You have purchased, or may be considering the acquisition of a hotel at significantly less than its replacement cost. You believe the location remains sound, the brand is right or can be fixed, and management is generally effective. You are optimistic that when pricing power comes back and demand strengthens, it will do well for you. But the “good ole days” may still be far off. Though margins should improve substantially from present, many costs are still going to continue to rise. Financing market terms are likely to lead to higher exit cap rates. And brand standards catch-up requirements and building “surprises” are likely to require greater capital investment than projected -- unless you provided a generous contingency. What then could and should you do to increase net operating income so that greater value is created? Following are some actions you should consider:
1. Assure that the manager and asset manager, if in place, have touched all the bases to wring excess costs out of the operation. You especially need to look at:
a. Organization structure and staff utilization -- Have former training and development and other “nice to have when times are good” positions been wrung out of the Executive Committee and is the management staff right for current business? Are sound business volume forecasting procedures in place, good staffing guides utilized, overtime tightly controlled and staff productivity closely monitored?
b. Have amenities, services and service levels, hours of operation, and the rest been adjusted to reflect guest expectations and actual customer use? Have outsourcing opportunities been explored and exploited to cut fixed costs and possibly increase revenue? Have potential activity traps such as an extra restaurant outlet, Sunday Brunch and the like been evaluated and ended if unprofitable?
c. Have leases and service agreements been thoroughly gone over and renegotiated where appropriate? Have new “make or buy” analyses been performed and acted upon? With earnings down sharply, have property tax assessments been appealed? It is surprising how many hotel owners have not done this. Are personal property records up to date or is the hotel still paying taxes on items that have been removed from service? Have recent audits been performed in areas such as telephone equipment service charges, high-speed Internet costs, sales taxes, preventive maintenance and energy conservation opportunities? Have all low-cost or high-ROI energy-saving measures been carried out? Many of these are simple procedural changes. Have competitive price surveys been conducted to assure that food and beverage prices and charges for ancillary services are in line with competition and hotel positioning?
2. Improve the hotel’s appeal and make sure the facilities are highly competitive in the marketplace.
a. Take a hard look at the sense of arrival given to customers. Visit the competitors and see how you compare. A few planted flowers, a steam cleaning and perhaps some paint can often make a world of difference at the entrance. A new floor surface, some lighting changes, replacement of tired-looking furniture and new staff uniforms can provide a new lift to the lobby. Get rid of the negatives, they are distractions that serve to lower guest expectations and increase their sensitivity to price.
b. Moving to the guest rooms and bathrooms, get the greatest possible customer impact with the renovation money you have available. Whole-room renovation generally has greater affect, even if done in fewer rooms, but if budget and condition necessitate piecemeal renovation of all, be sure it is done against a master plan so that when the remaining elements are tackled the newly added parts will still fit. A few observations from experience:
i. Do not overlook the sleep sets; they are the number one priority. Those that are sagging have to go.
ii. The room and bathroom need to be light and bright. Fortunately, this can now be done with low watt CFL bulbs.
iii. Even if the brand has extended the deadline for flat screen televisions, be mindful that many select service and even budget hotels already offer them. They should be high on your action list. If the standard is below 42 inches, I suggest exploring with the brand and looking at the potential payback on going to the next larger common size to provide a competitive edge. If the rest of the case goods in the room are good, the tops can be cut off existing armoires and a piece of granite put in to provide a base for the new television.
iv. After replacing the carpet, if needed, which is one of the necessities, if the look of the guest room still needs refreshing, a good deal of punch can be achieved by revinyling the headboard wall.
c. Follow the same strategy in the public areas: work against a master plan and first fix the items that stand out as distractions. Of course you will put a multi-year capex plan in place.
3. Make Sure the Sales Department and Revenue Management Function are Hitting on all Eight Cylinders
a. Are pace and sales production reports carefully watched? Are ROI or at least ROS calculations developed for incremental sales activities, including trade show attendance, local corporate programs, weekend promotions, etc.?
b. Is participation in brand marketing programs challenged for potential benefit to the property and are results checked?
c. Has the sales department been shopped recently for effective and timely response to group inquiries? It is a good idea to shop reservations, be it internal or outsourced, as well. A surprising number of balls are dropped here. Upselling at the front desk, another old, but valuable “chestnut” is another area that should be tested.
d. Is the property web site an effective sales tool? Has search engine optimization been put into effect and has it been updated? Are E-mail and social media campaigns being used? If not, should they be? If they are, is adequate effort being devoted to them and is that effort cost-effective?
e. Are revenue management actions mostly proactive, or are they merely reactive? Are the total spend and total profitability of groups carefully considered when rates are quoted? Are sales people striving to get maximum penetration of a company or a group or other target market before dumping off forecast excess rooms to a deeply-discounted third-party site? Are packages and special events being created to take greatest advantage of features or activities in the community, so generating new demand, or is there over reliance on the standard brand offerings?
