In our view, the lodging and travel sector will be among the last to recover once the pandemic has subsided--as the need for social distancing, quarantine, and travel restrictions extends into 2021--and could be several years before a full recovery. With continued volatility in earnings expected, the ratings trend for hotel operators will be decisively negative this year. The lodging sector globally has a high number of investment-grade companies, and six issuers rated 'BBB-' have negative outlooks, therefore at risk of becoming fallen angels.

For the broader industry, we expect that revenue could decline by 50% in 2021, with EBITDA falling by more than 50% and dismal cash generation. Even so, the pandemic's impact on hotel operators across Europe has varied, and we expect this to continue. Both operators' and landlords' business models have faced disruption during the pandemic, and the industry overall is grappling with the potential for long-lasting effects.

The impact on the broader sector also has different implications for our ratings on European hotel REITs and CMBS. While we expect asset valuations for REITs to decline from 2019 levels, we believe that most of them will restore credit metrics at levels consistent with their current ratings within the next two years, because of fixed-leases or diversified activities. However, hotel asset devaluation of more than 25% would likely lead to lower ratings. For CMBS, we have so far adjusted some of our long-term cash flow assumptions for the transactions we rate.

Pent-Up Leisure Travel Demand Fuels Optimism About Recovery, Albeit A Slow One

S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up, and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Chart 1

During the first half of 2020, Europe's lodging sector was more impacted than that of other regions when compared globally due to stricter lockdown measures. International travel only resumed gradually in the late summer months. In July and August, when some countries reopened, hotel occupancy in these areas rebounded to 40%-50%, even climbing to 65% in some leisure-based hotels, reflecting pent-up demand from primarily leisure travelers. However, when European countries began introducing second and third lockdowns in October through December, demand dipped, and occupancy fell back to 20%-30%, reflecting only the need for small- and medium-enterprise (SME) business travel.

In 2021, we expect that most hotels and lodging companies in Europe will face difficultly in the first half of the year. We believe that the EU may be able to vaccinate 70% of its adult population by late July and people over 65 by the end of April, and the U.K. and the U.S. should also reach 70% by July. Any delays in ramping up production or distribution, or significant hesitancy in getting vaccinated, might mean the 70% target for EU adults isn't reached until late August or early September.

Hotels and lodging companies generally generate the bulk of their revenues in the second and third quarters of a financial year, which means that vaccine delays could translate into a challenging 2021. We expect revenue could fall by 50%, with an EBITDA decline greater than 50% for 2021, reflecting the slow and fragile recovery for the sector.

Chart 2

Hotel Operators' Earnings Will Stay Volatile In 2021, Though Some Will Fare Better

In most cases, hotel owners and operators are different parties. For the past decade, many operators have shifted from owning or leasing the real estate to become asset light. From a credit perspective, we favor operators with asset-light lodging business models. Under these models, revenues mainly comprise management and franchise fees compared with operators that own or lease hotels. Between the managed and franchisee fee model, we believe the franchisee model is more resilient, as it transfers most of the costs to franchisees, allowing the hotel to maintain low operating leverage to withstand periods of stress, which in turn lowers its earnings volatility.

For hotels that depend on international demand, we expect that they will remain heavily affected by travel bans, mandatory testing, and quarantines for cross-border travelers. For that reason, we believe that domestic drive-to hotels will recover quicker than hotels in key gateway cities or by an airport, which rely more on international demand. Additionally, in our view, upper midscale, midscale, and economy segments with limited services will pick up faster than luxury and upscale hotels that depend on corporate travel, international tourism, and services, which could be affected over the long-term.

In addition, hotel and lodging companies with a sizable presence in nonurban markets are performing better than those in urban ones. Revenue per available room (RevPAR) in nonurban markets declined 45% in March 2020, compared with over 60% in urban markets.

'CCC' category represents 56% of the total European travel portfolio.   Since the pandemic began, damage to credit quality in the leisure industry has been significant. In the beginning, concerns centered on the amount of liquidity companies had or could obtain to survive an uncertain duration. As time went on, negative free cash flow generation resulted in higher debt levels, prompting solvency concerns. About 56% of our rated European travel portfolio is now in the 'CCC' category, on concerns about the sustainability of the companies' capital structures. Aside from financial risk, the medium- to long-term risks depend on whether the pandemic would permanently change the travel industry.

Chart 3

The impact on business travel may lead to long-lasting changes in consumer behavior.   The pandemic necessitated work meetings to be held over digital platforms rather than in person, leading companies to question the cost of business travel. Because many businesses were able to cope without it, long-term changes in business travel are possible but difficult to quantify at this stage. In our view, a reduction of between 10%-30% in business travel could happen over the next few years. Hotels catering to large groups and conferences would likely be the last to recover once the pandemic is controlled.

