Investing in the future, today




Andrew Harrington of AHV Associates looks at the potential effects of the Covid-19 pandemic on the hospitality investment landscape.

It is clear that we are very likely now through the worst of the pandemic in most of the developed world. Infection rates and daily deaths are well down on the peak, and countries are starting to relax lockdowns slowly and cautiously in order to minimise the risk of further peaks. Governments have mostly responded to the pandemic with rapid and substantial support for economies, especially in the developed countries. This is unlike the situation post-2008 when support was limited and late.

Indeed, the IMF believes that this support should be enough to ensure that the rebound in economies this time should be much stronger and earlier than post-2008, albeit with the caveat that it will take several years to get back to the levels of economic activity that would have been the case if pre-Covid-19 trends had continued.

There are of course continued risks, including the possibility of further lockdowns in response to future uncontrolled peaks, but with testing becoming more available daily and the world’s pharma science community completely focused on developing effective drugs for the treatment of and vaccination against Covid-19, it seems likely that we will look back and see the March 2020 to April 2020 period as the moment of maximum uncertainty in this pandemic.

This is important, because the level of uncertainty determines the availability and price of capital. Stock markets have already recovered approximately half of their falls from their February 2020 peaks to their March 2020 lows, with the MSCI World Index now at levels last seen in February 2019. At its low point in mid-March 2020, it was back at March 2016 levels. 

Furthermore, stock markets are a reasonable proxy for the general mood amongst providers of all types of capital, and capital providers invest based on expectations as to how the future will pan out rather than based on the reality of current or historic events.

With this in mind, now is the time to consider the future of hospitality in the post-Covid-19 world of tomorrow, because there will be a tomorrow, and hospitality most certainly has a future.

My observations can be divided into three buckets: Operational, the future relationship between property owners and operators, and the availability of finance.

Operational
It is clear that, when hotels are permitted to reopen, they will have to deal with a shellshocked public unable (or unwilling) to travel and scarred by the pandemic. Set against this will be the desire to get out and about, meet people and travel somewhere!

As has been stated by many hotel commentators, domestic leisure will likely recover first, probably strongly, followed by domestic business. International leisure and business will start to recover only when international travel restrictions are lifted.

It seems to be received wisdom now in the hotel world that customers will require hotels to assume much higher standards of cleanliness and perhaps enable easy social distancing. I think this is very likely to be true in the short term and will probably be required by governments for a period of time, but in truth I do not buy the arguments that it will be required by customers beyond this initial period.

It reminds me of the increased security requirements at airports, and often in hotels, post 9/11. These were put in place for a year or so but then were relaxed as it became clear that they were not necessary as people understood that, although the risk of terrorist attack had increased, it was still incredibly unlikely that they and their families would be impacted.

Don’t forget that pre-Covid-19, hotels had been around for many decades without the sort of cleanliness and social distancing standards being discussed now.

There have been incidences of severe illness arising out of hospitality venues e.g. Legionnaires Disease, which is a bacterial disease that can spread via air conditioning systems, and first arose at a convention hotel in Philadelphia, USA in 1976.

Indeed, cleanliness standards were improved substantially as a result of that. But Covid-19 did not arise in hotels and did not spread as a result of lax hotel hygiene standards. Therefore, if cleanliness standards in hotels post-Covid-19 are necessary, it will be because of the perception of risk rather than the reality of risk. Ultimately, perceptions tend to move towards reality.

The same is true for social distancing, which was implemented as an emergency measure to quickly arrest the spread of the virus. So far it has worked, and I expect that as the number of cases decline, outbreaks are controlled and the risks are perceived to diminish, we will all get back to our old ways.

Likewise, international conferences will come back with a bang, probably in 2021, as we all like the informality of networking at these events! It is simply not the same with Zoom…

Relationship between property owners and operators
This will fundamentally change as it has become clear that having a lease with a good covenant does not necessarily mean that the property owner will always receive rental payments.

I would expect those companies who continue to pay rent as normal will get their pick of new sites in the future. Those who do not will find that landlords will require higher deposits, and maybe a share of the profits of the hotel, in addition to a basic rent. Some may even insist on management contracts, with much easier termination provisions.

In short, however it is constructed, there will be a requirement for much bigger returns to property owners for those operating companies who did not pay rent during the crisis period compared to those who did.

Availability of finance
As previously noted, there is a very large amount of capital in the system -in banks, debt funds and private equity funds - and it all needs to be invested in real companies for the providers of finance to make acceptable returns. Specifically:
• The amount of equity and retained reserves in European Banks (known as CET1-Common Equity Tier 1), is more than twice as big as in the 2008 period
• Unspent funds in European Private Equity funds is 50 per cent more than in 2008, and perhaps ten times as much in European debt funds.
• Moreover, and critically important, the rate of return for the risk-free benchmark, government bonds, is hugely lower than in the 2008 period - less than 0.5 per cent now vs three to four per cent then.

All this means that banks are now much safer than in 2008 and should be able to absorb any likely losses without any significant impact on lending. Furthermore, debt funds have a substantial amount of unspent capital available and will be looking to fund any attractive opportunities that prove to be too risky for the banks.

Based on conversations with numerous funders in the last four weeks, it is clear that debt and equity capital is indeed available and investors are keen to deploy it in attractive opportunities.

Having said that, of course, risks have increased, and funders are clearly more selective and price sensitive than pre-Covid-19. Also, there are practical difficulties in pursuing potential transactions e.g. how do you assess an opportunity to invest in the hospitality space unless you can visit the hotel?

However, investment fundamentals are the same as before - valuations are determined by expectations for future cash flows, discounted according to the investor perception of risk, which determine their required investment returns.

Many funds are seeking to acquire high quality assets at discounted prices. I have to say that it is unlikely that they will be able to transact on that basis, simply because there is so much money looking to do the same thing. Furthermore, thanks to government support and a strong banking sector, I suspect that the level of distressed sales expected by some in the financial community may prove to be disappointing.

I know that transactions are being initiated in the current environment, and I would expect them to complete once the lockdown restrictions are lifted enough so that physical due diligence etc. can be done.

Furthermore, I think the pricing and structure of completed transactions could ultimately turn out to be only modestly more favourable to the investor than what it might have been pre-Covid-19, due to competition from the large amounts of capital currently available for investment.

All in all, good businesses will survive the current pandemic, and good business plans are still fundable.

I do not know whether we are at the beginning of the end or the end of the beginning, but I do suspect that the hospitality industry in three years’ time will look remarkably similar to how it looks now, and that there is plenty of capital out there available to invest in that future, today.

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