Undervalued assets

Opportunity to create value with a hotel investment often comes in the form of an acquisition that requires renovation, repositioning or adaptive reuse. Hotels may be purchased for a relatively low price if they are under performing. If the hotel’s performance improves once renovated and/or repositioned, the value of the asset increases commensurately. The work that goes into changing the property is part of what the owner contributes to the value of the asset.  

Renovation and repositioning 

Repositioning a hotel involves buying a property that is outdated or no longer optimum for its market and turning it into an asset that has more value to its customers and to you, the owner. Advantages to repositioning, as opposed to new development, can be substantial. The building exists, so the initial aspects of development from site prep to zoning are already done. It is generally a simpler job to contract a renovation than to build a new construction hotel. Repositioning a hotel may also enable you to get into a market where there are barriers to entry, like very little available undeveloped land. Repositioning should come with the opportunity to buy at a discount and benefit from the upside of introducing a like-new hotel.  

There are two aspects to repositioning: renovation and market repositioning.  

Renovation: From a physical standpoint, you are creating a new or improved product. This can range from the cosmetic to the dramatic. In the most comprehensive renovation, the building gets a new exterior skin, new roofline, gutted and renovated rooms and baths and redeveloped public spaces allowing you to re-concept the entire image of the hotel. 

Renovation can lead to some of the most creative and rewarding hotel investments but there are pitfalls to avoid. Here are some physical plant considerations: 

• Asbestos and mold can be deal killers because they can be expensive to remediate 
• ADA (Americans with Disabilities) requirements can be deal killers because it may not be possible, within a realistic budget, to meet requirements that might include things like larger elevator shafts 
• Moving walls to create larger spaces, to make meeting rooms larger for example, may be cost-prohibitive because those walls may be load bearing and needed to support the building 
• The cost of each alteration to a guest room or bath is multiplied by the number of units, so enlarging a bathroom or adding outlets may not seem cost prohibitive until you multiply it by 100 or 300 units 

Market repositioning: From an operational and marketing standpoint, you are presenting a different hotel to different customers.  In the most minimal repositioning, the hotel gets a new brand and logo. However, with a comprehensive renovation, repositioning involves new pricing, image and marketing with the intent to attract a different type of customer: 

• Brand is a major aspect of repositioning, although branding by itself is not enough. You select your new brand to define the new image you want to portray, enhance your hotel story and support every aspect of the marketing program that will bring customers. 
• Market strategy addressing demand sources and competitive hotels underlies every repositioning decision – whether you add amenities, reconfigure meeting space, change restaurant concept, or simply adjust décor, each change coordinates to appeal to specific market segments. 
• Marketing plans to re-introduce the hotel to the market and the sales strategy to drive revenue and deliver business for your newly repositioned hotel. 
• The PIP (Product Improvement Plan from the brand) underlies the physical transformation that accompanies the repositioning; it must deliver a physical product appropriate for the market to be effective. Within reason, a PIP can be negotiated with the brand; make sure you and the brand have agreed on the scope of the PIP prior to signing your franchise agreement. 
• For your customers to see your repositioned hotel as a new and different place, it must look significantly different from the outside because the look of the building sets customer expectations; this can be as major as a new skin and roofline or as minor as dramatically different paint, lighting or entryway, but it must be enough to cue customers that you created something credibly different. 
• The lobby and public areas set guest expectations for the guest rooms; if you want guests to accept significantly higher room rates, public areas have to signal that changed value through their design and furnishings. 

Travelers know the difference between new and dated product and are very sensitive to it. For a repositioned hotel to be accepted as essentially “new”, its public areas, guest rooms, baths and hallways must be new to the customer’s every sense. The hotel must look new, sound new, smell and taste new (extremely clean) and be new to the touch. Its brand and sales programs must tie to the product and its market. 

The truth of repositioning is that customers are perceptive. To successfully capture the upside in terms of occupancy, average rate, ancillary sales and property value from repositioning you must truly deliver. If you just change signs, you will have the same revenue under a different sign. If you deliver product that is clearly different and significantly better designed for its market, then you can realize upside revenue potential.  

