With the U.S. lodging sector showing signs of optimism, naturally investor questions have centered around the sustainability of trends. As with any potential inflection point, we believe both upside and downside scenarios remain plausible, and the next few months and quarters will provide more certainty as to the pace and shape of recovery. Even in a scenario where our base-case forecasts prove conservative, we believe rating upgrades are unlikely, given extremely high leverage that will take multiple years for companies to reduce. While we think the recovery will begin in earnest in the second half of this year, and gain momentum into 2022, RevPAR won't likely return to 2019 levels until 2023 at the earliest. That said, we could return rating outlooks to stable over the coming quarters if positive trends prove sustainable and financial policy remains supportive. Conversely, lodging performance is going to be very sensitive to any slowdown in the recovery of hotel occupancy or rates. For this reason, we examine which companies might be most at risk of further downgrades if performance falls short of our base-case forecasts.

Table 1 

The U.S. Lodging Base Case

Even under our base case for widespread immunization by mid-2021 and business and group travel beginning to recover later this year and next, revenue in 2022 will still be 10% to 20% below 2019.   This RevPAR estimate could plausibly translate into next year's EBITDA that is 20% to 30% below 2019 for the overall sector. However, a specific company's 2022 EBITDA depends heavily on a lodging company's price segment and location, as well as the cash flow model--whether the company is a franchisor or hotel owner, the latter of which is subject to greater volatility. There's also still a big divergence in occupancy and rate between hotels at the lower end of the price range, which are recovering much better, and high-end full-service hotels, particularly those located in cities.

Table 2

The Upside

There's recent good news that could also result in upside to our base case.  The vaccination pace has been faster than expected a few months ago, at least in the U.S., and approved vaccines are apparently very highly effective, so far even against most known variants.

In addition, we've seen the following:

• Through April, U.S. RevPAR is up 250% and already trending toward the better end of our published 2021 forecast of down 30%-40% relative to 2019, driven by a recovery in the luxury segment.
• Many issuers are reporting positive EBITDA and reduced cash burn in the first quarter of 2021 based on better than expected trends, particularly in March.
• A significant reduction in hospitalizations and deaths in the U.S. compared to the highs in January 2021,
• Massive fiscal stimulus and greater consumer savings will likely serve to support travel recovery.
• Some hotel companies and passenger data for destinations dependent on air-travel show pent-up demand for leisure travel, resulting in higher bookings at resorts in recent weeks.
• Hiring in March 2021 in the U.S. hospitality sector was very strong and is signals recovery.
• Some of the lodging companies we rate and also some widely known and reputable third-party forecasting shops like Smith Travel and CBRE are starting to say the recovery in 2021 could be better than their current forecasts, and possibly ours.
• The transaction market for hotel asset sales and purchases is thawing, with several recently announced deals of varying sizes across our issuers. The improved transaction market indicates some issuers can raise proceeds from asset sales for debt repayment, which could help to mitigate downside risk to our base cases.

As a result, the worst truly could be behind us as long as nothing else happens to either slow the occupancy recovery or further lower the rate hotels are able to charge.

The Downside

Any delay in vaccine rollout, or if there's a spread of resistant COVID variants that also pushes out widespread immunization, local or regional restrictions on gatherings, and the travel and hotel occupancy recovery, would likely lead to downgrades.   In fact, that is our downgrade scenario in almost all cases across the sector. We are also mindful that even though hotel rates have fallen significantly since the beginning of the pandemic, recent close-in leisure travel and group bookings for later this year and next at higher-end hotels have reportedly been at rates around 2019 levels. Many hotels have been betting there is no benefit in lowering rates because safety fears are the reason for low occupancy as opposed to pricing considerations. Rates could also benefit from pent-up demand and strong consumer savings than before the pandemic. However, we believe there could be some as-of-yet unknown rate competition in the hotel sector that could happen later this year and hurt RevPAR recovery.