Business travel also includes SME owners and managers, such as a short visit to a supplier or manufacturing plant. However, these SME travelers had been behaving more like leisure travelers before the pandemic, as they sought the best value for accommodation and flights. Thus, we have seen steady demand for midscale to economy hotels, which offer average daily rates (ADRs) of €40-€75 per night. We believe that this subsegment will stay resilient for the foreseeable future, reflecting further consolidation.

Chart 4

The strongest hotel operators have relied on cost management.   Hotel operators' ability to trim their fixed cost base has been a major factor in their performance. Most were able to improve their overhead costs, such as if they reduced staff or used government schemes, such as furloughs and loans. Cost management and reduced discretionary spending on capital expenditure (capex) will continue to be the main theme throughout 2021 and beyond.

For instance, France-based hotel group Accor S.A. has a sizable number of employees in France, where labor laws relating to layoffs are less flexible. Last year, Accor announced cost-saving plans of about €60 million in early April and announced an additional €200 million permanent annual cost saving plan by 2022. These plans included reducing sales, marketing, and information technology costs. We also expect that Accor was able to reduce capex by €60 million to about €140 million last year. Since then, Accor has performed an extensive budgeting process in which it identified areas where it could save up to €200 million annually, including in its management structure and real estate and by using automation, contractors, and streamlining tasks. While we see this as a positive step that would help improve the group's margin profile, we expect the associated costs to implement these measures would pressure the group's already stretched credit metrics in the near- to medium-term (see "Full Analysis: Accor S.A." published Dec. 18, 2020, for more information).

In some instances, we have noted that asset-heavy hotel operators with a high fixed-cost base were able to negotiate rent-free periods to reduce their overall debt burden. With delays in vaccinations slowing immunization efforts, there could be further negotiations on rent deferrals, payment terms, and possibly, additional rent-free periods.

Smaller hotels outside city centers with capacity of 80-100 rooms have withstood the pandemic pressures better as some of those remained open and were operated by reduced staff, resulting in increased market share.

Hotels Owners' Revenues Will Likely Not Fully Recover Before 2023

Hotel operators have been impacted by the collapse in global travel to an unprecedent extent. Their operational efficiency has therefore deteriorated, and those renting their hotel space to a landlord are struggling to pay rent, which is among the highest costs for such hotel operators. The subdued travel demand and weaker tenant creditworthiness therefore also affect hotel owners' revenue, and we expect their performance to remain depressed until the pandemic is under control, with only a slow and gradual recovery afterward. We also think the impact of COVID-19 on hotel landlords' revenue will be uneven, and it will firstly depend on the types of contracts they have with the operators. These include fixed leases, variable leases, and management contracts, which allow the landlord to operate the hotel.

Two to three months of fixed rent could be lost on average during the pandemic, partly compensated by lease extensions.   Through fixed leases, generally based on inflation and a triple-net feature, hotel operators that rent hotels commit to pay rent on a regular basis, usually quarterly or monthly, and with long maturities, around 10 years. The fixed leases give the tenant (the hotel operator) the right to operate the asset. In turn, hotel landlords benefit from predictable and secure revenue, as long as the hotel operators are solvent. However, operators' revenues have dropped sharply since March 2020, which has had a major impact on their ability to pay rent. Although leases are contractually not breakable before maturity--and some tenants have tried to invoke "force majeure" clauses to attempt cancelling rent payments--most owners have accepted to renegotiate some of the lease terms and payment modalities. The aim has been to preserve their tenants' future rental streams in exchange for lease extensions, as was the case for France-based Covivio Hotels and German real estate group Aroundtown S.A., for example. While it is still too early to determine the full extent of these negotiations, we assume that 15%-30% of cash from rental income could be lost as a result of such renegotiations, from 2019 levels.

Beyond 2021, we believe there is a risk of negotiations to lower rent, as some hotel operators under leases will be more affected than others. Tenants' creditworthiness will therefore be a key factor when assessing hotel landlords' path to recovery.

In addition, for most companies, rental income reported in profit and loss statements might not reflect the full impact of lower rent collection. This is because the International Financial Reporting Standards (IFRS) allow:

• The impact of cancelled rents may be streamlined during the remaining lease's duration for leases that have been subject to a modification such as an extension; and
• Deferred rents can still be recorded as rental income, while we are unsure what portion of deferred rent will be collected.

