• Debt structures under pressure

With hotel cashflows collapsing as a result of coronavirus lockdowns, owners and operators are facing tough decisions around maintaining their businesses.
While operators focus on cutting overheads and paying rent, investors who are highly leveraged face a different range of pressures. And those with complex debt instruments are wrestling with a number of unintended consequences of structures devised in happier times.
Fast growing brands with predominantly leased properties will, in common with the retail sector, be looking to freeze payments. Serviced apartment operator Staycity, for example, is understood to be calling on landlords to agree to a six-month rent-free period. Luxury and conference hotels are viewed to be under more pressure, due to their higher operating costs.
In the USA, real estate billionaire Tom Barrack, chairman and CEO of investor Colony Capital, has warned of the potential for a domino effect in the commercial mortgage market. Unless banks and government take action quickly, defaulting borrowers could set in play a nasty train of events. In a white paper released online, he suggests a rescue plan that should include USD500m of taxpayer funds, to provide liquidity; suspension of key accounting rules; and flexibility from banks, to stop them triggering default clauses.
One area that is relatively immature as an investment medium, is the use of ground leases. Originating from the residential long leasehold sector, these have spread within the last five years into commercial property, and notably into the hotel sector.
Pitched as an additional way to apportion income from an asset, ground leases present owners with another opportunity to earn from their asset. But, in situations where highly leveraged property deals have been done, there are concerns. With the sector still new, some contracts could put key players in the debt stack in a poor position, as income flows dry up with the coronavirus forcing hotels to effectively – or actually – close.
Among the leaders in the sector has been Alpha Real Capital, which in 2019 agreed a GBP360m ground rent deal on four central London hotels, as they were sold from the Grange portfolio to be rebranded by Leonardo. In a 2019 paper, Alpha had argued that ground rent investments were bond-like, with values typically 30-40% of underlying property value, with a starting rent of 8-15% ebitdar, or a fraction of market rent. The paper noted that, in the event of a ground rent default, “investors have the benefit of a freehold ownership (effectively first charge) over the property (ahead of any mortgage providers) and, given the collateralisation, expected recoveries would often be higher than for corporate bonds even in stressed value scenarios”.
One consultant in the sector told Hotel Analyst that there is a wide range of variability in ground rent structures – but that none of them were designed to withstand what the industry is currently seeing. And part of that problem is to do with the lengths such contracts have been written over. “They probably didn’t give enough thought to volatility – my view is that over a 125-year period, things are bound to go wrong. What seemed like a good idea of paying away 10-20% of ebitda may no longer.”
“The question is around how the lending was structured, and I don’t think all banks have taken the same approach. Unfortunately, there will be some casualties.”
Will Kirkpatrick, a partner at Gerald Eve, said he understood defaults are already starting – but that, for now, those in ground rent agreements would be flexible. “A lot of funds are taking a pragmatic approach – abatements are probably the key thing for the minute.” Most ground rents are held by pension funds, who are prepared to take a long-term view. “And I just don’t see pension funds playing hard ball. Indeed, some pension funds cannot hold trading assets – under duress they could probably do so, but I just don’t see it.”
All parties are looking forward, with hope and expectation, to a time when the industry has a chance to return to a new normality – albeit probably without those casualties lost along the way. “In this situation, the human consequences are much more tragic,” said one, “but the recovery time for the industry will be relatively quick.”

HA Perspective [by Andrew Sangster]: The Black Swan nature of current events is going to create a lot of stress in capital structures. As always in such situations, those at the top of the tree will get to call the shots.
Usually, this is the senior debt providers. But with ground rents, these bankers will be in the unusual position of being subordinate.
For the immediate future, it seems unlikely that much action will take place other than a few calls with lawyers to confirm respective positions. The extent of bailouts by governments are still in the balance and grow more generous as the crisis deepens. The outcome of such bailouts may well mitigate some of the worst pressure.
Meanwhile, force majeure is going to be a term business leaders will become very familiar with as they spend more time with their lawyers and discuss contractual relationships.

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