There’s a wide disparity in performance and recovery in the hotel market across the UK. Demand for rural and leisure focused assets was strong over the summer due to continued international travel restrictions. Hotels in popular UK holiday destinations such as Cornwall or the Lake District enjoyed a significant rise in ADR and RevPAR, with occupancies reaching close to 100% in certain locations.
In contrast, many city centre and airport hotels, or assets with an event or corporate-focused offering, are still operating below pre-COVID-19 levels. For many of these hotels, the return of international travel will be key to their recovery. While the US recently reopening its doors to international visitors is a hugely positive milestone for transatlantic travel, according to data released by Tourism Economics in July 2021, international journeys are not predicted to return to pre-pandemic levels until 2024.
Furthermore, many question whether business travel will ever fully return, in the same way that it never recovered after the global financial crisis. On one hand, technology has made remote working possible for many jobs and corporate travel may seem less appealing to business leaders who are achieving significant costs savings and who have sustainability targets to meet. However, we may find that business leaders want their teams to meet in person at larger, longer events more frequently than they did pre-pandemic. So while the Global Business Travel Association is forecasting business travel spending to 'surge' in 2022 and fully recover to pre-pandemic levels in 2024, we expect corporate travel demand to be different in a hybrid working world.
Will hotels reconfigure themselves to meet this change in demand, for example by offering co-working spaces? Will we see more people 'working from holiday'?
The uncertainty around the recovery of international travel and business travel makes it challenging to predict future demand or produce reliable forecasts. Operators will need to keep closely monitoring and adapting their models to cater for these potential shifts in demand.
As well as market uncertainty, operators are dealing with other significant challenges:
UK hospitality estimates there will be 188,000 vacancies at any one time over the next 18 months. According to Savills Research, 30% of hotel operators have had to reduce service levels to cope with demand. We may see hotels investing more in technology to automate tasks to help mitigate this issue.
To attract staff, average salaries for lower wages are expected to increase by approximately 25-30%. This comes on top of food and energy cost inflation.
Supply chain issues
Countrywide supply chain issues present challenges, with the potential for rising costs as operators scramble to source reliable supplies.
Managing increased costs and maintaining service levels with fewer staff will be a key issue for operators over the next year.
The government support that cushioned the hotels sector throughout the past 18 months continues to unwind. The furlough scheme ended in September 2021, but the next few months will see further potential stress points:
We expect most hotels will opt to pass on the VAT increases to customers and for the increase to be less of an issue for corporate guests who may be able to reclaim VAT. But what impact will these increases have on demand from leisure guests? Will the additional cost be enough to change consumer behaviour in favour of cheaper alternatives?
Hotels will need to continue closely monitoring the unwinding of these government support measures and assess the impact on liquidity and covenant headroom.
There's a consensus that lenders worked extremely hard during the pandemic to support the hotel industry, providing covenant waivers, capital repayment holidays, and facility extensions to give hotels time to recover.
Now that recovery is under way – albeit patchy – lenders are re-evaluating their portfolios. Many find themselves lending at higher LTV and/or lower than normal debt service cover ratios. Depending on their confidence in a particular asset, lenders may look to reduce their exposure. After a period where operators may not have had to comply with financial covenants, many will now have to do so or face challenging conversations as lenders potentially look to trigger a refinancing or restructuring process.
The main clearing banks may be reluctant to aggressively enforce on loans – keen to avoid the reputational damage sustained after the global financial crisis. However, the lender landscape has become much more diversified since 2008, with a myriad of non-bank lenders entering the market. Will debt funds feel the same reluctance to enforce a covenant breach?
The resilience of asset values in the hotel market – largely due to an abundance of available capital and continued demand as an asset class – only assures lenders that they will be able to recover their capital via a disposal should they wish to reduce their exposure.
As loans made over the past two to five years approach maturity, the level of refinancing risk will be higher for many hotel businesses. We expect senior loans with LTVs of more than 60% to be the exception rather than the norm, meaning that in some cases, operators will need to find equity or mezzanine finance to fund any shortfall in the capital stack.
In addition, some lenders are asking for interest on account or operational loss reserves leading to a potentially significant cash requirement on Day 1.
Operators are likely to find that margins on newly refinanced facilities are higher than their existing facilities, largely because the risks and uncertainty of lending in the hotel sector has increased. The Bank of England is also widely expected to increase the base rate soon, with some economists predicting the base rate to increase to 1% by the end of 2022.
As well as higher interest costs and debt levels, hotels may still be generating lower EBITDA and cash flows than they were at the time of their previous refinance. Consequently, there may be insufficient cash available to service the current level of debt. One of the options available in these situations is to include an excess cash sweep mechanism to allow the debt to be repaid quicker if trading is better than expected.
Lenders will be aware of the uncertainties facing hotels, but they will want to see a clearly articulated plan that demonstrates how the debt will be reduced to more sustainable levels.
We believe the challenges set out above and the need for additional equity, or to release cash to cover debt service, will be a key driver of refinancing and restructuring activity in the market.
Given the wide level of uncertainty in the market and the variance in projected recovery of different subsectors, lenders are undertaking increased levels of due diligence.
Business plans and financial forecasts are facing deeper interrogation and need to be based on careful and realistic analysis. Operators can no longer extrapolate historical performance as evidence for their forecasting. For example, many UK hotels have enjoyed a significant rise in revenues over 2020 and 2021, but should international travel return next year, how will that affect trading performance in 2022 and 2023?
Lenders want to fully understand the growth drivers and segmentation of forecast revenues, and ultimately, to understand whether the projected recovery profile works. They will also want to understand the hotel's ability to absorb higher interest costs. Given the uncertainty around future trading, we expect breakeven and scenario analysis to remain a key area of focus for lenders in 2022.
I agree that the phrase 'cautiously optimistic' is a good way to describe the current outlook for the hotel sector. As the sector navigates through this transition period away from government support to self-sufficiency, I expect we'll see an uptick in both new lending and restructuring activity. Operators who've pivoted towards buoyant demand - whether leisure or business – and who continue to maintain a resolute focus on cash generation, will stand most chance of success. Particular attention needs to be paid to:
New variants of COVID-19
The recent discovery of the Omicron variant is a timely reminder that the recovery may be bumpy for some operators.
Forecasting
Producing reliable trading and cash flow forecasts given the number of uncertainties in the market presents significant challenges, and yet is essential to achieve funding required for survival. Operators will need to put together a convincing business case to attract new funding.
Liquidity
Careful cash management is needed to enable operators to understand what their liquidity and covenant headroom will be in a variety of different scenarios.
Costs
Operators face the juggle of keeping costs down whilst maintaining good service levels. This may be particularly difficult while there is a shortage, or worker and current supply chain issues continue.
Capex
With much expenditure put on hold over the pandemic, some assets will require investment to maintain their value. Global supply chain issues have significantly increased the cost of construction in 2021 and this trend looks set to continue in 2022, which may lead to new hotel developments and major refurbishment capex being deferred or costing more to complete.
Refinancing risk
Many operators will face increased pricing or an equity gap when they next refinance.
Whatever happens, early communication with lenders, investors and stakeholders is key to maintaining support during pressure points. An experienced adviser will be able to help with the many nuances of the debt, equity, and restructuring markets.
