Throughout your time as an owner, you will do major repairs and improvements on a regular capital expenditure (CapEx) cycle. CapEx will occur due to wear and tear, obsolescence, regulatory requirements such as ADA, at the behest of your brand as their standards flex, changing technology, market demands for product change, and in response to unexpected events at the hotel (sometimes there are water leaks, things break, stuff happens…). Some repairs and improvements can be completed by property management and your maintenance team and you will engage general contractors for others.
As a hotel owner, capital expenditures (CapEx) will be a key part of your investment strategy and an ongoing creative opportunity.
The term FF&E Reserve is sometimes used for the CapEx reserve. But CapEx is much more than the replacement of worn-out furniture, fixtures and equipment. Over the life of hotel – which typically spans multiple owners – a hotel that is as competitive in its 25th year as it was in its fifth will have spent an average of more than 7 percent of revenues annually on CapEx.
CapEx and revenues
The relationship between CapEx and revenues is not constant from year to year. CapEx expenditures are cyclical, with major spikes every 7 to 10 years when the hotel has a PIP (Product Improvement Plan) or franchise renewal and FF&E nears the end of its life cycle. Spikes are larger around 16 to 25 years when the hotel’s building systems need replacement or overhaul (elevators, roofs and mechanical systems). It also spikes when several significant capital requirements surface in the same year – like a new roof plus a lobby renovation. During a major renovation year, CapEx may exceed 50 percent of revenues.
The rule-of-thumb is to reserve 3 percent of revenues in a CapEx reserve. It is common for mortgage holders to collect funds for CapEx in this range in your mortgage payment and hold it in an escrow account. This is sometimes called the FF&E reserve. Some owners allow this to build up as a cash reserve to defray major needs. Other owners keep the reserve drawn down and use these funds for on-going CapEx investments required in the normal course of business. In a typical year, when there is not a major renovation, ongoing capital needs may still cost 3 percent of revenues or more. So, major projects commonly require additional funding.
CapEx is a smaller percent of revenues for select service hotels and is 2 to 4 percentage points higher for more complex full-service hotels with restaurants and other amenities. Over the life of a hotel, CapEx averages from 4 to 10 percent of revenues annually, depending on the type of hotel and location.
The International Society of Hospitality Consultants (ISHC) in partnership with the Hospitality Asset Managers Association (HAMA) publishes periodic statistical studies to inform Capex planning. CapEx 2018: A Study of Capital Expenditures in the Hotel Industry is the most recent. The Society updates the study in approximate 5-year intervals. The study reports capital expenditure trends on full-service, select-service, and extended stay hotel segments.
The 2018 study contains data from 902 hotels across the United States representing 64 brands and various independent properties with data from 2013-2017. It reports on Repairs & Maintenance Expense as well as CapEx because there is flux between these accounting categories. The numbers quoted in this post, and the charts and tables, come from the CapEx study, with permission.
Life span of finishes, furnishings and fixtures
As an owner, you should plan for both regular ongoing short-term CapEx needs and anticipate long-term CapEx funding needs as well. Here are examples of CapEx for select components of the hotel.
|Typical Life of Hotel Finishes, Furnishings & Fixtures|
|Area of the Hotel||CapEx Needed||Year of the Hotel’s Life|
|Corridors||Replace carpet, wall covering, art/accessories, window treatments, paint doors and trim, signage, reupholster furniture||5-7
|Lobby/Front Desk||Replace carpet, wallcovering, window treatments, lampshades, art/accessories, furnishings, paint||5-7
|Porte Cochere/Entry/Vestibule||Replace lighting, flooring, ceiling tile, signage, bell carts, art. refinish millwork||17-19|
|Guest Rooms||Replace lighting, carpet, art, wall coverings, repaint, window treatments, replace or refinish furnishings||5-7
|Source: International Society of Hospitality Consultants, “A study of capital expenditures in the hotel industry”|
Bathrooms, restaurants and lounges and each other area of the property will have its own schedule. Infrastructure including the laundry, plumbing, wiring, elevators, roof, fire system, parking lot, building exterior, etc. requires major maintenance and then replacement on its own schedule.
In a hotel’s first year, CapEx is low because the hotel is new and equipment and furnishings are under warranty. So, CapEx reserves are used to build a cushion. By the fourth year, CapEx will be a significant budget item for on-going needs. By year 7, some larger elements will be ready for replacement or renovation. CapEx generally has a peak between 16 to 25 years when major buildings and systems need to be replaced, repaired, or updated.
Full-service hotels typically incur greater capital expenditures than select-service because their systems are more complex and expensive. Reasonably, full-service hotels draw additional revenue from these additional areas of expense.
CapEx strategies and budgets
Your approach to CapEx will follow a strategy that is appropriate for the asset, the market and your investors. For instance:
- If you are in a market where demand is strong and hotel supply is very limited, you may choose to spend the bare minimum on CapEx to keep the hotel running. This maximizes your cash flow in the short term. However, the longer you follow this strategy, the more you will spend on repairs and maintenance and the more you will lose revenues from rooms out of service or disgruntled guests. It’s difficult and expensive to keep rooms rentable when they are in poor condition. This strategy also puts you at odds with your franchise company and you may risk losing your flag.
- If you are in a highly competitive market, you may invest in CapEx to consistently provide a more desirable product than your competitors. With this strategy, your repair and maintenance budget should be more stable. Your reviews should be better from guests as well as your franchise company.
- Ownership also affects capital expenditures. REITs tend to outspend non-REIT hotel owners. This is partly a function of tax planning. As a non-REIT owner, you may choose to expense certain investments for income tax purposes to minimize your taxes. Recognizing these large investments on the income statement in the year they are incurred reduces income and therefore taxes. In contrast, a public company like a REIT might prefer to capitalize CapEx, reporting it on the balance sheet and then depreciating the expense over time. This shows higher income in the short term, but can have tax consequences.
- If you are coming up on a major renovation or are planning the sale of the hotel, you may curtail CapEx. This can shift the expense to the buyer. If a renovation is coming up, delaying CapEx may save you from the double expense of redoing some investments. So, timing of major CapEx projects is strategic.
From the time you plan the acquisition or opening of your hotel, you should have a CapEx plan and budget. In budgeting, you and property management look forward five years and plan timing for investment in every component of the hotel. The budget covers anticipated replacement of each piece of equipment, furnishings, soft goods (drapes, carpet), beds and bedding. It also covers renovation needs like paint, meeting space upgrades and replacements, roofs, parking lot, lighting, etc. Actual CapEx in any given year may be higher or lower than the budget. Expenditures will depend on factors such as available funds, which items wear faster or slower than anticipated, business volume and unexpected impacts like storm damage. However, the budget is crucial for cash management and managing investor expectations. It also lets you plan your purchases so that furnishing replacements continue to match, while giving a fresh face to your hotel.