Reconfiguring Hospitality’s Financing Arrangements

COVID-19 and its aftermath are testing the relationships between commercial hospitality real estate owners and operators like never before.  Recovery from this crisis will require temporary and permanent changes to the contractual and business relationships that govern this important industry.  Commercial real estate owners and developers, as well as attorneys, brokers, and finance professionals will need to adjust their expectations and practices to thrive in the post-COVID environment.

The circumstances presented by the effect of COVID-19 on the hospitality industry were unexpected and unprecedented.  Earlier epidemics, such as SARS, were but a faint shadow of what emerged over the last 18 months.  The industry did not expect, nor was it prepared for, the scale of the crisis with case counts surpassing SARS in weeks and reaching a global spread unprecedented in modern times.

Unprecedented declines will take years to rebound.  For example, revenue per available rooms (RevPar) fell by 50% in 2020 as compared to 16.7% in the “Great Recession” of 2009.  CBRE forecasts Occupancy will not recover until 2023, and higher-end chains, which rely heavily on business travel, will lag.  [E&Y Material, quoting CBRE Hotels’ Americas Research, Kalibri Labs, Q2 2020].  There is a growing consensus that business travel will not return to pre-COVID-19 levels for years.  Industry experts believe there will be long-term effects on the nature of business travel, including less non-client travel, greater approval requirements, fewer individuals per trip, and adjustments in stay-length, requiring hotels to adapt to the decline in business travel.  There will also be sustained adjustments to operating costs as hotels focus on hygiene, enhanced cleaning, and regulation-driven employee benefits costs (i.e., national minimum wage) and greater insurance requirements.  These issues will come to the fore as owners and operators begin to engage with their lenders on the timing of comprehensive negotiations affected by vaccine distribution, government relief and, ultimately, the end of lender forbearance.

Impact on Hotel Brands  

In the short term, hotel brands and owners will have to engage their lenders and investors to adjust their financing arrangements to re-establish operations.  Early in the pandemic, brands and owners drew down their corporate lines of credit or entered into forbearance agreements with their lenders.  Operators have also taken drastic measures to contain costs.  Hotel operators must now restructure their businesses and financing arrangements to ensure a “soft landing.”  Negotiations with lenders must maximize liquidity and manage liabilities to re-enter the post-COVID environment.  

These efforts will benefit from a close review of financing arrangements. Companies may engage in “asset dropdown,” transferring assets to newly created subsidiaries not covered by the company’s existing lending facilities.  Intellectual properties assets similar to those held by brand companies have performed well in these types of transactions executed by large retailers. These subsidiaries may borrow against the transferred assets on a priority basis to provide additional runway to allow hospitality assets to re-emerge from the COVID-19 period.

In addition, certain liabilities, especially obligations to employees and the government, may be accelerated. State and federal statutes put special obligations on company management to ensure these liabilities are paid. Most hotel operators are employers at most hotels and so are obligated to provide for employee liabilities (accrued wages, sick and separation pay, tax claims, etc.). While the hotel owners contractually agree to pay these liabilities or indemnify operators, when property owners fail, hotel operators will find themselves the only deep pocket available. Claims often snowball in a property shutdown pursuant to federal and state WARN Act requirements, which require 60 days’ notice of a shut-down or impose substantial claims for severance. Professionals experienced in wind-down or restructuring scenarios can help manage these liabilities.  

Preparing for the Future  

Hotel management agreements, and related documents, create a stable flow of fees supporting all these businesses. Hotel operators must aggressively protect these arrangements through the inevitable restructuring process to come. As evidenced by recent cases, owners may look to reject these agreements to convert operators’ rights to unsecured claims in bankruptcy and pay these claims “pennies-on-the-dollar.”  If successful, owners may rebrand or re-purpose their properties for the future. This will place extreme pressure on the brands’ agreements and implicate financing arrangements with respect to these arrangements with operators. The documentation governing these transactions varies greatly and will be fertile ground for challengers seeking to unseat hotel operators.  

Streamlining operations may also result in a variety of adjustments to present business models, including re-assessing operating structures, re-arranging employees by brand, modifying portfolio organizations, or rationing personnel and processes to increase efficiency. Technology can also improve organizational and operational efficiency.

Hotel operators will lead the way on legal, financial, and business reactions to the emergence from the COVID-19 period. This industry will need to be creative to test and identify the most effective steps and reactions as the world looks forward. Industry leaders must navigate uncharted waters as a myriad of market segments prepare their own path forward.

Sam Newman is a partner in the Los Angeles office of Sidley’s Restructuring group.