Expecting a tidal wave of distressed selling and recapitalizations at 30 percent to 50 percent discounts to pre-COVID values, the private equity industry raised an unprecedented amount of capital in the early months of the pandemic. Fund after fund reported breathlessly the size of their newest, distressed real estate offering and the ease and speed with which they attracted capital. In the second quarter of 2020, new funds dedicated to real estate investing raised $45.5 billion, the largest second quarter amount in each of the past five years and 24.4 percent higher than the $36.5 billion raised in second quarter 2019.
However, since then, other than some creative structured financings by the likes of Starwood Capital, Angelo-Gordon, Oaktree, MSD Capital and Ramsfield, there have been surprisingly few institutional-quality distressed real estate closings. The lament throughout PE land is that sellers have an unrealistic sense of value and lenders are not forcing a day of reckoning. What the heck happened? The answer is multidimensional.
- First, there are few “bad guys” in this crisis. Delinquent borrowers are generally trying their best to deal with an unprecedented situation and lenders have been inclined to work with borrowers rather than punish them.
- Second, Dodd-Frank successfully forced the banking industry to reduce leverage, maintain greater liquidity and limit their holdings of complex financial instruments. As a result, the banking industry entered the crisis in an unprecedented state of fiscal strength, which gave banks the financial capacity to be more flexible with borrowers.
- Third, banks recognized, especially in the early months of the pandemic, that negative press likely to accompany foreclosure actions would be intense and wisely elected not to repeat their PR mistakes of the global financial crisis.
- Finally, critically, lenders were unwilling to step into the chain of title in situations where they would be writing checks every month to cover operating losses and would also be vulnerable to lawsuits from guests and workers exposed to COVID.
With the vaccines being rolled out, lenders will continue to “kick the can” down the road and the window for buying truly distressed assets will rapidly close. That doesn’t mean that there won’t be good deals available, but the opportunity to buy quality hotel properties at steep discounts will disappear more quickly than anyone imagined. Instead, beginning late in the second quarter and extending through the rest of 2021, we will see a large number of recapitalizations, and quite a few sales, by “motivated” owners (as opposed to “distressed sellers”) at valuations around a 10 percent to 25 percent discount to 2019 levels.
With banks and securitized lenders relegated to the sidelines in the hospitality market because of their pesky requirement for trailing cash flow to support their underwriting, the debt funds should have a heyday for the next 12 to 18 months. The tidal surge that was looming on the horizon in the summer of 2020 will reach the beach as a large, but comfortably surfable, wave this summer.
Most investors view hotels as a niche investment class and place fairly strict limits on their hotel exposure. That viewpoint makes sense when one considers the relatively small size of the hotel market, the operating complexities of lodging properties, the daily mark-to-market on room rates and the cyclical nature of the industry. Interestingly, this cycle could be different, as hospitality assets will comprise a much larger share of most portfolios, especially those of private equity funds and large family offices, and for a more sustained period than we’ve seen in past recoveries.
The reason for this change is less a function of something good happening in the hotel industry than of secular changes in other classes of commercial real estate. Specifically, when one looks at the four major classes of commercial real estate, office and retail are severely challenged by the complex, still-evolving changes in demand for those assets, while multifamily and industrial have seen prices soar powered by low interest rates and a torrent of equity capital. Put more simply: office investment is a conundrum, everything but grocery-anchored retail is toxic, multifamily is overpriced and warehouse is wildly overpriced.
That leaves hotels as one of the only CRE classes where (1) assets can be acquired at a discount, (2) there is a reasonable expectation demand will eventually return, and (3) valuations are expected to recover to pre-COVID levels.
Stephen O’Connor is a principal and managing director of RobertDouglas.