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In a COVID-19 World, Hotel Owners Must Be Wary of Vulture Funds

Hotel owners and investors face a business landscape that has drastically changed this year.

The first ten months of the year have presented hotel owners, operators and investors with a series of unprecedented challenges. The business environment surrounding the hospitality industry in 2020 is proving to be rapidly changing, disrupting and shifting. The COVID-19 pandemic and other recent headlines have shown us all that urban areas—a and their major hospitality centers—must adapt to a new marketplace that none of us could have predicted. However, for the savvy hospitality property owner or investor, such periods of great change can present equally great opportunities.

In a COVID-19 world, not all hotels will be created equal. As the pandemic subsides, hotels with a destination resort character and prominent outdoor or wellness components—as well as hospitality properties that can quickly pivot to these types of experiences—are better situated to take advantage of the travel surge expected to come after the national reopening.

As the winter months begin, we should expect a decent percentage of families to follow their annual tradition of taking a winter vacation. Based upon feedback we are hearing from our clients, we expect travelers to focus on outdoor experiences, such as national parks or beaches. After enduring months of being subject to Stay-At-Home directives and being encouraged to embrace social distancing, U.S. travelers will minimize their potential health exposure by choosing experiences and properties with outdoor settings that also provide privacy. Hotels that are located along or near major routes or thoroughfares should similarly see an uptick in activity, as we expect families to embrace road-trip vacations over the winter months.

That is not the same picture for hotels in concentrated urban areas that were considered hotspots of the pandemic. Traditional “big-box” hotels located in traditional downtown areas, especially in cities that have been identified as hot-spots of the pandemic, will have the greatest challenges to return to normal occupancy rates. The design and location of these hotels, as well as their typical reliance on hosting highly attended special events such as business conferences, will require owners to consider saving whatever equity they may have in their property by transferring the property at a discount.

With more and more studies showing that vacation experiences with outdoor components will be “in” this year, the management teams of urban hotels should take note of this trend and try to adapt their properties as much as possible. The operators of hotels with some degree of outdoor facilities can re-emphasize these aspects of their properties, especially if they weren’t already taking advantage of them prior to the pandemic. These areas can be refurnished or renovated to play a greater role in the program of the hotel. Alternatively, these hotels can add a wellness center component to their properties. While making such an important operational change would be difficult for any business, for urban hospitality properties it might be a life-saving solution.

Some hotel owners and investors, however, will decide that operational approaches to the COVID-19 recession are insufficient—and that now is the time to sell. These decisions are, of course, dependent on the investor and his or her investment strategy. Hotel dispositions will also be motivated by a need to avoid (or resolve) a default with respect to their debt financing. Depending on their location and nature of their operations, hotel owners will be challenged to satisfy the Debt Service Coverage Ratio, or DSCR covenant that is customarily included in their loan agreements. With the cashflows of many hotels at historic lows, DSCR covenants for some hotel owners will become harder and harder to meet. As a result, we expect to see an uptick in sales of hotel properties and the equity of such properties in the coming months. For investors seeking an exit from their obligations to their mortgage lenders, a timely disposition of a majority or minority share in their hotel properties may be their only chance at recovering some of their equity. Whether these prospective buyers make their lives any easier, however, is a different question entirely.

In recent months, we have been repeatedly approached by “white knight” investors and clients forming opportunity funds that seek to take advantage or rescue distressed hotels and/or related debt. Hotel owners must be wary that several “white knight” investors are in fact vulture funds in disguise. Generally speaking, the term “vulture fund” usually refers to a hedge fund, private equity fund or distressed debt fund that knowingly searches for and buys equity interests and/or debt securities in distressed investments, all while taking what could be considered an aggressive approach with the concern in question. They stand in direct contrast with true “white knights”, or investors that instead seek to cooperate with the management teams of the businesses or assets in which they invest. The merits of these two approaches aside, the average real estate investor would certainly prefer to deal with the latter as opposed to the former. But when faced with an appealing but seemingly out-of-nowhere offer or term sheet from a surprise party, how can investors know whether they’re dealing with a vulture or white knight?

Fortunately, both of these approaches do have identifiable traits and characteristics. First and foremost, the branding and reputation of a prospective investor will reveal a great deal. Well-established vulture funds will have a corresponding reputation for how they approach the businesses in which they are investing. When faced with a new partnership or lending opportunity, talking to other real estate professionals and investors about the counterparty in question is likely the best way to get the “word on the street”. White knights and vulture funds also tend to stick to different sectors and subsectors of the real estate industry. Vulture funds are much more likely to be credit funds (or even hybrid funds making a combination of equity and debt investments). They are also more likely to function as capital allocators, while white knights tend to be local operators. The term “vulture funds” is typically used to characterize investors in the private equity and hedge fund spaces, and—for example—is rarely used in reference to insurance companies engaged in real estate investments. From a negotiating perspective, vulture funds even have a different set of priorities than white knights. They are more likely to insist on stringent financial and operating covenants, so that they can keep their partners or borrowers on very, very short leashes throughout the duration of their relationship. With respect to lending transactions, vulture funds are also far more likely to fight for onerous prepayment premiums during negotiations.

Hotel owners and investors face a business landscape that has drastically changed this year. They are facing challenges related to both operations and capital. Any owner considering taking on new investors, lenders or partners should consider the nature of the proposed business relationship in question, and how it has been affected by the pandemic and other recent events. What hasn’t changed for hospitality professionals, however, is the importance of understanding the new environment in which we are in and how that can be used to their advantage.

Luis Flores is the Managing Partner of Saul Ewing Arnstein & Lehr’s Miami office. He represents developers nationally in the acquisition, construction, development, leasing, refinancing and sale of vacant land, condominium projects, multifamily housing apartment complexes, hotels, commercial shopping centers, and commercial office buildings. Luis also focuses his practice on banking and lending, having represented national and local financial institutions in commercial mortgage and mezzanine loan transactions involving properties throughout the United States.

Teo Victoria is an Associate in Saul Ewing Arnstein & Lehr’s Miami office. He focuses on real estate matters, including contracts for sale, closings, leases, due diligence and title reviews. 

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