Landlords could see variable revenues squeezed by 50%-80% from 2019 levels, and gradually recover by 2023.   Variable leases and management contracts are ways through which hotel owners can benefit from substantial growth in demand during good times. From 2014 to 2019, the volume of international arrivals in Europe steadily increased by 5% per year on average, outpacing hotel room supply. In 2019, arrivals increased by 3.6% while hotel supply rose only 1.2%. As a result, RevPAR was outperforming average inflation in Europe, rising 2.4% in 2019 compared with 1.9%. However, this incremental benefit also brings higher risk when demand curtails or the market tumbles. Compared with fixed leases, revenue from variable leases and management contracts is less predictable and stable, because it depends directly on the hotel operator's performance, in particular daily occupancy rates and revenue per room. As of Dec. 31, 2020, Covivio Hotels' revenue from hotels under management had declined by 88.4% in the last 12 months, on a like-for-like basis, and revenue from variable leases was down 73.2%, compared with a decline of 3.4% from fixed leases. Although it may bounce back stronger and faster than revenue from fixed leases, we don't expect a return to 2019 levels until 2023.

Owners of economy, midscale, and upper-midscale hotels, located in countries where government support and domestic tourism are stronger, should fare better.   Leisure hotels located in countries that benefit from strong domestic demand may be more resilient. In France and Germany, domestic tourism makes up 64.8% and 76.3% of total tourism, respectively, according to MKG Consulting. Therefore, some of their hotel operators were less affected than other European countries in 2020, with RevPAR shrinking by 61.3% and 63.8%, respectively. This compares with declines of 75.2% and 77.4% for Spain and Greece, which rely more on international tourism.

Chart 5

Although most European hotels were ordered to close to the general public during lockdowns, many managed to generate some revenue during these periods by providing rooms to essential workers on behalf of the government and to other charitable organizations, for example. Even so, we expect such sources of revenue to remain marginal. To cover expenses, most operators used government furlough schemes, such as in the U.K., where the government also offered business rate relief. In addition, some operators have voluntarily closed during the pandemic because their revenue was insufficient to cover fixed costs and operating expenses.

Have Real Estate Valuations Captured All Downside Risks?

After a record year in 2019, with €26.1 billion in transactions, the European hotel investment market saw a substantial drop in 2020. According to Cushman and Wakefield, the volume of hotel investments in Europe declined by 55.4%, to €5.7 billion, during the first half of the year, with 79% of these transactions agreed before the pandemic began.

By contrast, property appraisers had only slashed a limited portion of hotels' asset value as of June 30, 2020, in the low single digits for the hotel REITs we rate. Covivio Hotels, one of the first companies that reported its full-year 2020 earnings, reported a 7% devaluation of its overall portfolio.

Most companies' half-year reports in 2020 included a "material valuation uncertainty" clause due to COVID-19, particularly because there was such a limited number of transactions, which usually provide a benchmark for property valuations. We believe hotels' real estate will reprice from pre-pandemic levels, reflecting a potentially stronger impact on revenues than anticipated and new challenges hotel operators could face for the medium- to long-term (see "Looking Beyond The Pandemic" section below). As a result, we conservatively assume a 10%-15% discount to 2019 hotel appraisal values as a base-case scenario for hotel REITs.

Chart 6

For CMBS transactions, we derive an "S&P value" for hotels as part of our rating analysis. This property valuation does not reflect the hotel's open market value at a specific point in time. Instead, we aim to assign a long-term, through-the-cycle, sustainable value to avoid overvaluing properties during periods of market exuberance and undervaluing properties during downturns. To calculate the S&P value, we divide the adjusted net cash flow amount, or the "S&P NCF", for each property by the capitalization rate, or the "S&P cap rate."

During the pandemic, we have lowered our S&P NCF for the hotel transactions we rate to reflect the properties' constrained occupancy levels, increased costs, and reduced revenues. At the same time, we have not changed the cap rates for these properties. We have applied additional stresses to our S&P NCF for hotels located in key gateway cities or by airports to reflect our view that these hotels will take longer to recover. Across the three rated CMBS hotel transactions, our S&P value for the underlying hotels has fallen by 6% on average since the start of the pandemic (see chart 7). This compares to a decline in market value of 16% for Helios Finance DAC, with our S&P value currently at a 15% haircut to this market value. For the remaining two rated European hotel transactions, there has not been any changes in the market valuations because the servicers have not requested new valuations.

Chart 7

In our assumptions for CMBS transactions, we incorporate our view that hotel revenues will not recover to pre-COVID levels before 2023. We expect that the rollout of multiple vaccines and immunization targets in many European countries are likely to lead to a relaxation of travel and social distancing measures. We believe that this would likely jumpstart the recovery in occupancy rates and RevPAR, although we do not expect any significant improvements until the summer. In our view, even in the second half of the year, it is unlikely that corporate business travel will rebound significantly. While we expect that leisure travel will contribute to the recovery, we think that this will benefit limited-service more than full-service hotels initially.

Finally, our property valuation assumptions are based on pandemic concerns subsiding toward the end of the year. Should there be developments that change this, such as new variants impeding widespread immunization, we will re-evaluate our forward-looking assumptions.

