A hotel is the only major commercial real estate asset class in which the ownership can adjust the rents daily to attract customers, fill empty rooms and raise revenues. An underperforming hotel, therefore, isn’t necessarily a bad investment or one that will be viewed as overly risky by a lender.
A faltering hotel can often be turned around quickly through operational changes, renovations and upgrades. These changes can make it possible to obtain favorable loan terms from lenders. It is important to recognize, however, that operational changes also have limitations. Certain hotels face stiff competition and other issues that make them particularly vulnerable to economic downturns, regardless of how well the business is managed.
Last year, the hospitality industry found itself at the end of a great run. Room revenue growth slowed. And although it is not yet clear whether this slowing trend will continue beyond this year, there is the possibility of a downturn in the U.S. economy. For commercial mortgage brokers, the change in the cycle should lead to more asset sales and opportunities for your investor clients, but these deals should be approached with caution. Lenders are understandably wary of granting loans for some hotel properties this late in the cycle.
Some hotels can easily be turned around via new management or an infusion of capital. In other cases, even well-managed and updated hotels will struggle. Mortgage brokers can serve their investor clients well by recognizing what the hotel operators can and can’t achieve in bolstering the value of a particular asset. This also will help you predict how lenders will react when you are hunting down a loan for a hotel.
A hotel is a business that can grow considerably under the right operator. A struggling hotel can often be turned around by simply hiring a professional management group
Bolstering value
A hotel is a business that can grow considerably under the right operator. A struggling hotel can often be turned around by simply hiring a professional management group. Hotels are frequently under temporary management when they are placed in receivership, or taken over by a bank or other agency. A new professional management team can change the operational results and significantly increase the hotel’s value. Under a temporary operator, there is generally a lack of focus on results.
The fortunes of a struggling hotel also can be bolstered by a capital infusion that will enable the owners to renovate and update the hotel, so it can stay competitive. Aside from the main business of renting rooms, hotels often have a variety of revenue sources, including restaurants, bars, golf courses, spas and parking. These components can quickly become rundown and tired. In some cases, a hotel is closed after a major incident, such as a serious roof leak or mechanical failure. A new owner with capital can invigorate the asset.
Hoteliers also have unique flexibility to adjust their rental rates. Unlike a warehouse, office building or apartments that have 12 monthly rental periods per year, a hotel has 365 daily periods. The rent can be adjusted by the day. That alone is an astounding difference and it gives the hotelier much more flexibility when adjusting to market conditions.
A hotel can move rents and pricing at will. Although the 12-month fixed-rent model secures a steady annual revenue stream, the landlord typically can’t adjust the monthly rent if the economy suddenly weakens. A hotel has this option, however, and that can be an advantage in weathering a downturn or adjusting to a new competitor. In other cases, however, a hotel’s fortunes may be tied to factors that are hard to control. In these instances, a lender is right to be wary of extending financing and your client may be best served by passing on the opportunity.
Hotels located in areas with strong supply growth, for example, could struggle regardless of how well they are managed. Increased supply has to be offset by demand. This is particularly challenging when a new hotel has opened nearby. And economic downturns generally make it harder to fill rooms and maintain revenues.
Another warning sign is if the property has lost its franchise flag. For example, if a hotel loses its affiliation with Marriott and must carry the flag of a less-popular chain, this can negatively affect revenues and the hotel’s ability to grow.
Another potential issue is if the property is older and the franchise requires the new owner to complete a property-improvement plan to keep its flag. If you are working on a purchase mortgage with a potential new owner, you will need to ensure that your investor client has sufficient funds to complete the plan in order to remain competitive.
A hotel’s fortunes may be tied to factors that are hard to control. In these instances, a lender is right to be wary of extending financing.
Timing your deal
The condition of the U.S. economy is another area that should be of concern to would-be hotel buyers. Economic conditions can affect the demand for rooms, capitalization rates and asset values.
Over the past two years, room-revenue growth has slowed considerably, a trend that continued through much of 2019. Although room rates may start to pick up again in 2021 and 2022, the slowing trend in room-revenue growth should continue this year.
The point is that the timing of your hotel deal can determine its probability for success. Prior to the last downturn, for example, many investors purchased or built hotels at the top of the market in 2006 and 2007. They saw amazing results initially, only to get caught in the economic tsunami of the Great Recession.
Although the market recovered after a couple of years, many owners were forced to sell at deep discounts that wiped out their equity.
The hotel industry is not a place to invest unless you understand the basics of the business. For mortgage brokers and lenders, it’s critical to recognize the importance of timing and where the deal lies in the cycle. Plenty of signposts point to where the industry is headed. Hotel consultants also can be helpful in spelling out where the hotel has been and where it needs to go to be successful.
The hotel industry is unique among commercial real estate assets. To the savvy lender and broker, this is a good time to pay attention to this sector. Over the short term, expect to see the market heat up as sellers bring potentially good deals to the market, as well as ones where your clients should be cautious.
