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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2017

Hotels March to Their Own Beat

Lodging facilities don’t follow a typical commercial revenue model

Should we lend to a hotel buyer? This is an important question for lenders and, consequently, for commercial mortgage brokers working hotel deals.

First and foremost, what is a hotel? Obviously, they are brick-and-mortar operating businesses that are part of the commercial property sector, but they are distinct from warehouses, office buildings or multifamily units.

Contrast an office building with a hotel. The office building has a revenue component — the rental of square footage. The project is underwritten with the cost of the building and the anticipated revenues in mind. A set cost is sold to renters. That cost is set on a yearly lease basis, so there are 12 rental periods where this rent, which never changes during the term, is paid. The rent may be for one year or for multiple years, based on the lease. Typically, there are percentage increases in the rent each year.

Basically, that is all the revenue that the office building can produce. In some cases, there are additional tenants in the form of retail shops, but most of the revenue produced by this segment comes from the rental of square footage. It is fixed in the lease. Period.

A hotel’s major revenue source, however, is far more fluid because it depends on daily visitors who do not commit to long-term leases. Consequently, a hotel’s revenue stream can vary greatly over the short term depending on a host of factors, ranging from the weather to the economy. Investors are both attracted to and avoid the hotel industry for that very reason.

The lodging market

The example of the office-building lease holds true for other real estate segments as well, such as warehousing and multifamily. Certainly, it seems like a safer bet to “have a bird in the hand” and to know what your rental income is for the next five years based on a lease, as in the case of an office building. You can bet on it — unless the tenant loses its business.

The dynamics of the hotel market may sound less predictable and more convoluted, but it is a smart segment to lend to for many reasons. Hotels change their rates every day, for example. When business is strong, hotels can raise their rates to yield more revenue.

The hotel segment is generally broken into two main segments: full service and limited service. A full-service facility is defined by these characteristics:

  • Larger than 150 rooms and found in city centers or in centers of population;
  • Food and beverage facility within the hotel;
  • 5,000-plus square feet of space available for groups and catering; and
  • Bellhops, valet parking, room service, and other service components.

A limited-service hotel is defined by these characteristics:

  • Under 150 rooms and found not only in major city centers, but in secondary and tertiary population centers;
  • Complimentary breakfast;
  • No restaurant or bar on property; and
  • No facilities for catering or groups, although the recent trend is to add board rooms and small flex-space areas for groups.

These categories are typically branded by one of 50 or so main companies that franchise their names and their services. These company’s brands, and the many sub-brands within them, are awarded based on the size and type of hotel in question.

Attractive sector

Recently, limited-service brands have aggressively expanded. Along with this growth and brand expansion is the growth of a newer segment, called boutiques.

Profit margins in limited-service hotels exceed other real estate segments. They can suffer in downturns, however. Prudent investments can hedge against that potential.

Full-service hotels generate cash, but typically operate on slimmer margins than limited-service hotels. Full-service hotels enjoy revenues from not just the daily rental of rooms, but also from food, beverage and other services offered in the hotel. If managed carefully, these properties will expand revenue during periods of increased usage and lower costs during business slowdowns.

This segment is management heavy, which is a valid concern. The good news is the industry is replete with excellent management companies that produce healthy margins in high-volume periods and protect profits when business slows down.

Ownership groups that invest prudently and understand the segment are equally important. Owners can enhance their opportunities if certain investment rules are followed: conservative loan-to-value ratios, equity participation, investor track records, avoiding buying above replacement costs, and experience with real estate.

•  •  •

Hotels are solid profit-makers. Remember, it’s not the hotel business that fails. Over the past 40 years, there have been several ups and downs in the hotel industry, but the hotels have continued to operate and produce cash flow. The danger is not in the hotel, but in the investors who over-finance or underwrite projections that are not attainable.

As lenders and commercial mortgage brokers, you have access to information and expertise to decide if a project is viable. Reach out to those sources for help in making a loan decision. This year should present you with many opportunities to test some of these ideas. Happy lending.


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