HJ Sims Market Commentary: Conversions and Reversions

by Gayl Mileszko

Champions World Resort, a 435-key hotel and conference center in Kissimmee, Florida is undergoing a $14 million redevelopment and will soon re-emerge as a 352 micro studio and one-bedroom market-rate apartment complex intended as affordable workforce housing for employees of Disney and other area resorts. It is one of many hotel-to-housing conversions taking hold in the United States in the wake of the pandemic. The severe stress experienced by hotel operators in 2020 and growing interest in addressing various housing shortages are driving projects such as one in Colorado Springs, where a developer has proposed to turn the city’s second largest hotel, the Hotel Elegante Conference and Event Center, into 642 “attainable” apartments. Real estate owners with distressed assets are finding a number of interested for-profit and non-profit buyers looking to reposition their properties. Repurposing projects involving hotels with in-unit kitchenettes and bathrooms involve behavioral health, multifamily, student and senior housing. An April Jones Lang LaSalle study on hotel conversion activity suggests that the total market value of hotels sold for conversion over the next five years will range between $25 billion and $30 billion.

Hotel and Motel Conversions to Multi-Family, Student, Senior and Homeless Housing

Manchester, Connecticut is just one city that is amending its zooming regulations to allow hotels and motels to be converted to multifamily units. The 22-year old extended stay Homewood Suites by Hilton in Charlotte is planned for conversion into a market rate multifamily community. In Baltimore, an investor group just purchased the Embassy Suites Inner Harbor and plans to convert the 37-story hotel into apartment units. California is using federal stimulus funds for the new Homekey program which has purchased 94 extended stay hotels and motels to convert into permanent housing for the homeless. In New York, the 122-year-old Park 79 Hotel is being transformed into 77 units of affordable housing for seniors. A National Association of Realtors (NAR) survey of commercial brokers conducted between February and March of this year documented 187 hotel or motel conversions in progress, 57% of which were for multifamily housing, 11.7% for temporary or permanent homeless shelters, 11% for senior housing, 7.5% for student housing, and 6.4% for hospital or COVID quarantine facilities.

Reverting From Depressed to Best

Hotels were among the first to see demand drop after the pandemic was declared and lockdowns took effect, but they have been among the first sectors to see demand come back. Average occupancy plummeted to 36.7% in 2020 according to the American Hotel and Lodging Association (AHLA) and the average daily room rate dropped 30% to $92. The NAR reported that midscale, extended stay and short term rental hosts like Airbnb were less impacted than luxury and upscale hotels reliant on business and group travel. But in most markets, hotel occupancy remains well below 2019 levels. The AHLA recently studied 21 of the top 25 hotel markets, categorizing the overall U.S. industry as in a recession and urban hotels as in a depression. As a result of the dramatic drop in business and group travel, primarily in urban areas, revenues are not expected to recover fully until 2023 or 2024; in the case of New York City, a rebound is not expected until 2025. May 2021 revenue per available room (RevPar) fell 22% from 2019 levels; in urban areas RevPar was down 52%. The hardest hit area is San Francisco, which was down 70%, just below Boston, Washington D.C., New York and Chicago. Among the properties that have closed for good are the Marriott Wardman Park in Washington, D.C., the W New York Downtown, the Standard West Hollywood, and Luxe Rodeo Drive. But hotels in Tampa and Miami are another story altogether; these two markets began outperforming in terms of either 2019 occupancy or RevPar in May, and state and local hotel occupancy tax collections are up.

Hotels Built by Bonds

In the municipal bond market, Bloomberg reports that $23.5 billion of hotel tax-backed bonds are outstanding. Strong fiscal management, surplus cash, well-funded reserves and some refinancings have kept nearly all of these projects financed by municipal bonds current on debt service. Many operators and employees received a lifeline from federal stimulus; the accommodation and food services industry received more than $80.3 billion in Paycheck Protection Plan loans in 2020 and 2021. Some municipalities have even gone forward with plans for new hotel projects during the pandemic. Last December, the Virginia Small Business Authority issued $6.5 million of non-rated bonds to assist in the development of the Embassy Suites Oceanfront in Virginia Beach, secured by portions of state sales and use taxes and guest access fees. This past March, the Georgia World Congress Center Authority $439 million of bonds to construct a new upscale convention center hotel with 975 rooms adjacent to the Mercedes-Benz stadium in Atlanta to be operated under the Signia by Hilton brand. Bonds are secured by gross operating revenue generated from the hotel on deposit in a lockbox fund. A similar lockbox feature, however, secures $195 million of the bonds issued for the Hilton Austin Convention Center in 2017 that are now distressed. The hotel, which opened in 2003, had an average occupancy of 22.7% last year and the total net position of the owner and operator decreased by $19.2 million as compared to a net position increase of $12.2 million for the year ended December 31, 2019. Revenues have been insufficient to pay debt service, so there have been draws on six Trustee-held funds to make the last three interest payments; bonds were downgraded to below investment grade in March.