Adaptive Reuse 

Some of the most creative and successful hotels, particularly boutique hotels, are developed in structures that were originally banks or office buildings, hospitals or prisons, apartment buildings or factories or warehouses. Adaptive reuse means the reuse of older buildings for a new purpose and is typically considered when: 

• Barriers to entry make traditional ground-up development difficult or impractical 
• Historic tax credits can add a financial incentive; a 20 percent tax credit is available for the rehabilitation of historic, income producing buildings that are determined by the Secretary of the Interior, through the National Park Service, to be “certified historic structures”. Work is reviewed to ensure compliance with the Secretary’s Standards for Rehabilitation. Many if not most adaptive reuse projects would be cost prohibitive without government incentives. However, the process and cost associated with taking advantage of tax credits must be incorporated into the project budget.  
• TIF (Tax Increment Financing) is available. A TIF is a form of development, or redevelopment, incentive created on the local level. Locations that offer TIFs tend to be undergoing transformation and are commonly associated with transformative infrastructure – like railway or wharf redevelopment initiatives. Through a TIF, a municipality can divert future property tax revenue increases (the “increment”) from a defined area toward economic development or public improvement. This enables public funding for some aspects of preparing a site or its surroundings for hotel and other projects. 
• Architecturally interesting buildings are available at a low cost. 
• Zoning, building or historic district government restrictions make demolishing a building undesirable. 
• Mixed use developments that are large scale include a hotel in the adaptive reuse plan; this can give the hotel access to demand generators and amenities as part of the project. 

Adaptive reuse can incorporate wonderful elements of history and the local community. Creating a special – and valuable – hotel experience can be a strong advantage to your marketing and community relations initiatives. 

Interesting aspects of the original building can be integral to the new hotel. Some features lend themselves to transformative architecture and design – like an old bank vault or marble lobby. Less desirable aspects may include spaces with low ceilings, columns, small elevators, small bathrooms, structural systems and floors that cannot be cut or modified, staircases, airshafts and elevators in the wrong place or that cannot meet code. You have to be flexible to bring about an adaptive reuse. You also want to be practical, which means quickly finding out if the conversion to a hotel can be done cost effectively. 

1. Work with an architect early on layout efficiency to ensure that the building and layout can function as a hotel including infrastructure, storage, guest flow, traffic patterns, fire safety, etc.   

2. Work with a tax credit specialist to choose attributes you want to preserve and highlight. This includes features as well as materials that contribute character.  

3. Work with an ADA expert to make sure that retrofitting to bring the structure into compliance is practical. It’s important to look into ADA compliance for all buildings, but those built before the ADA took effect in 1990 are likely to have bigger ADA challenges.  

4. Ensure your architect engages a structural engineer experienced with hotels and historic buildings to make sure that the building’s bones and distinctive materials will stand the rigors of hotel use. 

5. Get creative with your architect to plan the guest rooms. Hotels tend to be narrower than buildings with other uses. Maximizing the guest room key count is a significant way to drive value in your design.  An architect experienced with historic adaptive reuse projects can be a strong asset. 

6. Balance charm and practicality in your design. Make the back of the house completely modern and efficient. But maximize the charm in the front of the house. 

7. Build relationships with local officials responsible for permitting. Legal, political and economic factors take on extra weight with an adaptive reuse because there are judgment calls and sometimes public opinion is involved in tax credits and TIF approvals.  

Adaptive reuse is recycling on a grand scale. The overlap of adaptive reuse and sustainable design may be an advantage. In addition to helping the environment, older buildings may bring unique materials, structures and finishes.  

Other sources: 

https://www.ccim.com/cire-magazine/articles/federal-historic-tax-credit-aids-adaptive-reuse-developers/

https://www.nps.gov/tps/tax-incentives.htm

https://www.irs.gov/newsroom/tax-reform-brings-changes-to-real-estate-rehabilitation-tax-credit

Distressed Assets – Find upside in restructuring and repositioning 

When the hotel industry goes through periods of financial distress, hotel revenues are lower which, in turn, reduces values. This creates an opportunity for new owners to buy at a discount and ride an ensuing upswing in value. An uptick in workouts and foreclosures, which tend to put undervalued assets on the market, coincides with times that hotel revenues are impacted by a recession or disaster, like COVID or the Great Recession, and opportunistic prices may be available.  

