Typically, major hotel owners had set aside four per cent of gross annual revenue for capital improvements and four to five per cent in reserves for repair, maintenance, and replacement of furniture, fixtures, and Equipment (FF&E), depending on a hotel’s size and service level.
But due to uncertainties, inflation, and increasing construction costs, those reserve amounts no longer are cutting it. A 2023 industry study found that the average expenditure for capex is now about eight per cent, with full-service and hotels older than 15 years spending more on upgrades and other improvements. And a 15 -25 percent reserve is now recommended for FF&E expenditures.
This has been a tough row to hoe for hotels, which are financially still recovering financially from the effects of the pandemic.
Why Capital Improvements Are Lagging
Craig Amos, chief development officer for RLJ Lodging Trust said that hotel owners depleted those reserves during the pandemic just to keep their hotels afloat. “There was some lag in deploying of capex because people were replenishing their FF&E reserves. But that’s not the whole story,” he added. “A bigger part of the story, I think, is just recovering operations and confidence, in general, that you will get a return on your investment and trying to figure out the timing on that.”
In regard to hotel improvements, Scott Hammons, president of Ground Level, a project management subsidiary of HEI Hotels and Resorts, said hotels are currently spending more and doing less. He noted that capital improvements have been tough because the post-COVID rebound in market demand and hotel performance wasn’t as strong has had been hoped, so reserves were “handicapped.” As a result, brands allowed deferral of brand-mandated improvements.
“Most owners have been very focused just on infrastructural stuff that keeps the heart beating in the hotel,” Hammons continued, noting that many hotels haven’t had a renovation in 10–12 years. “Now they're in a tight spot, because they either have to invest capital to compete with newer product in their market or sell, and it's not a good time to sell.”
Deferred PIPs May Offer Value-Add Opportunities
Hammons said that this is creating some interesting deals, where opportunistic buyers are looking for both hotels that need work and hotels in great shape to buy that don’t need a lot capital investment. He noted that this is causing owners to focus very strategically on a one-time investment, rather than year-over-year improvements, which definitely takes more capital than the reserves allow.
Miraj Patel, president of Wayside Investment Group, is an opportunistic investment firm with an in-house construction renovation side, said that is company is looking for branded hotels with deferred property improvement plans that have been pushed back beyond the seven-year cycle to renovate. “If that means re-flagging, we reflag, if that means maintaining that good flag, then we’re doing the capex all at once,” he explained. That's where our interest level is.”
He noted that branded hotels with long PIP deferments will eventually be unable to compete. Meanwhile, many lenders are not deploying additional capital reserves because operational costs have gone up. Patel, therefore, suggested that a family of brands combine it resources to create one large PIP fund to convert underperforming assets, or use reserves set aside to maintain hotels that over time accumulated to make capital improvements that benefit the hotel’s position in the marketplace. “At the end of the day, this eventually benefits the brand because of top line growth,” he said.
“Our overall strategy has been to do full value-add,” Patel continued. “In fact, we actually come in, shut the hotel down and do it all at once, instead of doing floor-by-floor,” which he noted disturbs guests and the hotel’s online score goes down, plus and it takes longer to do than a full capex and then reopen.
Brands Lax on PIPs After Covid
Hamnons noted that more owners today have a similar mindset. “Six or seven years ago, business displacement was the topic everyone wanted to talk about—how to mitigate displacing the business to keep the hotel open. We tried to fit renovations into tight windows by spreading it out. Now here's a lot more people saying, ‘Let's get in and out and get all the bang for the buck as soon as we can.’”
The brands are more understanding of the ownership perspective on trying to drive returns on capital investment than in the past and are very engaged in discussions around how to do this in a reasonable way and still protect brand integrity and the guest experience, Amos said. But from the perspective of an owner, he said that while it’s important to do the best thing for the hotel, “for every renovation we do, we need to know exactly how much money we're going to spend, exactly what we expect to get in return, and how we hold our teams accountable to getting those returns. “
Amos suggested that owners and brands are aligned because they’re both “rowing in the same direction. There’s a real correlation between better products and better performance,” he said, noting that the brands are incentivized on the top line and owners on the bottom line. And better top-line performance means better bottom-line performance. “When you do a renovation, and come out of the gate, reposition in the market with $10 extra rate, everyone's on board,” Amos noted.
Both Hammons and Patel noted that the pandemic made the brands more willing to compromise on PIPs and other conventions owners wanted to implement to reduce costs or increase revenue, like allowing a more entrepreneurial approach to food and beverage and other amenities.
