The ongoing capital investment needs of hotels are typically greater than those of other real estate asset classes. Hotels are made up of a large number of depreciable components that wear out with guest use, become obsolete or require updating to maintain brand requirements and meet market demands.
At the time of acquisition or development, hotel owners make assumptions about the future capital needs of a property and often contribute to a capital expenditure reserve to fund those expenses. Lenders often require the reserve be set aside as a portion of operating revenues—typically in the 4-5 percent range. Capital reserve contributions may fluctuate based on economic cycles; however, capital expenses rarely decline. The resulting stresses on capital expenditure escrows, combined with the industry’s need for continuous reinvention, have created a heightened need for hotel owners to adopt a strategic approach to capital investments.
As hotel brands are continually evolving, with reinvented lobby experiences, changing guest expectations, expanding technology requirements and design being an ever greater part of the hotel experience, it is easy for ownership to get lost in the noise of capital investment execution. While hotel-specific physical needs and brand requirements are important, ownership should also ensure capital investments align with the broader investment objectives for both the individual assets, as well as those of the overall fund or portfolio in which they reside.
After the initial cost to purchase or develop a hotel, one of the greatest value add opportunities ownership has is through strategic capital investment. A properly executed renovation, for example, can reposition a hotel to capture greater market share, increase existing revenues, create new revenue streams or decrease operating costs.
It should be recognized that while creating value is the ultimate goal, many hotels are renovated with purely defensive objectives. For instance, a renovation goal may be to maintain a competitive position and prevent loss of market share or to meet a brand requirement. If a hotel in a low rated market, for example, is currently outperforming its competitive set with little upside potential post-renovation, ownership should proceed with caution. It may be time to study the product and understand what components can last another cycle.
Of potentially greater consequence for hotels in a defensive position could be extending the life of assets in place. If the product remains relevant to the market, ownership needs to consider whether waiting a year to commence a renovation will potentially negatively impact the guest experience or not. In addition to the value of time and money saved, a renovation deferral allows ownership more time to extract the full value from existing assets and make additional escrow contributions.
Just as strategic capital investments can greatly improve overall returns, over-capitalizing in a market that cannot support a rate increase or drive performance in other ways could be devastating to the asset’s returns over the hold period.
A high level strategy for optimizing return on capital investments should include the following four steps:
Identify fund, corporate and portfolio objectives. All capital investment decisions must align or advance a fund’s investment strategy. The starting point for the development of any asset-specific capital investment strategy begins with understanding the fund’s targeted asset type, age, quality, return expectation, hold period, cost of capital, finance availability, capital reserve requirements/limitations, portfolio management approach and exit strategy. After considering capital investment needs and identifying value add opportunities, it’s important to determine if the hotel still contributes to the fund’s investment goals and if its full potential can be realized within the expected holding period.
Assess market and competitive landscape. Identifying the potential of the asset within its specific market must also drive capital investment decisions. To determine this, begin by asking the following questions:
- Is the market growing or shrinking?
- Is there new product entering the market that will require the hotel upgrade in order to compete and maintain its position?
- Are there new demand generators entering the market with specific needs?
- Can the hotel be repositioned within the market to drive rate or capture business that is currently serviced by a competitor?
- Can capital improvements add value to the asset to deliver new revenue sources—and if so, can these opportunities be quantified and benchmarked against?
- What is optimal time to execute renovations to minimize business interruption and guest impact?
The answers to each of these questions must factor into the decision of whether or not to move forward with the capital improvement project. Failure to consider short- and long-term market fundamentals can be a costly mistake.
Evaluate physical needs. Assessing where the asset is within its life cycle, physical obsolescence and remaining franchise term are the more obvious components of the strategic capital investment decision making process. However, knowing what to examine is half the battle. Below are some basic questions that should not be overlooked:
- Will the hotel require a large scale renovation or minor upgrades during the hold period?
- Are the decor and facilities appropriate for the market and existing or potential key clients?
- Is there an opportunity to reposition the hotel within the market?
- What are the immediate Property Improvement Plan (PIP) requirements and potential brand initiative expenditures?
Beyond PIP requirements, what else is happening at the hotel and in its market that will impact ongoing capital needs, create value add opportunities and drive ultimate performance?
Can the hotel be adapted to meet any needs identified in market analysis, such as a larger exercise room, more double occupancy rooms or the conversion of underutilized meeting space to guest rooms?
Understand competency level. Assessing the ability of your team to execute on strategy will help determine if the capital investment in question is a good fit. For instance, it can be risky to move forward with a capital investment strategy that is outside the core competency and financial ability of your ownership/asset management team. What must also be considered is whether your operations team is able to deliver on a repositioning strategy with specific performance goals.
There is no “one size fits all” approach when it comes to deciding on a capital investment strategy. Considering capital investment in the context of these variables, however, can assist ownership in the identification of additional value add opportunities and potential pitfalls. Capital investment strategies are best considered at the front end of any investment committee discussion, prior to acquisition of hotel assets. Capital expenditures have the potential to greatly impact returns and should never be an afterthought.
Craig Amos serves as executive vice president of capital investments at Apple Hospitality REIT.