• Workout: A workout agreement is a contract mutually agreed to between a lender and a borrower to renegotiate the terms on a loan that is in default. It serves the interests of the lender by making it more likely that the lender will recover their principal and avoid long and costly legal disputes. It serves the interests of the borrower by avoiding foreclosure and long, costly legal disputes. Workouts may include waiving existing defaults such as delinquent payments and restructuring the loan’s terms and covenants. Some workouts result in a hotel sale with advantageous terms. 

• Foreclosure: In a foreclosure, the lender assumes control of the hotel due to lack of payment as stipulated in the mortgage agreement. Almost all foreclosures result in liquidation, which means the hotel is sold, sometimes at an advantageous price for the buyer. 

• Bank loans: Loans with banks, including SBA 504 loans, are worked out on a level where they can be negotiated between a banker and a borrower.  

• CMBS: CMBS loans have been packaged and sold as securities to raise the money that was borrowed for the hotel. Ownership of individual loans in a Commercial Mortgage-Backed Security (CMBS) is transferred to a legal trust through a tax entity known as a Real Estate Mortgage Investment (REMIC) which then securitizes the pool of loans and issues a series of bonds of varying yield, duration and payment priority. For the hotel borrower, this is seamless and provides a low interest rate. However, if something goes wrong, like a delinquency, CMBS are restricted in how they can do workouts with borrowers. When there is a problem, the loan is turned over to a Special Servicer. The special servicer has a fiduciary duty to make decisions that will be in the best interest of all classes of bonds including some workout options or selling the asset (liquidation). Special servicers sometimes package several hotel loans into a single sale to simplify the transaction. In a package sale, the buyer may keep some of the hotels and flip others (think, picking up the discard pile in Gin Rummy). They may also bring several individual hotels to market at the same time. 

To be the successful bidder for a distressed asset, consider: 

• Cash wins: Buyers who can demonstrate an ability to move quickly and decisively are likely to be selected. Moving quickly requires having financing arranged and ready. Moving decisively means being able to complete due diligence quickly and offer a hard (non-refundable) deposit. 
• Understand the seller: A lender or special servicer may control the asset and be able to close the sale, or an owner may control the asset. It strengthens your negotiating position if you understand who controls the decision, what their priorities are and what alternatives they have to closing the sale. The broker can explain this to you, if asked. 
• Understand the debt: It improves your ability to negotiate and be the chosen buyer if you understand the status and terms of the hotel’s debt such as whether it can be prepaid, remedies the lender is enforcing, defeasance, whether the debt can be acquired, etc. Most confidentiality agreements will prohibit you from contacting the lender directly.  However, the broker can provide information about the debt, and you also may be able to find information in documents about the hotel on the broker’s data site. 
• Management: Some hotels have management contracts that survive the sale. All hotels have some management with a vested interest in the outcome of the sale. Transitions of ownership can be fraught if the existing management company is owed fees or other expenses including penalties for termination. The management company can cooperate with you or put obstacles in your path. If this is a consideration, you might choose to work with the management company, at least temporarily after the sale, if they meet your requirements. In any case, maintaining good relations with the management company and on-site management is in your best interest. 
• Franchise: If you would like to keep the existing brand on the hotel, you will similarly need to understand if there are any outstanding fees owed.  Preferably, you will be able to start with a clean slate with the franchisor, but you should verify this in advance. 
• Deferred CapEx: Distressed hotels have often been starved for capital so needed improvements, replacements and repairs are likely to have accumulated. As a buyer, you evaluate the hotel’s physical condition to properly budget for these costs. You search for liens and accounts payable through your bookkeeper and attorney, including cooperating with the seller so they can send a letter to every vendor announcing the sale. Liens and payables will need to be satisfied before closing on your acquisition. You should study accounts payable and the hotel’s unsecured vendors so you can negotiate to continue service or find new service providers to keep the operation running. 

Liquidations are likely to be sold through a broker so that the lender is assured of an arms-length transaction. By the time the hotel is listed with a broker, it will be ready to sell. There can be special terms to a sale of this type. Your attorney as well as the broker should review these with you.