Hotels? The Longer Term Opportunity in Trophy Properties

With the world going back into economic shutdown—or modified shutdown—it may be hard to envision opportunities in the commercial mortgage-backed security (CMBS) sector. That space has not recovered at the same pace as other securitized markets since March, as there are likely long-term ramifications from the widescale shift to working from home and ongoing concerns about large gatherings.

What we are finding interesting has been another troubled area—hospitality. Yes, hotels.

After a record-setting 2019, many hotels have taken a huge income hit in 2020, with some remaining closed. But we’re finding opportunities outside your typical, business travel hotel. Rightfully so. Business travel is likely not recovering to where it was anytime soon as more businesses realize the efficacy and cost savings of video conferencing. We don't think large gatherings are coming back soon either, and there will be continued downward pressure on business conference hotels. What is changing is people's attitudes about personal travel. As soon as travel restrictions have been lifted, we’ve seen people willing to drive, fly and go on vacation for a few weeks. We believe there are opportunities among CMBS representing high-end properties, or what we call trophy properties.

For example, there are Hawaiian properties with unique land attributes that have been very profitable, renovating continuously over the last decade. Those properties are also trading at very depressed levels right now. Among them are properties we believe can be long-term winners. They are typically held by very strong equity holders that aren’t going to let a 2020 cashflow depletion drive them away. Also, the leverage is typically low relative to the valuation. In fact, we would argue it's hard to figure out what value to even use when assessing loan to value. Using a 2019 valuation, many of these AAA-rated CMBS representing trophy hotels are in a 25% range. Meaning, the hotel’s value needs to drop about 75% for the AAA bond holders to take a loss—that's pretty extreme.

Looking back to where some of these hotels transacted post 2008, the cashflow drop still doesn't make much sense. What’s more, even at 25% of 2019’s valuation—albeit the highest valuation for some of these properties ever—that’s still well below replacement cost. You couldn’t build a hotel at some of these prices.

We think many of these trophy properties are here to stay. Maybe they will be challenged for a time, but people will likely still want to visit these places when we do get a vaccine—maybe that’s the back half of 2021 or maybe it's 2022. It seems like a short-term, very painful carry for the owners, but for the bond holders, the situation appears much better.