Understanding the “COVID Discount” in Hotel and Resort Acquisitions

As many have read, because of the COVID-19 pandemic, 2020 was the worst year on record for travel and tourism, accounting for more than USD 4.5 trillion in losses globally. While vaccines have arrived, government bureaucracy, poor planning, supply chain issues, and individual skepticism have made full reopenings difficult, if not impossible.  2021 may turn out to be better than 2020, particularly for domestic, seasonal tourism, but even 15-18 months of pent-up demand is not going to fix the overall problems across the industry.

Unlike traditional real estate, hotel and resort properties are businesses first and foremost with their financial condition being more important than the land and the buildings on that land.  The value of the land may appreciate over time no matter what, but the buildings on the land, especially if they are not generating revenue, offsets the land value appreciation.  Hotels and resorts as real estate are much more complex than accepting rent from tenants or buying materials, paying for labor, and selling it at a profit upon completion.  It is also different from commercial real estate where there are comparative values that can be used to determine a cost per square meter or square foot.  If you take one general location and compare prices, you may not find any legitimate comparison.

In the past, due to year-over-year, often exponential, growth, many hotels and resorts, especially those in seasonal locations, took loans to expand and renovate while not knowing what was going to happen in early 2020.  This created a situation where unserviceable debt has permeated the hotel and resort industry.  Since the pandemic began, lenders have prolonged repayment, delayed as much as they could, and done almost everything they can to work with property owners to avoid having to act.

But how long can a lender wait?  12 months?  18 months?  24 months?

Nearly all hotel and resort portfolios at nearly every lender globally are near total default.  Governments have intervened but this has not been a solution, just a short-term reprieve.  Nevertheless, the worst-case scenario for a lender is to force liquidation and potentially be stuck with a property they cannot sell (or accepting the less attractive option of taking a loss at auction).

This has led to lenders telling hotel and resort owners to sell before the situation escalates.  And owners cannot sell a property in 2021 for what it was worth after a record-breaking 2019 when there has been no clientele and no substantive revenue in well over a year.  Not only does the property itself have unserviceable debt, but it also resides in a business that has been losing money since early 2020.  In today’s market, what property owners are offering a buyer is a hotel or resort that has potentially massive, unserviceable debt as well as a business that has been losing money and, in many cases, has been closed for over a year.  That’s not an attractive proposition unless the sale price is greatly reduced.

Emotion is a huge factor in tourism.  People travel based on emotion.  Locations popular today may be unpopular tomorrow.  Hotel and resort owners, operators, and staff try to create an experience.  This is emotion.  Owners also have a huge sense of pride in their property.  Pride is an emotion.  So, despite the fact a property may carry more debt than its value, owners want to sell for the most they can get and often have unrealistic expectations on what someone is willing to pay.  Realistically, buyers never pay high prices for underperforming assets.  Investors look at something that has potential or something that is doing very well, but they are not going to look at something failing that is unrealistically expensive… after all, past performance is not a defining component of future profitability, especially where there are so many unknowns with respect to ever-evolving travel trends and the pandemic.

Occupancy rate percentages do not equate to profitability.  A beachfront resort may have a 100% occupancy rate due to relationships with all-inclusive travel agencies, but if the per-night revenues are low, the property may not generate enough overall revenue to service any debt.  Moreover, ever-changing travel restrictions and cancelations make occupancy expectations useless for predicting outcomes.

Then there are the all-inclusive travel agencies who sell packages, with their operation functioning like this:

They tell seasonal hotel and resort owners that they will guarantee occupancy but only if the property charges a small amount; and if the hotel or resort refuses, the package travel operator will simply send their customers to other hotels.

The property owner really has no choice, the most they can make is defined and has a ceiling.  All-inclusive means there is no room for revenue anywhere else and it limits the properties earning potential.  If the most an owner can make is $40 per guest per night and there is a finite quantity of rooms, the revenue ceiling is established from the outset.  So, what do these property owners do?  They go to their bank, take a loan against their hotel and earnings to expand and build more rooms.

When you mix all these factors together, what you end up with is a situation where a hotel or resort property can be purchased at a discount.

Now, to be clear, there is a difference between “discounted” and “distressed.”  Distressed refers to an asset that is carrying so much unserviceable debt the lender is on the verge of acting, if not already actively forcing the situation, e.g., repossession, foreclosure, liquidation, etc.  Discounts, on the other hand, are the percentage less than valuation that the owner is willing to accept.  The distressed debt component may be part of an overall discounted price, but it is not the only factor.

Many hotels and resorts available for acquisition today had financial issues before the pandemic.  Those properties were not necessarily affected by the pandemic because they may have already been closed and they likely need a lot of repairs and renovation.  On the other hand, there are many properties available today at a substantial discount who may have had concerns before the pandemic, but that were exacerbated by the pandemic.  These are the properties worth exploring:  available today because of the pandemic and not in need of extensive renovation.  Even more, there are property owners that simply refuse to go on any further given the hardships of the pandemic and have a desire to get out of the business because they realize that meaningful “recovery” is not going to happen in 2021.  They want to get out now before their property is worth even less.  The common thought process would dictate that the longer the hotel is underperforming the less it is worth.

Investors often look at hotels and resorts without understanding the reality of the situation regarding the financial component.  Hotels and resorts, even in prime locations, and before the pandemic, have high operating costs, operate on a small margin, and an investment today may take 15 years or more to realize profitability, much less an actual return on investment.  True profitability and wealth generation on a hotel may take 20 years.  As many bankers and advisors will say, a hotel or resort may be a “trophy asset” but an overall waste of money unless the client is truly in the hotel industry.

But what does all this mean?  In simplest terms, if a property can be bought today at a discount, particularly a property without the need for costly renovations that eat away the discount, with the goal being to re-attain its 2019 valuation in 5 years, the return on investment is significant.  And if a geographically diversified portfolio of properties is acquired at an average 50% discount on 2019 valuations in 2021… doubling the valuation in 5 years to simply re-achieve the 2019 valuation… the initial investment is doubled.  It is a safe investment in real assets.

This is GESCO T1 Ltd.’s basic strategic business plan.  And in a world of unstable, soon-to-be-corrected markets, low interest rates, rising inflation, and a lack of double-digit returns, a bond, over-collateralized and capital guaranteed by real assets, paying a 20-50% coupon after 5 years, becomes a good opportunity for diversification and return on investment.  It is designed for anyone who sees value in fixed-income, collateralized investments, not merely for those who invest in hotels and resorts.

In the end, if the bonds default, the investor sees their initial investment returned; however, there is no need for concerns about liquidating assets.  Everything is handled by third parties.  That is the problem banks and other lenders have globally.  Lenders and investors lose their money and then must wait – often years – to merely get a portion of their investment.  And in today’s negative interest rate world – where it costs money to simply keep cash in the bank and where 100-year government bonds paying a negative interest rate are bought without hesitation – receiving the initial investment capital plus a very good coupon payment in 5 years without loss is an easy decision for investors that understand short-term massive equity market returns might not be around in perpetuity.