Investments in hotels and offices are a high risk, high reward bet
Following the disruption of COVID-19, the the credit market today is very different than a little over a year ago. The value of long-term assets in the hospitality and office markets remains strong, but funding for short-term construction will require additional planning and capital to withstand the uncertainties.
How should property managers and lenders think about this new environment? To what extent does the phenomenon of remote work caused by the pandemic impacting the demand for office space and hotels? What steps, if any, can developers take to tackle the funding issues for hotel and office projects? And what can market participants expect in the next six to nine months from a funding standpoint? To answer these questions, we must first take a closer look at what has happened since the start of the pandemic.
Office occupancy rates (employees physically going to the office) fell sharply in the first few weeks of COVID-19, from over 95% to less than 10% in hard-hit markets initially by the virus. The occupation of the hotel followed the same path, with the occupation nationwide drop to less than 25 percent in April 2020. Since then, office and hotel occupancy has followed our progress against COVID-19. The initial occupancy gains in 2020 were reversed with the “second wave” in November. Subsequent increases in 2021 in the middle of the vaccine rollout were again reversed with the appearance of the Delta variant.
In mid-November, companies like Apple and Amazon pushed back return-to-work dates to the first quarter of 2022 and office occupancy rates are less than 40 percent of capacity in the top 10 metropolitan markets according to Castle systems. Hotel occupancy rates have fallen to 60% (compared to 73% for the same period in 2019), but business travel has yet to materialize. The American Hotel & Lodging Association predicts that business travel revenue for 2021 will be 90 percent down from 2019 levels.
Meanwhile, some prominent tech companies like Twitter and Dropbox have given employees the option to work from home all the time. Many others, such as Pfizer, HSBC and Deutsche Bank, have reported permanent cuts to their travel budgets. With National office vacancy rate exceeds 17% for the first time since 2010, many wonder if this is not the beginning of a permanent decline in the demand for offices and business travel.
Money for nothing?
While the possibility of a centuries-old trend towards working from home has been the center of attention, much of the increase in the number of vacant offices to date can be attributed to the money-saving efforts of companies. that are between the leases. With 10-year leases as the norm, around 15% of companies have requested renewals of their leases since the onset of COVID-19. It’s no surprise that small and medium-sized businesses with employees already working from home due to health concerns are in no rush to renew an expensive long-term lease. Likewise, businesses of all sizes will continue to constrain travel budgets while their clients’ employees will not be able to return to the office, let alone accept visitors.
These impacts on the demand for offices and hotels, while significant, are temporary. But what about companies that have announced permanent work-from-home policies or permanent reductions in business travel?
Each company will undoubtedly draw its own conclusions about the effect these decisions will have on productivity and profitability, but an initial assessment published last month in the leading research journal Nature should be a source of concern for companies. remotely first ”. The Nature study analyzed the number of emails sent by Microsoft employees in the three months before and three months after the company’s March 2020 work-from-home order, and found that the number of coworkers with whom every employee communicated has declined over the past three months and the extent of communication between different departments has diminished. Simply put, remote working has reduced communication between departments, which in most businesses is critical both for individual employee learning and for the long-term success of the business.
Long-term demand in the office and business hotel segments is not threatened, but a cloud of uncertainties may persist in the short to medium term. Yahoo! abandoned its remote working policy in 2013 and IBM halted a similar experiment in 2017. But in each case only after several years of observing the results. Similar efforts today will also take time to evaluate.
For developers and operators making short-term investment decisions, expect continued caution from lenders and investors in the hospitality and office industries until collective immunity. either convincingly achieved or the severity of COVID-19 reduced to the level of seasonal influenza or other endemic. virus. Many experts believe this will likely happen in the next six to nine months, but the ultimate timing will depend on social and political factors, as well as the rate of mutation of the COVID-19 virus. (In fact, the world is currently awaiting more conclusive research on the transmissibility and potential severity of the Omnicron variant first spotted by health authorities in South Africa). Ups and downs on the way back to “normal” are to be expected and should be factored into both underwriting and capital structure. Specifically:
- Moderate leverage. Think of preferred stocks as an alternative to mezzanine debt. Ask for loan structures that defer a portion of the interest on the loans to reduce short-term interest payments.
- Maximize liquidity. Hotel developers should ensure they have borrowing capacity and / or cash reserves in the event of another COVID-19-related shutdown. Consider larger interest reserves based on more cautious operating proforma.
- Plan for longer ramp-up periods than usual. Many office markets face supply issues in addition to COVID-19. Housing starts in the office sector are down from pre-pandemic highs, but the volume of recent shipments will take time to be fully absorbed.
Short-term hurdles remain, but hotel and office developers can now position themselves to complete their projects in a post-COVID-19 world.
Michael Phillips is Managing Director and Head of Portfolio Management at Cottonwood Group, a private equity real estate investment firm. Phillips is responsible for the company’s more than $ 3 billion real estate investment portfolio and is an expert in mortgage lending, including senior mortgages, A / B tranches, repo structure structures and mezzanine debt.