Negative Ratings Bias Remains High

Despite signs of optimism, ratings bias remains overwhelmingly negative in the sector.   We have lowered lodging ratings since the beginning of the pandemic, and approximately 94% of rating outlooks in the sector remain negative compared to 34% pre-pandemic. The ratings migration downward has resulted in one or more notch downgrades for most lodging issuers, and a big increase in the number of 'CCC' category ratings (35% of lodging issuers). There have been no defaults yet; however, access to the debt markets and liquidity are the primary reasons. While demand is likely to continue to rebound from historically low levels, there has been and will likely be variability on the path to recovery. Restrictions by regional governments during the most recent U.S. winter as well as Europe and China, demonstrated that governments can quickly and temporarily stifle lodging occupancy and hurt issuers' operating results.

Chart 1

There have been several downgrades and/or outlook revisions on our largest and highest rated issuers, with one Fallen Angel (i.e., an issuer credit rating that has fallen to speculative grade from 'BBB-' or higher; see chart 1). We lowered our issuer credit rating (ICR) on Host Hotels & Resorts Inc. to 'BB+' from 'BBB-' in March. We didn't base the downgrade on the slow recovery for business and group travel alone, but also because we consider Host more exposed to high-end, full-service hotels relative to other diversified lodging companies. In addition, Host began to publicly talk about a more aggressive financial policy regarding using its cash to make hotel acquisitions, which we believe would slow down restoring credit measures that would support the former investment-grade 'BBB-' ICR. This was later substantiated by Host's recent announcement to use an aggregate of approximately $800 million of cash to acquire hotels, including the 444-room Four Seasons Resort Orlando for approximately $610 million (nearly 17x 2019 EBITDA).

There are two lodging companies we haven't downgraded since the start of the pandemic--Choice Hotels International Inc. and Four Seasons Hotels Ltd.--because both issuers started the crisis with material leverage cushion in their ratings. In addition, despite low pre-pandemic leverage we didn't raise our ratings on these companies because of a lack of a financial policy commitment to a higher rating.

Table 3

Potential acquisition activity poses a risk to the restoration of credit metrics.   As the recovery comes into fuller view, issuers could be opportunistic and access the favorable credit markets or use stockpiled cash balances to complete acquisitions. A number of issuers including Host, Choice, and Wyndham Hotel Corp.

have publicly discussed growth strategies involving acquisitions or organic investments, and, in some cases, have stated a prioritization of growth before shareholder capital returns. Our base cases do not incorporate acquisitions and any increase in M&A would reinforce our negative rating bias, especially given that purchases multiples will likely be based on 2019 EBITDA levels, which would allow the deleveraging path.

A Divergence In RevPAR Trends

Looking back over the past 12 months, what is most striking is how far RevPAR fell in 2020--by far, the largest decline in history.   In addition, there's a very large divergence between higher-price hotels and lower-price hotels. Higher-price hotel segments are trending much farther below 2019 than their lower-price counterparts (see chart 4). Lower-price, midscale, and economy segments are much closer to 2019 RevPAR levels. As a result, the shape of recovery within the price segments plays into our specific company forecasts.

The recovery in midscale and economy-price segments is evident in Choice's and Wyndham's operating results.   They experienced more moderate revenue decline in 2020 but achieved hotel-level profitability for a significant portion of franchisees in the second half of 2020. We believe Choice and Wyndham will continue to be profitable and lead the recovery for most of 2021. Because of their lower RevPAR percentage decline last year, relative to the industry, Choice and Wyndham's percentage RevPAR recovery this year will also be more moderate compared with the industry, particularly in comparison to issuers that franchise or operate full-service hotels.

The pressure on RevPAR at full-service hotels exposed to business, group, and destination travel was significant last year and remains so, although we're beginning to see signs of rebound. The stress is evident in the results of Marriott International Inc., Hilton Hotels Corp., Host, and Hyatt Hotels Corp. Stressors affecting credit metrics are particularly acute for issuers that own or bear the operating risks of hotels, such as Host which is a REIT; Hilton, which has a substantial lease portfolio of hotels in Europe, where some economies continue to be hobbled by local restrictions on social gatherings; and Hyatt, which has substantial owned assets that generated 45% of total 2019 EBITDA. These companies have cut costs deeply so that break-even profitability can be achieved at lower levels of RevPAR, occupancy, and average daily rate, although we currently believe it could take the next couple of quarters before they can achieve occupancy that is profitable on a run-rate basis. Issuers with business models that generate a significant majority of EBITDA from franchised or managed hotels, such as Marriott, Choice, and Wyndham, will experience less strain on credit metrics.