4. Start to “Dig for Gold” at the property.
The late Conrad Hilton was one of the earliest proponents of this and was highly successful at it. The vitrines he created in hollow columns at the Waldorf=Astoria and the store leases he negotiated to provide ongoing streams of revenue at Hilton Hotels are legend. After the “quick hits” have been dealt with, it is time to start digging into the physical property and the hotel operations for “veins of NOI” that earlier owners and managers have overlooked, or that have been made newly feasible by changes in the market or technology or incumbent manager performance. The prospecting should include:
i. Physical Property
Scour the hotel for unutilized or underutilized space. I have seen and/or been a part of turning a former maintenance storage area into a concierge lounge, freeing up prime guest rooms formerly devoted to this; adding new meeting space by converting unutilized building areas, leasing rooftop areas to cellular service providers, outsourcing a business center, creating a new banquet room from a formerly unprofitable restaurant, carving out additional shops or a Starbuck’s counter from unneeded lobby area, creating a feature pool, transforming a low-volume gift shop into a popular restaurant, leasing out unappealing and poor performing restaurant to an operator with a local following and relocating a remote production kitchen to a high-traffic area. These are but a few examples of steps that can be taken to produce a high return on investment, and provide points of difference that add to the hotel’s competitive advantage.
ii. Operations
A former boss likened this process to “turning over rocks.” Hotel Operations should be systematically and repeatedly scrutinized to unearth new opportunities for additional revenue or greater efficiency. I’ve increased cash flow and raised NOI through reviews of billing and collection procedures, labor management systems, house laundry, telephone equipment and network fees, energy management, maintenance department performance, broadband provision agreements and others. I have also increased top line revenue and NOI by updating competitive price comparisons, adding sales people against targeted markets, strengthening hotel web sites and Internet marketing. Many other opportunities are available; the potential and the payback will vary with the property.
Even if the trend line of improvement is below what the optimistic forecaster’s project, your efforts and your investments to add value may still be very rewarding. At a 10-cap, an extra $100,000 you added in NOI translates into nearly $1 million in added hotel value.
Wednesday, November 10, 2010
Monday, May 17, 2010
Distressed Hotels: Picking Up The Right Pieces
The hotel industry is finally getting some long-awaited good news. Business and leisure demand are rising, and so occupancy is increasing. Group pace is picking up, rate cutting has leveled off and hotel financing is starting to become available again. Groups and Funds have raised billions to acquire distressed commercial real estate, including hotels, and many other unpublicized investor groups are ready to get in if the opportunity appears right. I believe there are few who truly wish to buy distressed hotels. What they are looking for is distressed hotel deals.
A distressed hotel is one whose location has become inferior; whose position in the market has declined and whose physical condition has become substandard. Not every property will suffer from every failing, but it only takes one if the shortcomings are severe. And these problems are likely to be accompanied by deficiencies in service levels and amenities, in management and marketing. A few such distressed properties may be able to be brought back with time and massive capital investment. But for most, the answers lie in downgrading, in conversion to alternative use and even demolition for an eventual land sale. Yes, there is money to be made, but the continuing income stream will be limited and there is little upside potential.
What is in demand is the distressed hotel deal: a property that is generally well-located, in good condition, well-managed and expertly marketed that was over financed and cannot meet its debt service requirements. Even if RevPAR returns to former levels, and if aggressive cost cuts made during the downturn are maintained, the NOI (actual and forecast) will be insufficient to amortize debt, provide comfort to a lender through an adequate debt service coverage ratio and produce an acceptable return to the owner. While the tsunami of distressed properties that some expected may not develop, more high-leverage CMBS loans are coming due and lenders are becoming more aggressive about foreclosure so more “distressed hotels” will become available. Prices will be well below replacement cost and cap rates higher or EBITDA multiples lower than what prevailed during the bubble years. The challenge is to choose the deal that has the greatest upside potential and which offers the best return.
Identifying tomorrow’s winners involves a six-step process. It is not necessarily the discount to replacement cost, as a strike price may still be too high to get a target return. It is also not necessarily the cap rate, as the income stream upon which it is predicated may reflect cuts in vital areas like marketing and maintenance that will have to be restored. And it may be necessary to impute an addition to the sales price to allow for deferred maintenance, PIP costs, roof or major mechanical equipment replacement or critical MEPS (mechanical-electrical-plumbing systems) overhaul. Also, a build-up period should be figured into operating income forecasts to return the property to a “stabilized” earnings position.