How Brand Proliferation Is Affecting Capital Improvements
Brand proliferation also is having an impact on capex deployment but in different ways in different markets. Hammons noted that when multiple hotels within the same branded families are competing with each other in the same market, managers may need to consider adding amenities that differentiate them and attract difference types of guests, like one specializing in the transient and the other focused on groups. He said, for example, a branded hotel in one market that wants to attract transients might add an Executive Lounge, but this amenity may not make sense for the same brand in another market.
Patel said that when he looks at deals, he considers if there is too much of the same type of hotel in the same market. He noted, for instance, that during the pandemic extended-stay hotels did very well. “Suddenly, you come out of the pandemic and every brand launches an extended-stay brand in the same market, with the same target market.”
Amos pointed out, however, each of them will have a different flag bill on both margins. “I think the brand proliferation has pushed us to take a more surgical, more of a sharpshooter approach to really understand what our position is within the market, what we are solving for, where we are trying to compete, and which guests we’re trying to attract.
“And by the way, negotiations go both ways,” he continued. “In some cases, you may be over-branded and trying to do a little less than the brand wants. In other cases, you want to do more.” Amos noted, for example, one of his company’s hotels is a high-rise Hampton Inn in Midtown Atlanta that has a rooftop bar and acts a lot like a lifestyle hotel. “So again, it's less about the brand and more about what are you trying to solve for in that particular market,” Amos opined.
Making Capital Improvements on a Limited Budget
Patel noted that he grew up in a hotel family and sticks to his father’s advice that what hotel guests want the most is a good bed for a good night’s sleep and a good shower, so he would focus on the beds, flooring and bathrooms.
Hammons said that when working with a “bare bones budget,” Patel is right, and recalled that in his early days as an executive housekeeper, his boss had told him: “Listen, guests spend 90 percent of their awake time in the room and bathroom, so make sure it’s clean.
“But I think my answer is that it's often condition-based, and what's the marketing plan—is it a transient or a group hotel,” he continued. “The thing that we seem to be spending a lot of time on for owners is advising on food and beverage and a focus on reprogramming food and beverage for convenience, but also from a labor savings standpoint. Self-service is a big labor driver, and the cost of labor is going up everywhere,” he added. “So you're seeing a lot of grab and go markets going into hotels and lobby bars that are very beverage centric, have light bites in the evening for dinner, and can also function in the morning for breakfast. And that's all about sort of consolidating the labor, and what the guest really wants.”
When budget resources are limited, Amos suggests considering which items in a room can “go another turn,” and which cannot. For example, he suggested that hoteliers can get extra life out of “case goods or hard goods,” built-in or free-standing unupholstered furniture and accessories like dressers, nightstands, desks, and lamps, but not soft goods, like sofas, linens and drapes.
“But I think the key is to give your design team direction very early on that you're working around these components,” he continued. “When you tell the designer the pieces that are staying, it's so much easier to have a cohesive look and feel, such that when you go into a room that's only had a limited scope (makeover), it's much more difficult to tell that those pieces weren't replaced at the time of the renovation.”
How to Evaluate Opportunistic Acquisition Deals
Hammons said that when looking at hotels to acquire, sellers often pitch tie asset as a low-cost rehab, but his team reprices the whole job with the help of construction professionals, as he noted that there can be big swings in construction pricing from one market to the next. “I'm a big believer in bringing a general contractor to weigh in on construction cost estimating,” he added, noting that renovations are not just a cost risk but also a schedule risk. As a result, Hammons said that his team is tapping procurement agents earlier and earlier to determine the schedule.
Amos noted that his company has a 10-year plan and a detailed five-year plan, but it has become more difficult to budget projects in advance, as there are so many variables that costs change quickly. “All the numbers we had six months ago, we’re revisiting again,” he said.
Patel said his company uses a budget template. “Before we go into any project, we get bids on two sides, labor and materials,” he explained, noting that his company has working relationships with subcontractors and can get a pretty firm estimate on labor, but on the materials side, “you don't know what's shifting.” Additionally, he said that contingency funds are included in the construction budget, because of unknowns that can crop up once the box is opened.
“The number one thing is having trusted partners,” Hammons stressed. “If you don't have your own general contractor or procurement group, you really need to partner with people you've worked with for a long time that get it so you know that they're not low-balling it. You need to know where they're getting their labor from. Know where they're getting their materials from,” he added. “This is a relationship-driven business.”
This article originally appeared on our sister site Hospitality Investor.