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Steps to Buying Distressed Hotels

distressed hotels

The hotel industry is finally getting some long-awaited good news. Business and leisure demand are rising, and 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.

What is a Distressed Hotel?

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, Net Operating Income (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, Property Improvement Program 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.

Examining the Market for Distressed Hotels

The Buyer’s critical first step is to examine the market: what is happening in it and how this 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.

Review the Property and It’s Historical Performance

Next is a hotel site selection 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 available business 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 renovations will take time and money, and could lead to displacement of NOI if part must be finished during peak business periods.

Perform an Expert Property Condition Assessment

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 conditions 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.

Increasing Revenue and Net Operating Income

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 strategic plans. I strongly recommend that you find a hotel development consultant 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 defined, other than food and beverage? 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 costs at closing. What you are not buying, if needed, must be added to your all-in costs.

Financial Modeling

The final step is financial modeling: pull together all your assumptions regarding the market, your strategies to add value, your purchase deal and your sources and cost of money into a pro forma 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.

If you would like to talk to a professional consultant on how to go about buying distressed hotels, then contact us today!

About the Author

Jim Burr is a former member of Cayuga Hospitality Consultants.