The critical first step is to examine the market: what is happening in it and how the hotel is performing against the competitive set. The property’s location in relation to the major room demand generators and what is happening with those sources of business is fundamental. The market may have declined temporarily because of political and economic conditions, but the question that needs to be answered is if a rebound can reasonably be expected or if systemic changes – plant closings, mergers, loss of popularity of attractions or convention facilities will lead to reduced lodging demand for the foreseeable future.
Next is a review of the property and its performance within the market. Is the location still good or is the neighborhood declining? Has the hotel kept its share of the business available or has it lost it? If the latter, the reason or reasons should be pinpointed. Have the physical facilities been allowed to get into disrepair? Has management cut service levels to a point that customer satisfaction has been affected? Have sales and marketing budgets, and sales efforts, been cut so much that present and future inflow of customers into the hotel have been reduced? Are the positioning and branding of the hotel best suited to current and expected future demands? Is management effective? An operational review and a SWOT (strengths-weaknesses-opportunities-threats) analysis for each major market segment can pinpoint problems and opportunities. Answers here could yield fixes that could quickly turn the property around. But time and costs must be factored in. You could be looking at liquidated damages to end a franchise agreement. And a termination payment or a period of conflict (legal fees, performance test issues, rejecting proposed budgets, etc.) may be involved in order to replace the manager. Major renovation will take time and money, and could lead to displacement of NOI if part must be finished during peak business periods.
A property condition assessment by an expert is needed to determine building and system needs that are going to have to be met soon. This review should necessarily encompass any outstanding code violations or certificate of occupancy issues. I have personally had to deal with roof replacement, cooling tower replacement, building tuck pointing, replacement of obsolete fire alarm system panel, ADA compliance modifications and other costly items after experts had reported condition to be satisfactory. Get the most qualified expert you can find to reduce such surprises; add the cost of major repairs to the acquisition price and provide a capex contingency to provide for others.
Now a strategic plan to add value can be devised. Beyond fixing what needs to be fixed, how do you plan to increase revenue and net operating income? I will save the details for a future article but the plan should cover:
• Physical Plant: renovation, reconfiguration of space, facility and services additions, exterior and sense of arrival
• Operations: labor cost controls, suppliers and services review, closing unprofitable outlets, outsourcing, lease opportunities, pricing and revenue management
• Property and Business: Repositioning and Branding, Management, Marketing
• Financing and Sale Opportunities: Sophisticated operators who are buying for all-cash are projecting refinancing, with cash out, at a future date to improve their yield. At some point, the asset is usually forecast to be sold. Do not fool yourself with an overly-optimistic terminal cap rate that will inflate the (on paper) projected return.
Due diligence runs coextensively with other steps and investigation will lead to the development of the strategic plans. I strongly recommend that you find and hire a law firm with hotel experience to help you work through franchise and management agreement issues, potential labor issues and in putting together the purchase and sale agreement. The agreement needs to specify clearly what is being bought and sold outright and what is to be prorated. Are you, for example, buying the FF&E reserve? How are inventories, other than food and beverage defined? Are you getting the operating equipment, maintenance supplies and marketing materials? A purchase and sale agreement that is not clear can add hundreds of thousands to cost at closing. What you are not buying, if needed, must be added to your all-in costs.
The final step is financial modeling. Pull all your assumptions regarding the market, your strategies to add value, your purchase deal and your sources and cost of money together into a proforma that covers at least five years – longer if suggested by your planned holding period. You may find it helpful to prepare a sensitivity analysis that considers varying assumptions for occupancy and ADR, for time needed to deploy capital and carry out strategies and for completion of any planned sale or refinancing. If the results show a return on investment that meets or exceeds desired hurdle rates, you have a probable winner and will wish to go ahead. If the estimated return comes up short, you will need to develop different strategies, or decide to “keep your powder dry” until you find a troubled hotel that is the right situation at the right price.
A distressed hotel is one whose location has become inferior; whose position in the market has declined and whose physical condition has become substandard. Not every property will suffer from every failing, but it only takes one if the shortcomings are severe. And these problems are likely to be accompanied by deficiencies in service levels and amenities, in management and marketing. A few such distressed properties may be able to be brought back with time and massive capital investment. But for most, the answers lie in downgrading, in conversion to alternative use and even demolition for an eventual land sale. Yes, there is money to be made, but the continuing income stream will be limited and there is little upside potential.
What is in demand is the distressed hotel deal: a property that is generally well-located, in good condition, well-managed and expertly marketed that was over financed and cannot meet its debt service requirements. Even if RevPAR returns to former levels, and if aggressive cost cuts made during the downturn are maintained, the NOI (actual and forecast) will be insufficient to amortize debt, provide comfort to a lender through an adequate debt service coverage ratio and produce an acceptable return to the owner. While the tsunami of distressed properties that some expected may not develop, more high-leverage CMBS loans are coming due and lenders are becoming more aggressive about foreclosure so more “distressed hotels” will become available. Prices will be well below replacement cost and cap rates higher or EBITDA multiples lower than what prevailed during the bubble years. The challenge is to choose the deal that has the greatest upside potential and which offers the best return.