Ratings Sensitivity And Peer Analysis: Who's Holding Up

Hotel operators

The table below compares key metrics for the European hotel operators we rate.

Table 1

Chart 8

Hotel REITs

Ratings on REITs that are exposed to the European hotel industry have stabilized thanks to their solid business profiles. We believe rated European hotel REITs should be able to withstand the forecasted economic conditions at their current rating levels, thanks to fixed-lease basis and diversified customers and real estate activities. However, if widespread immunization takes longer than expected, or if hotel assets are devalued significantly more than we expect (by more than 25%, for example), this could lead us to reevaluate our forward-looking assumptions and ratings on hotel REITs.

We currently rate four real estate investment companies in Europe, which operate fully or partially in the hotel industry: Covivio Hotels, Vivion Investments S.a.r.l., Aroundtown, and CPI Property Group S.A.

The pandemic has affected these REITs' performance to different degrees due to their lease profile and property segment diversity. In 2020, we lowered the standalone credit profile of Covivio Hotels to bb+, from bbb-, and we revised our outlook to negative for the 'BBB' rating on CPI Property Group, mainly due to tighter headroom under credit metrics. While most of these companies' credit metrics have been impacted, we think that they can restore ratios that are compatible with their current ratings in the next 24 months. Given the uncertainty around future asset valuations, we have run a sensitivity analysis in which we assumed hotels' valuations to decline by 25% by 2022 from 2019 levels (compared with around 15% on average in our base case). The results show that such a decline would push ratios of debt-to-debt plus equity very close to thresholds that may warrant a downgrade (see chart 10).

Chart 10

Chart 11

Chart 12

CMBS

During the course of the pandemic, we reviewed each of our European hotel-backed CMBS transactions and adjusted some of our long-term cash flow assumptions where necessary. Specifically, we have applied further stresses to hotels by airports or in the center of key gateway cities, which depend more on international demand. Moreover, for some classes of notes that do not benefit from liquidity coverage, we have applied an additional adjustment to reflect elevated risk due to the current operating environment. As a result, we have taken various rating actions on three European transactions, which reflect our expectations of how the underlying properties will perform over the medium-term.

Table 2

Table 3

Table 4

Chart 12

Chart 13

Chart 14

In our view, for all three transactions, the credit quality has declined due to operational disruption related to COVID-19, and this may continue to negatively affect the cash flows available to each issuer. Our rating actions on two of the transactions, Magenta 2020 PLC and Helios Finance DAC, were largely due to an unprecedented decline in cash flow from the underlying hotels and because the affected classes did not benefit from any liquidity support.

Looking Beyond The Pandemic

Although we anticipate that a full recovery in demand will be achieved in 2023, we remain cautious about potential structural changes in the sector. Continued remote corporate meetings or long-term health concerns even after vaccines become widely available could prolong the recovery. In 2021, we expect the staycation trend to dominate, while immunization efforts ramp up.

Beyond the pandemic, hotel performance has always been closely linked to the macroeconomic environment. In times of economic decline and increased unemployment, companies are less willing and able to spend on corporate travel, and consumers spend less on discretionary purchases, such as vacations. This reduces cash flows for hotels, which has a negative impact on the properties' valuations. On the other hand, continued challenges with international travel may spur demand for domestic holidays. Furthermore, pent-up demand and a backlog of travel needs could supercharge demand for hotels once a large enough portion of the European population is vaccinated and government restrictions and social distancing measures ease.

Overall, it remains to be seen whether the coronavirus outbreak will have a long-term impact on the hotel industry. In the medium-term, we don't expect that hotel performance will be directly correlated with the severity of a given country's epidemic situation. Instead, we expect it to be linked to the hotel type and location, as well as the hotel's reliance on international demand.

Related Research

• EU Could Meet 70% Vaccination Target By Late July If Production Steps Up, Feb. 11, 2021
• Full Analysis: Accor S.A., Dec. 18, 2020
• Full Analysis: Aroundtown S.A., Dec. 14, 2020
• Industry Top Trends 2021: Hotels, Gaming, And Leisure, Dec. 10, 2020
• Industry Top Trends 2021: Real Estate, Dec. 10, 2020
• Hotel Landlord Covivio Hotels Affirmed At 'BBB+' Despite Weaker Stand-Alone Quality Amid The Pandemic; Outlook Stable, Nov. 10, 2020
• Full Analysis: Vivion Investments S.a.r.l., Oct. 22, 2020
• Full Analysis: CPI Property Group SA, July 8, 2020
• Full Analysis: Covivio, May 28, 2020
• COVID-19: Implications For European Real Estate Investment, As Tenants Begin To Suspend Rent Payments, March 26, 2020

This report does not constitute a rating action.