What opportunities are out there in the bleak retail and hotel sectors?

Expert explains valuation in these spaces and how originators can still win

What opportunities are out there in the bleak retail and hotel sectors?

In terms of valuation, the retail and hotel sectors have had a bleak year. REIT returns in both sectors dropped around 60% during the first half of 2020. Hotels make up a disproportionate percentage of the estimated $126 billion in distressed CRE assets and analysts are wondering if certain aspects of the retail sector can even survive. Within that overarching bleakness, however, there’s a great deal of variation.

While the COVID-19 pandemic is to blame for much of the valuation damage done to both sectors, it has worked differently at their underlying fundamentals. Many of the retail assets hit hardest by the pandemic were the same assets already struggling due to the rise of e-commerce, they became victims of COVID trend acceleration. Conversely, the pandemic has introduced new issues for the hotel sector as travel restrictions and the more widespread use of video conferencing technology pose risks to business travel. One expert explained the unique challenges and opportunities facing mortgage pros operating in these spaces.

“Right now for retail and for hotel, it’s very difficult to get financing,” said Brian Velky (pictured), managing director at SitusAMC. “In almost all cases, either short term or long term, it’s being done with some other guarantees or cross collateralization. In contrast, you can finance an industrial property or an apartment at pretty high LTVs and interest rates as low as 2.5%.”

Velky emphasized the unique sub-sectoral breakdown within hotels and retail. Retail valuations, in particular, are extremely type and tenant specific. A crucial bright spot in retail real estate has been the grocery-anchored category, he noted, as well as some standalone drug stores and other essential retail outlets. Those retail assets have seen their valuations fall only slightly - Velky estimates around 5% or less. Class B and C malls have seen their valuations fall by about 20% as the pandemic has exacerbated longstanding trends.

The biggest losers in retail, according to Velky, are actually the regional and super-regional malls that had enjoyed a resurgence in recent years with a focus on entertainment, experience, and attraction as a shopping destination. COVID restrictions and individual aversion to gathering places have derailed that particular business model, but Velky believes that as we get past the pandemic, those entertainment-focused retail assets will regain some of their value.

While hotels have been huge value losers in the pandemic so far, some observers have predicted a quicker bounce back due to pent-up travel demand. While Velky acknowledges that there is likely some pent up demand for recreational travel, the hotel sector has historically been slow to recover from major shocks. After the great financial crisis, hotels took about five years to recover their value and Velky believes there are fundamental changes brought on by this downturn that could make any bounce back slower - primarily, the impact both anxiety around the pandemic and the rise of videoconferencing will have on business travel.

Conferences, he noted, have been a consistent driver for hotels. With so many events and conferences shifting online, as well as the ease of transcontinental business meetings facilitated by Zoom or Teams, Velky believes a strong driver for the hotel industry might be fundamentally altered in a post-pandemic world. He does not think business travel will be gone, noting a widespread acknowledgement among business leaders of how crucial in-person meetings can be. However, Velky predicts a world where key businesspeople spend weeks on end travelling may not come back anytime soon.

Ultimately, he suggests that some aspects of travel real estate will recover, especially those that serve the salaried, higher-income earners who have actually managed to save money as the US experiences a ‘K-shaped’ recovery. As vaccine uptake becomes more widespread, Velky expects to see differentiation in the hotels that appeal to those travellers and those that might still be reliant on a slower business travel sector.

While the outlooks aren’t rosy for the value of hotel or retail assets, Velky believes there is opportunity for new origination in these spaces. The key for originators, in his mind, will be in ameliorating structural risk as best as possible.

“At some point, do you say ‘look, I’d rather be a lender on a well-leased, solid credit, quality retail property and get one and a half times the interest rate with much greater protection associated with the loan?’,” Velky asked. “I think we’re seeing that start to happen for solid, sponsored deals with sub 50% LTVs for repriced real estate at even sub-four interest rates and from a risk adjusted perspective that might actually be a pretty decent deal relative to what you will get for other property types that are the flavour of choice today.” 

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