Identifying tomorrow’s winners involves a six-step process. It is not necessarily the discount to replacement cost, as a strike price may still be too high to get a target return. It is also not necessarily the cap rate, as the income stream upon which it is predicated may reflect cuts in vital areas like marketing and maintenance that will have to be restored. And it may be necessary to impute an addition to the sales price to allow for deferred maintenance, PIP costs, roof or major mechanical equipment replacement or critical MEPS (mechanical-electrical-plumbing systems) overhaul. Also, a build-up period should be figured into operating income forecasts to return the property to a “stabilized” earnings position.
The critical first step is to examine the market: what is happening in it and how the hotel is performing against the competitive set. The property’s location in relation to the major room demand generators and what is happening with those sources of business is fundamental. The market may have declined temporarily because of political and economic conditions, but the question that needs to be answered is if a rebound can reasonably be expected or if systemic changes – plant closings, mergers, loss of popularity of attractions or convention facilities will lead to reduced lodging demand for the foreseeable future.
Next is a review of the property and its performance within the market. Is the location still good or is the neighborhood declining? Has the hotel kept its share of the business available or has it lost it? If the latter, the reason or reasons should be pinpointed. Have the physical facilities been allowed to get into disrepair? Has management cut service levels to a point that customer satisfaction has been affected? Have sales and marketing budgets, and sales efforts, been cut so much that present and future inflow of customers into the hotel have been reduced? Are the positioning and branding of the hotel best suited to current and expected future demands? Is management effective? An operational review and a SWOT (strengths-weaknesses-opportunities-threats) analysis for each major market segment can pinpoint problems and opportunities. Answers here could yield fixes that could quickly turn the property around. But time and costs must be factored in. You could be looking at liquidated damages to end a franchise agreement. And a termination payment or a period of conflict (legal fees, performance test issues, rejecting proposed budgets, etc.) may be involved in order to replace the manager. Major renovation will take time and money, and could lead to displacement of NOI if part must be finished during peak business periods.
A property condition assessment by an expert is needed to determine building and system needs that are going to have to be met soon. This review should necessarily encompass any outstanding code violations or certificate of occupancy issues. I have personally had to deal with roof replacement, cooling tower replacement, building tuck pointing, replacement of obsolete fire alarm system panel, ADA compliance modifications and other costly items after experts had reported condition to be satisfactory. Get the most qualified expert you can find to reduce such surprises; add the cost of major repairs to the acquisition price and provide a capex contingency to provide for others.
Now a strategic plan to add value can be devised. Beyond fixing what needs to be fixed, how do you plan to increase revenue and net operating income? I will save the details for a future article but the plan should cover:
• Physical Plant: renovation, reconfiguration of space, facility and services additions, exterior and sense of arrival
• Operations: labor cost controls, suppliers and services review, closing unprofitable outlets, outsourcing, lease opportunities, pricing and revenue management
• Property and Business: Repositioning and Branding, Management, Marketing
• Financing and Sale Opportunities: Sophisticated operators who are buying for all-cash are projecting refinancing, with cash out, at a future date to improve their yield. At some point, the asset is usually forecast to be sold. Do not fool yourself with an overly-optimistic terminal cap rate that will inflate the (on paper) projected return.
Due diligence runs coextensively with other steps and investigation will lead to the development of the strategic plans. I strongly recommend that you find and hire a law firm with hotel experience to help you work through franchise and management agreement issues, potential labor issues and in putting together the purchase and sale agreement. The agreement needs to specify clearly what is being bought and sold outright and what is to be prorated. Are you, for example, buying the FF&E reserve? How are inventories, other than food and beverage defined? Are you getting the operating equipment, maintenance supplies and marketing materials? A purchase and sale agreement that is not clear can add hundreds of thousands to cost at closing. What you are not buying, if needed, must be added to your all-in costs.
The final step is financial modeling. Pull all your assumptions regarding the market, your strategies to add value, your purchase deal and your sources and cost of money together into a proforma that covers at least five years – longer if suggested by your planned holding period. You may find it helpful to prepare a sensitivity analysis that considers varying assumptions for occupancy and ADR, for time needed to deploy capital and carry out strategies and for completion of any planned sale or refinancing. If the results show a return on investment that meets or exceeds desired hurdle rates, you have a probable winner and will wish to go ahead. If the estimated return comes up short, you will need to develop different strategies, or decide to “keep your powder dry” until you find a troubled hotel that is the right situation at the right price.
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