In the second half of 2021, we believe business and group travel could start to recover.  We expect U.S. RevPAR growth in 2022 to climb at a faster rate relative to this year. This is because the mix of rooms occupied (e.g., group and business) will increasingly be higher-price rooms as the recovery continues. While we acknowledge there could be some permanent disruption in business transient and group travel, many full-service hotel companies have reported group bookings for later this year into next at higher rates than 2019.

We also believe that demand for destination resorts will recover substantially and at a greater rate than drive-to hotels once consumers regain confidence in air travel, due to significant pent-up demand.   Issuers such as Marriott, Hilton, Hyatt, and Host have high-quality assets in resort destinations, which are positioned to capture demand when consumers eventually shift from drive-to leisure plans at regional locations to longer-duration aspirational stays that require longer booking windows and air travel. We're seeing early signals that reflect this trend, including in the week ended April 10, 2021, when U.S. resort hotels reported occupancy of 66.5%, higher than other hotel types including small metro/town, suburban, and interstate locations.

Chart 2

RevPAR Trending Toward Better End Of Our 2021 Forecasts

At the beginning of the pandemic, there was a precipitous drop in revPAR but it has recovery steadily since then (see chart 2).   U.S. RevPAR in recent weeks has neared the better end of our 30% to 40% below 2019 assumption for full-year 2021. The most recent week's RevPAR (as of May 1) was 30% below the same period in 2019. We believe the recent trend is partly due to spring break and Easter holidays, so it may not be sustainable. Nonetheless, the trend is in the right direction. Importantly, it's notable how far below 2019 higher-priced segments remain compared to the overall national average. By contrast, the economy segment has nearly recovered compared to 2019 in recent weeks. These recent trends, while still subject to volatility over the coming months, indicates our current base-case forecast is on the right track and could even prove conservative.

Chart 3

Access To Capital Remains Strong

Despite unprecedented strain on operations, U.S. lodging issuers have been able to access the debt markets to bolster liquidity and offset cash burn from operations since last April.   Over the second half of 2020 and into this year, pricing has tightened and is now in line with corporate benchmarks at similar rating levels and maturities. We believe issuers were able to complete liquidity-driven debt issuances by initially shoring up their liquidity profiles, cutting costs, and demonstrating that such issuances would result in long liquidity runways of 24 months or more, thereby staving off the possibility of unfavorable debt pricing. We also believe that future debt issuances will increasingly be motivated by lower-cost refinancing rather than liquidity.

Table 4

Many lodging issuers were able to access the capital markets despite the pandemic-related stress (see table 4). Those with ratings in the 'BBB' and 'BB' categories were able to issue unsecured debt at favorable rates, particularly as overall rates improved and market optimism increased, triggering a gradual but persistent recovery. In the first quarter of 2021, Marriott and Hilton issued unsecured notes below 4%, with Marriott's March issuance at 2.85% right in line with 'BBB' corporate 10-year benchmark rates. Debt issuance has helped to bolster balance sheets and stave off defaults, although it has left companies with significant debt burdens they must now navigate. Accordingly, even under a scenario where RevPAR recovers to 2019 levels by 2023, credit metrics could continue to lag pre-pandemic measures.

Stress Testing The Largest U.S. Lodging Issuers

We tested ratings for our largest U.S. lodging issuers under two scenarios that reflect a more prolonged recovery in RevPAR in 2021 through 2023 relative to our base case.   While positive trends in RevPAR and occupancy through April reflect a potential inflection point for the U.S. lodging sector, investor questions have rightfully focused on the sustainability of this performance. In our view, a slowdown in the RevPAR recovery, while not our base case, could be driven by a combination of factors including lower occupancy, rate competition, and more permanent disruption in group and business travel. We acknowledge these stress scenarios run counter to recent RevPAR trends and signs of optimism in second half of 2021 and 2022 bookings, but we believe it's helpful to understand the potential impact on ratings if an unanticipated slowdown was to occur.

