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In our continuing series of articles on topical financing issues, we turn our attention to the hotel sector. We have limited our focus in this article to accommodation hotels rather than pubs, which was a focus of our previous article.

The tourism industry has been one of the hardest-hit sectors due to COVID-19.  From a financing perspective, it is vital that both financiers and borrowers are taking steps to address any financing compliance issues and we expect most (if not all) participants in that sector are already actively doing so.

Background

Overwhelmingly, the biggest issue confronting the hotel sector is the downturn if not evaporation of occupancy given the closure of national, state and territory borders. Business travel has been severely curtailed and of course, no inbound overseas travel is permitted. Inbound tourism (with the possible exception of New Zealand) is unlikely to recommence until 2021; indeed, Qantas has announced that it will not be restarting long haul fights until 2021.

Market Structure

As market participants will be aware, generally hotels are owned by a freehold owner and subject to a management or operations agreement with a professional operator (for example Accor, Hilton, Best Western, Four Seasons, Hyatt and InterContinental). In other instances, hotels may be operated by the freehold owner (for example, some local brands of a more boutique style).

The relationship between an owner and an operator is generally different from the orthodox tenant/landlord relationship due to how “rent” is calculated – being a share of operating revenue of the hotel. Accordingly, while the owner is entitled to a fixed share of operating revenue, where that revenue suffers a significant reduction then the income to the owner will reflect such a downturn.

A downturn in revenue such as all hotel operators will be experiencing at the moment will impact on the owner as well as the operator and likely have consequences for debt service for owners and operators alike. 

Lender, owner and operator considerations

Some of the issues we addressed in our earlier article on commercial property and hospitality are relevant here.

In addition:

  • Covenant testing – we would expect Loan to Value Ratio (LVR), Interest Cover Ratio (ICR) and/or Debt Service Cover Ratio (DSCR) to apply.  For ICR and DSCR, we assume closures have already materially impacted covenant compliance and there will be a need to waive certain testing dates, as well as adjust future testing periods by reference to hotel re-opening dates.  As the typical management agreement is like a revenue sharing agreement between an owner and operator, there is no fixed rental revenue (i.e. as there would be for say a commercial office building).  Lenders and owners will need to consider any specific revenue arrangements that apply under the relevant management agreement (for example if there are any holdbacks by the operator under the management agreement, which might impact on debt servicing).  
  • RevPAR – the key metric for operators is what is known as RevPAR, which translates to “revenue per available room”. The calculation involves:

dividing

gross hotel guest room revenue

by

the number of rooms and the number of days in the relevant calculation period,

A very similar metric is TRevPAR or “total hotel revenue”, which includes the food and beverage and similar ancillary revenue in the revenue line. CBRE Hotels Research has reported that RevPAR has seen record the largest ever reduction since the onset of COVID-19, with both revenue and occupancy levels sinking to historic lows in some jurisdictions.  This represents the significant challenge that COVID-19 is having on the sector globally.  We understand some market analysts are focusing on occupancy rates over revenue as a performance metric until a normalisation of business.

  • State & Commonwealth Government concessions - Operators may well be utilising the JobKeeper support package for key staff. Since many hotel staff are casuals the benefit of JobKeeper is likely to be modest. A factor in re- booting hotels as border controls relax may be in the availability of casual staff.
  • Operator exposure and reporting – unlike most other commercial properties, the owner of a hotel has a single tenant (being the operator) and there is, therefore, concentration risk from a financing perspective.  It is critical for the lender to be in a position to monitor hotel revenue and any compliance issues under the management agreement.  Is the operator keeping the owner updated on hotel performance?  In turn, is the owner keeping the lender updated of the performance of the hotel and operator?  What reporting mechanisms are in place as to the performance of the hotel, occupancy rates, room rates and staffing levels? 
  • Non-Disturbance Agreement / Tripartite Agreement - we would expect a tripartite agreement to have been entered into between the lender, owner and operator. The ability for a lender to step-in and cure an owner default under the management agreement in this environment is key.  In addition to the typical provisions for step-in and cure rights, such an agreement may give a lender access to reports or information that may assist further in monitoring hotel performance and thus the ability of the owner to service debt. A careful review of any existing NDA/Tripartite Agreement and the related management agreement should be a part of an overall review process.
  • Capital expenditure - typically a capex fund is established out of a percentage of operating revenue. This should be applied not only for capex requirements (refurbishment for example of rooms, restaurants, foyers) but also furniture, fittings and equipment (FF&E). Maintenance of a high standard of hotel is in the owner’s (and lender’s) best interests. Ensuring that the operator is undertaking both capex and FF&E in accordance with the agreed terms of the management agreement both as to regularity and quality, is an important element in maintaining the value of the asset over the long term. 
  • Working capital – a further issue for hotel owners and operators in this environment is how they can fund their working capital requirements for any period in which the hotel is closed or not at full operation.

Outlook

The outlook for the hotel sector remains challenging, with:

  • inbound travel to Australia some way off, other than Trans-Tasman/South Pacific ‘bubbles’
  • business travel severely curtailed by state and territory border closures and general social distancing requirements, and
  • consumer wariness about coming out of lockdown generally.

However, we are aware of hotel developments that are proceeding, and which have attracted significant investor interest notwithstanding the current environment. It may well be that, at least for some period, there is a structural shift in hotel accommodation demand (for example the prospects for regional hotels, particularly in tourist destinations, may become more attractive especially as state and territory border restrictions get wound back but national borders remain closed) and this could create potential opportunities for sponsors.

 

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