Municipal Bond Market News

In a municipal market with more than $3.9 trillion of par outstanding, Bloomberg reports a total of only 55 distressed and defaulted bond financings with combined outstanding par of $2.45 billion. 51% of these projects have had covenant defaults including taps of the debt service reserve funds while only 27 projects have had actual debt service payment defaults, including the January 1 principal and interest on a Middlesex County, New Jersey bond issued in 2005 for The Heldrich Hotel and Conference Center in New Brunswick. The majority of these deals were troubled before the pandemic struck. But the vast majority of muni bonds are paying timely principal and interest, a true testament to the fundamental strength and resiliency of the municipal market, the rapid and unprecedented federal and state stimulus, the talent and adaptability of project managers, and the essential nature of the publicly financed projects. Given the sudden and severe adversity, the length and magnitude of the shutdowns, and the continuing impacts on municipal sectors including mass transit, senior living, student housing, and parking systems, performance is indeed impressive. Granted, the pandemic is by no means over and financial stress persists on general obligation as well as revenue bond issuers. But Moody’s just reported that none of the bonds it rates had a virus-related default last year; the average municipal default rate between 1970 and 2020 was reported at 0.08%.

Struggling Amidst Economic Recovery

Higher prices for everything from drywall and steel to beef and gasoline place a new layer of financial stress on businesses, governments and nonprofits still struggling in the economic recovery. Last month, inflation ran at the fastest pace in nearly 13 years. The Consumer Price Index just made its largest jump since August 2008 to 5.4%, well above expectations from economists. Core CPI, a measure that excludes the prices of food and energy prices most relevant to Main Street, was up 4.5%, a jump not seen since 1991. Higher prices continue to prevail in the stock market, where major indices are up between 1.4% and 2% since June 30. At this writing, the Dow is up 493 points on the month to 34,996. The S&P 500 is up 86 points to 4,383. The Nasdaq is up 229 points to 14,733. Oil prices at $74.10 have gained 63 cents a barrel, gold at $1,805 is up $33 an ounce, and silver at $26.15 has gained 11 cents. Just about the only sector down so far in July is Bitcoin, off 3 percent at 33,149. Bond prices also continue to escalate in astonishing contrast to almost every prediction made since the start of the year, indeed since 1981 when the 10-year Treasury yield stood at 15.84%. The 10-year yield at this writing is 1.36%, down 10 basis points on the month. The 2-year Treasury has fallen 2 basis points to 0.22%, and the 30-year yield is now below 2%, down 9 basis points in July.

Fear of Missing Out

Last year, borrowers in the global corporate market came in droves to raise as much cash as possible at record low rates for their COVID war chests. Cash holdings increased to an all-time high of $5.2 trillion as companies positioned to sustain themselves through the recession, grab more liquidity than the competition, and forestall any future impediments to market access. Dealogic reported that nonfinancial companies issued $1.7 trillion of bonds in the U.S. last year, nearly $600 billion more than the previous high. By the end of March, their total debt stood at $11.2 trillion, according to the Federal Reserve, roughly half the size of the U.S. economy. The Securities Industry and Financial Markets Association reports that the U.S. Treasury raised $4.28 trillion of net cash last year and the Municipal Securities Rulemaking Board reports $516.9 billion of new issuance in 2020. Year-to-date in 2021, new muni issuance exceeds $238 billion. High yield munis have returned 5.8%, while investment grades are up about 2%. So far this month, the 2-year muni AAA general obligation yield at 0.12% is down 4 basis points, the 10-year at 0.84% is down 15 basis points, and the 30-year benchmark at 1.33% is down 17 basis points. These levels remain extraordinarily attractive to borrowers but for a variety of reasons many have not yet come to market. In the meantime, buyer demand has been insatiable in an environment where talk of higher taxes and signs of low volume in both the primary and secondary prevail. Customers have been adding to muni bond mutual fund holdings for 18 consecutive weeks. Net inflows to bond funds total $51.3 billion this year; inflows to muni ETFs total $12.08 billion. Buyers consistently outnumber sellers: CreditSights reports that the last day of net customer muni sales was on December 22. Unfortunately, there is still not much being offered to these buyers, both institutional and retail. The amount of negative net supply is estimated at $12.3 billion for July. There are $12 billion of coupon payments on top of $41.5 billion of redemptions and called bonds expected this month while the 30-day visible supply totals a mere $13.7 billion.

High Yield Offerings

So far this month, we have seen only a small number of high yield deals. The Massachusetts Development Finance Agency sold $56.7 million of non-rated revenue bonds for Ascentria Care Alliance structured with 2056 term bonds priced with a coupon of 5.00% to yield 4.04%, and the National Finance Authority sold $28.8 million of non-rated companion bonds with a 2056 maturity priced at the same level. The City of Manhattan, Kansas issued $44.8 million of BB+ rated health care facility revenue bonds for Meadowlark Hills that had a 2046 maturity priced at 2.75% to yield 2.82%. The Arkansas Development Authority brought $21.9 million non-rated charter school revenue bonds for Responsive Education Solutions that included a 2052 term bond priced with a 3.625% coupon to yield 3.92%. This week’s $10 billion calendar includes a $68.4 million BB rated California student housing bond issue for Sonoma County Junior College, a $40 million non-rated Arkansas deal for Carti Surgery Center, a $40.8 million BB+ refunding through the Public Finance Authority for Carson Valley Medical Center in Gardnerville, Nevada, a $14 million non-rated PFA deal for Ripple Ranch Recovery Center in Spring Branch, Texas, and a $150 million Ba1 rated deal for the Catholic Bishops of Chicago. Bonds come to market in the context of economic data releases including CPI, producer prices, and retail sales; data showing the resurgence of COVID-19 in many regions; the Federal Reserve Chair’s appearance before House and Senate Committees delivering the semi-annual Monetary Policy Report; the first second quarter corporate earnings of the season; an ongoing OPEC+ deadlock on production policy; and high yield corporate bond yields that hit an all-time low of 3.53% last week.

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