Table 2 

Key assumptions under our scenarios include:

• Base case RevPAR is down 30%-40% in this year versus 2019; down 10%-20% next year versus 2019; and down 5%-15% in 2023 versus 2019.
• Downside scenario 1 assumes RevPAR and revenue is 5% lower than the base case in 2021, 2022, and 2023 compared to 2019, so it moves the ranges in those years five percentage points lower than the base case.
• Downside scenario 2 assumes RevPAR and revenue is 10% lower than the base case in 2021, 2022, and 2023 compared to 2019, so it moves the ranges 10 percentage points lower in those years relative to the base case.
• Under both scenarios, there's no significant M&A or shareholder returns assumed over the forecast period.
• Both scenarios depict a cumulative effect of lower RevPAR in each consecutive year.
• Under both scenarios, we assume that if revenue recovers more slowly, then companies won't increase costs faster than revenue recovers, as they've demonstrated through the pandemic a willingness and ability to cut costs dramatically and keep them low.

Importantly, the specific RevPAR assumption can differ for each lodging company because they differ in terms of price segment and location. In addition, to arrive at the leverage forecasts, we also consider EBITDA margin differences and typical cash flow generation. If the company is primarily a manager and franchisor of hotels, it typically would have higher margin and higher cash flow generation. If the company is primarily an owner of hotels, it typically would have lower measures.

We also don't assume any change in current business risk assessments or rating triggers, the latter of which we could tighten over time if businesses are more permanently impaired than currently expected. The existing strong business risk assessments are typically aligned with a globally diversified management and franchising model, and the satisfactory businesses are typically aligned with an owned hotel model, as long as there is significant diversity to warrant that high of an assessment.

Stress Scenarios Summarized

Downside scenario 1

Under downside scenario 1, leverage for the majority of companies with the exception of Choice Hotels and Wyndham Resorts would remain above our downgrade triggers in 2022 as depicted in Chart 7. While all companies are able to reduce leverage below and build cushion against our downside triggers by 2023, this is outside our current outlook horizon for these entities. As a result, potential downgrades under scenario 1 would depend on a number of factors, including whether a company could reduce leverage below our triggers on a run-rate basis by late 2022, which would provide more certainty about business trends and the ability for companies to restore credit measures on a trailing 12-month basis by early 2023. We believe companies most at risk of further downgrades under scenario 1 would include Host Hotels.

Downside scenario 2

Under scenario 2, all companies with the exception of Choice Hotels would remain above our downgrade triggers in 2022. While all companies with the exception of Host Hotels reduce leverage below these triggers in 2023, they do so with less cushion compared to scenario 1. Additionally, we believe the stress in scenario 2, where RevPAR remains 15%-25% below 2019 levels in 2023, would likely reflect more permanent impairment in business models relative to our base case and could lead to reassessments of business risk profiles and/or tightening of downside triggers. Accordingly, we believe more downgrades and additional potential Fallen Angels would occur under scenario 2, such as Hyatt Hotels given its tighter threshold at the 'BBB-' rating.

An Upside Scenario Could Accelerate The Stabilization Of Outlooks

As stated earlier, we currently believe that upside to our base-case forecasts are equally plausible.   While we currently don't expect that upside to our RevPAR forecasts would lead to company upgrades given elevated leverage and uncertainty around the financial policy of specific issuers, such a scenario could lead to stable rating outlooks over the next few quarters. Under this scenario, we believe Choice and Wyndham would be the top candidates for stable outlooks, potentially followed by Hilton Hotels, given its cushion against downgrade thresholds in 2022 under our base case. We'll continue to monitor RevPAR and occupancy trends over the coming months, as the second half of this year will likely provide increased certainty as to which scenario seems most likely.