. I will address one part of that asset plan: considerations around asset preservation and the unique capital needs of hotels bringing to the forefront issues for lenders in anticipation of stepping into title.
A lender’s most detailed evaluation of the hotel physical plant is typically a property condition report commissioned at a loan’s origination or refinancing. Because hotels shutdown or transitioned to limited operations in March 2020, this PCR is going on 12-plus months old.
What is known about a hotel’s current physical condition may be limited to borrower conversations and reviews of capital expenses and budgets and/or annual property inspections, which may not have happened in 2020. The likely scenario is limited to non-existent major capital spending over the last 12 months, with furniture, fixtures and equipment reserves reduced to near zero while existing funds were diverted to debt service payments and contributions waived or significantly reduced due to lower revenue levels.
At first glance, eliminating property, operations and maintenance spending appears an attractive opportunity to reduce cash burn, magnified by a corresponding drop in utilities. An effective asset manager can help identify issues with building maintenance while presenting a balanced risk assessment shutting down completely or partially, as well as the start-up cost associated with reopening.
Major mechanical equipment and building systems, such as plumbing, electrical, HVAC and fire/life safety, require the proper maintenance and monitoring. When not in use, natural deterioration occurs, affecting the collateral’s value.
The process for restarting mechanical equipment includes a full flush or reset of the system. However, a full shutdown may also expose a five-, six- or seven-figure repair or replacement of a major piece of equipment. Damages that permeate the entire building also could occur. Sometimes damage is immediately apparent. Other times, the problem hides behind walls until a larger failure occurs or, worse, is found during due diligence as part of a sale, resulting in a buyer re-trade.
HVAC and building conditioning should not be shut off completely, even during times of limited to no occupancy because of condensation, moisture and/or fungal growth on mechanical components, surfaces, finishes and soft goods. A lender does not want to walk into an REO situation with an OSHA claim from an associate “forced” to work in a building with black mold. Fresh air is good for a building, and in the COVID-19 era, the universal guidance from medical experts lists fresh air as reducing the likelihood of transmission.
Lack of maintenance of water and plumbing systems can damage pipes and create unsafe health conditions. Water needs to be pulled through the building periodically by running showers and sinks in guestrooms in addition to flushing toilets. This is also necessary in kitchens, bars, pools, locker rooms, spas — anywhere with potable water. Water heaters and chilled water systems must be properly maintained, operating or not. Proper temperature settings, regular water circulation and other correct non-operating conditions need to be maintained. Stagnant water or dried out pipes can lead to corrosion and potential development of biohazards, such as Legionella or sewer gas infiltrating the building. These issues can manifest physically as pinhole leaks in pipes and, in the case of a biohazard, negative PR. The worst-case scenario would be a person's death coupled with the temporary loss of a certificate of occupancy.
After the physical plant, an honest evaluation of the useful life and obsolescence of FF&E needs to be conducted. Even though buildings had significantly reduced occupancy in 2020, the actual wear and tear should be evaluated to determine the remaining useful life of FF&E and any option to extend the economic life. Other factors an asset manager can evaluate are the completeness of prior renovations, current brand standards, current design and customer trends and the competitiveness of the hotel product based on the other hotels in the market and potential new hotel openings in the near future.
The most important part of an REO is a brand’s product improvement plan requirements. During the Great Recession, lenders took back properties in all stages of product quality and various phases of renovation. With input of a lender’s REO strategy and appetite for capital investment, an asset manager can provide recommendations on PIP negotiations with the brand to remain in compliance and maintain the value of the flag. During COVID-19, brands largely have worked with the owners to set realistic expectations around renovation requirements and timelines. Although lenders are not the typical ownership base of hotel brands, they need to ensure PIP requirements are not overly onerous and match the lender’s disposition strategy.
These issues are a sample of what an asset manager can do. For lenders, a hotel asset manager can advise on loan strategy in anticipation of REO by providing additional visibility into an asset to ensure the health of the collateral through recovery and help lenders maximize value recovery.
Darryl Law is an asset manager overseeing hotel assets for public REITs, private equity and lenders. His coverage includes a wide range of property types, including select-service, resort, full-service, convention and lifestyle hotels located in suburban, destination and top-25 gateway markets.
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