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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2017

Hotels Are in a Class of Their Own

Value-add properties can offer buyers a competitive advantage in the market

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Hotels are among of the oldest forms of real estate. Before office buildings, before multifamily projects, there were inns and hotels, dating back to Roman times.

People have and will always travel — for vacation, for work and to visit family. As a commercial mortgage broker, it makes business sense to understand this market and the financing opportunities it affords.

Attaining that understanding, however, requires grasping how hotels create value and why they are so different from other real estate classes.

Daily accounting

Hotels have 365 daily accounting periods. They close their books every night. Every new day is another accounting period, another opportunity to sell that room and earn revenue.

Room rates change on a daily basis. Most other classes of real estate have a monthly rate and those rates do not typically change for a fixed period. By contrast, with hotels, when there is demand for rooms, they can increase their rates to yield higher revenues. This makes hotel revenue streams very different from the cash flows of other property sectors.

Hotels also have other revenue sources beyond renting out rooms. Full-service hotels, for example, have entertainment, food and beverage revenues that can include catering and restaurant services; spa, golf and other recreation revenues; parking and more.

The ability to adjust pricing as needed is an edge a hotel has over other types of real estate. Nothing is set in stone. This creates opportunities to exceed expectations based on prudent management and market trends.

Room revenue

REVPAR is an industry term meaning “revenue per available room.” If you have a 100-room hotel property, you have, in one year, 36,500 available rooms. If the total annual room revenue for the property is $5 million, then the REVPAR — $5 million divided by the rooms available annually — is $136.98.

This makes math easier, given most of the reports commercial mortgage brokers and lenders see are based on REVPAR. Among the reports most used by the industry to assess REVPAR and other hotel information is the Smith Travel Research Report (STR). The report provides market-specific benchmarking and analytics data for the hotel industry, which is critical to understanding the value of a hotel.

Let’s say a 200-room hotel has a REVPAR of $100. In that case, the annual room revenue would be $7.3 million. A 30 percent margin for net operating income, or NOI, calculated by subtracting operating expenses from property income, produces income of about $2.2 million. If the property’s capitalization rate is 10 percent (NOI divided by current market value), then the property is worth $21.2 million. Let’s assume the property is in poor repair and needs capital to be revived. The purchase price, then, is low as such.

The STR report shows the market where the hotel operates has a benchmark REVPAR of $130. So, the borrower presents a capital plan to renovate the property, with the goal of making the hotel more competitive so it can reach the benchmark REVPAR.

Attaining full market potential, then, would add about $2.2 million of additional revenue to the hotel’s balance sheet. At the same NOI margin of 30 percent, that would produce an annual income bump of $657,000. With a 10 percent cap rate, this boosts the property’s value by more than $6.5 million. It’s easy this way to see the “value add” that a renovation can produce.

Investment rules

Over the past seven years since the last downturn in the hotel sector abated, very few full-service properties have been built. Many existing hotels also need renovation. Now might be a prudent time for savvy investors to identify these undervalued assets and to then work with a mortgage broker in finding a lender willing to finance the required value-add upgrades.

There are some rules to follow, however:

  • Replacement cost: The price of the hotel should be well below replacement value. Building a 200-room hotel would cost a minimum of $40 million. A value-add property of similar size that needs renovation might cost under $20 million, or 50 percent of replacement value.
  • Renovation costs: Typically, a sizable renovation will be required to bring the property to a competitive position. This is the most important part of the value-add proposition. Buying the asset well below replacement cost and adding a renovation component can make your acquisition competitive with properties that cost twice as much.
  • Scope: The amount invested must meet the need. Overspending does not guarantee greater returns. Having expertise to help price the improvements is critical. The good news is that if your loan is on a “value-add” property, your downside should be well below replacement cost.

Hotels in need of renovation are great candidates for value appreciation. Brands do not want to lose their franchise fees, but they also do not want hotels that are in poor condition in their portfolios. To ensure this, they issue PIPs, short for property improvement plans. These PIPs tell buyers they need to spend capital on specific areas of the property. Those targeted areas often include infrastructure upgrades; heating, ventilating and air conditioning improvements; and other mechanical upgrades.

The costs associated with these PIPs chase away many buyers, but a potential buyer also must consider that the property is typically being sold at a significant discount before the PIP is factored into the equation. It is critical on these transactions that the bank find expertise to assess the costs associated with the PIP, with the goal of helping the buyer to correctly price the necessary upgrades.

• • •

Loans on hotel real estate have many advantages, but a buyer must still exercise caution. Lending on a full-cost asset can be a good investment because a new property, built or bought at full-replacement value, can certainly grow in value based on where you are in the real estate cycle and the property location. With proper equity in the deal, these types of transactions can make sense.

With that said, arranging financing for lower-cost, value-add hotel properties can be a less-risky path for borrowers than financing full-cost assets. Pursuing the value-add path in a hotel acquisition can offer a competitive advantage as well. After the PIP has been executed, a value-add hotel property can then compete with new full-priced hotels at a much lower cost basis.


 
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