By Michael Zukerman and Peter Griffith

Law360 (July 22, 2020, 5:59 PM EDT) --

Michael Zukerman

Peter Griffith

The COVID-19 pandemic and the related restrictions on travel, business activity, and leisure activities have combined to create the single most disruptive event for the overall economy in the modern era.

The hospitality industry, in many respects, has suffered the economic burden of this pandemic far more than any other industry sector. As of June, industry participants, including owners, operators, investors and lenders, either have been directly impacted by or witness to the pandemic's ongoing toll:

• Tourism Economics Inc. estimates that the impact will be nine times worse than 9/11;

• Oxford Economics Ltd. projects a 50% plus revenue decline in 2020, resulting in an industry loss of $124 billion;

• STR Inc. estimates that as many as eight in 10 hotel rooms may be empty;

• Several analysts believe that as many as 18% of standing hotel inventory may never reopen, may be acquired at steep discounts, or may be redeveloped for other uses, such as senior/assisted living or multifamily developments; and

• 70% of hotel employees either have been laid off or furloughed, representing nearly 4 million employees who either work in, or for, the hotel industry as of the end of March 2020, according to Oxford Economics.

Senior management in major brand groups are trying to express hope, and resolve these issues in weekly video presentations, but no one knows how long the pandemic will last, how the lifting of restrictions will progress, or when wide-scale travel will resume. It is not even clear if there will be a second wave or a second wave within the first wave?

The full, net impact on the near-term economy is unclear. While the current impact is far more severe than the shock events of the terrorist-related 9/11 and finance-related 2008 disruptions, the hospitality industry, together with the overall economy, went into this health-related downturn in much better shape.

An analysis of these past downturns clearly indicates that the COVID-19 impact on the hospitality sector is unprecedented, but if history of these past cycles provides us perspective and guidance moving forward, the industry will recover and survive. Undoubtedly, this process of recovery will reshape the landscape of the industry and, in doing so, create the opportunity for potentially strong returns through well-timed and well-executed investment strategies.

Potential Strategy

One of the more powerful and currently available strategies to address this priority is commercial property assessed clean energy, or C-PACE,  financing. C-PACE will create liquidity to provide owners with the ability to weather the 24-36 plus month recovery cycle until their respective markets settle into their own new normal.

As of the writing of this article, 36 states and Washington, D.C., have passed laws enabling C-PACE programs; 20 of these states and D.C. have active C-PACE programs. Most importantly, eight of these states have accepted look-back program modifications, described below, with up to 18 states considering the look-back modification on a case-by-case basis. The look-back modification creates an opportunity for C-PACE providers to inject cash into a completed hotel development that is less than two or three years old.

States and cities with look-back modifications are summarized below:



Proceeds, including third-party fees and program expenses, can approximate 20% of stabilized value. These proceeds represent a unique source of bridge capital that can be used to:

• Secure operational continuity: Fund much-needed working capital and reserves during the COVID-19 period;

• Navigate the COVID-19 recovery cycle with lenders: Reduce construction/senior loan principal and establish debt service reserves; and

• Address COVID-19 construction-related issues: Mitigate the financial impact of construction cost overruns.

The forecasted decline in market value created by the pandemic will have a significant and undesirable impact on the equity capital stack. The more immediate and serious problem for many hotels will be the insufficient level of earnings before interest, taxes, depreciation, and amortization available to pay debt service over the next one to three years, as hotels struggle to restart business from minimal occupancy levels during a recovery cycle tethered to multiple external factors in a post-COVID-19 world.

These factors include, the availability of a vaccine, vacation preferences, the level of business travel and the propensity of groups to resume frequent gatherings.

C-PACE Solutions

What realistic choices does a bank have in dealing with short-term loan modifications through major troubled debt restructuring without ultimately dealing with the adverse effects related thereto? Does a lender really want to fight through a foreclosure process and likely Chapter 11 counter-filing by the borrower?

An obvious near-term solution is consenting to a look-back C-PACE financing as a source of the much-needed bridge capital. Unfortunately, many lenders are resisting the use of C-PACE because the financing represents expanded real estate taxes that are prior in right to the debt service required by the first mortgage.

In reality, the underwriting of a project employing C-PACE financing should be evaluated in much the same manner as a ground lease. In a typical ground lease transaction, the senior lender agrees to fund its first mortgage based upon the value of the property after the tax requirements of C-PACE financing and also uses debt service coverage after the tax requirements of the C-PACE financing.

This then raises the question: Why would current lenders not consent to mid-construction or look-back post completion C-PACE funding? The practical answer is that lenders should consent, as it is in their best interests to do so. While the COVID-19 pandemic fails to present clarity to many questions and challenges facing lenders today, a few simple and straightforward procedures should be adopted to address the situation:

Stabilize Loan Performance During the Next 24-36 Months

While no one has a crystal ball regarding the COVID-19 recovery curve, it is reasonable to expect that owners will need cash resources to stabilize their operations and meet the financial demands of their senior loan financing. C-PACE financing can be structured to create interest reserves that would allow operators not only to carry the new C-PACE payments, but also to carry the first mortgage debt through the current health crisis, while enabling first mortgage lenders to effectively control the available funds to ensure no leakage to equity.

Accelerate Pay Down of Loan Balance

As a working partner in the process, lenders can negotiate a pay down of their loan to reduce the leverage level and debt exposure on lenders' balance sheets and create much-needed liquidity back to those lenders. This would provide both lenders and their borrowers the opportunity to positively navigate through the COVID-19 recovery period.

Nonacceleration

While the full assessment amount is recorded on property records, only the annual assessment typically representing only 1.5-2% of the property value can be collected, even in a default situation.

Lenders' Foreclosure Rights

C-PACE does not require an intercreditor agreement allowing the senior lender the ability to foreclose on its mortgage interest as if it were the sole financing on the property.

The recovery plan will need to acknowledge the decline in net operating income and the corresponding decline in asset value. There is no managed solution for increasing the market value of the asset, as the recovery of value will be entirely in the hands of time and external market forces.

C-PACE financing does represent a managed solution by injecting new cash into the hotel operation without alternative funding providers (e.g., mezzanine financing, preferred equity, etc.) seeking to extract major considerations from the equity stack or seriously threatening the position of the senior lender.

The hotel owner also benefits from the C-PACE funding strategy by establishing a cooperative relationship with its lenders, while at the same time, receiving working capital to help it pay bills as it works through a multi-year occupancy recovery.

Conclusion

By buying the time needed for the market to recover and for the value of the hotel to increase, accordingly, the C-PACE funding strategy enables the equity capital stack to survive and enjoy the recovery of its value. For those hotels located in the states that offer C-PACE look-back modifications, a win-win strategy for debt and equity stakeholders is achieved during this historic market disruption.

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Michael Zukerman is of counsel at Warshaw Burstein LLP and Peter Griffith is a managing director at Whitestone Realty Capital LLC.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. 

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