Funding CapEx: New report tells what it takes for hotels to stay competitive

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Financing the Refresh

New report details the level of capital expenditures hotel owners and investors can expect to face today and in years ahead

New report details the level of capital expenditures hotel owners and investors can expect to face today and in years ahead.

More than 20 years ago, a team of hotel industry consultants and asset managers got together to figure out how much hotels in the U.S. spend each year on property improvements and maintenance.

The idea was if owners and operators know in advance what it will cost to keep a hotel property up to date and in good working order, it would help them put the right amount of cash in reserve to deal with the expected as well as the unexpected.

In 1997, David Berins and Peggy Berg produced the industry’s first CapEx study. They recommended hotels increase their capital reserves from 3 percent to 4 percent to afford pending property improvement plans and inevitable equipment replacements.

Today, that 4 percent is still regarded as an industry standard. But modern day consultants say the reserve benchmark is woefully underestimated and CapEx planning is so much more complex than it was two decades ago.

“Using a percentage of revenues as the metric by which you set aside reserves for future capital expenditures is flawed right from the beginning. It’s almost irrelevant.” – David Berins of Berins & Co

New Point of View

During the Southern Lodging Summit in August in Memphis, Rick Pastorino, principal and CEO of REVPAR International and a member of the International Society of Hospitality Consultants, briefed the audience on a book titled “ISHC CapEx 2018: A Study of Capital Expenditures in the Hotel Industry.”

Pastorino noted each study covered several years and gathered data from different comp sets of hotels.

He called the new 276-page report a “tale of two statistics,” noting the 32 percent increase in FF&E spend and a slight decrease in total revenue from the previous report published in 2014.

The CapEx 2018 report covers the years 2013 through 2017. It was a time of recovery and abundance for the U.S. hotel industry when average spend per available room neared $5,000.

In the previous study, which covered the years 2007 through 2012, the average spend per available room was $3,700.

CapEx spending over the life of a hotel is impacted by many factors such as age of the asset, ownership, brand affiliation, market and hotel product type, says ISHC’s 2018 CapEx study. This chart that appears in the study shows that, on average, CapEx spend exceeds the traditional reserve of 4 percent of a hotel’s revenue.

But that statistic does not tell the whole story.

The Great Recession gave the hotel industry three very bad years.

The data show that before the commercial real estate crash in 2008, CapEx was an average $4,400 per available room. That’s 15 percent higher than the succeeding years.

A lot changed in the U.S. hotel industry during the decade of recovery.

David Berins of Berins & Co. is a longtime hospitality consultant who authored the first report in 1997 with Peggy Berg.

He takes credit for shortening the term capital expenditures to CapEx.

While researching the inaugural report, the team was debating an acronym when a FedEx delivery truck drove past the window and Berins had a Eureka moment.

To begin with, Berins explained what constitutes CapEx.

“It’s any money that is invested in a hotel for the purpose of creating or improving the product.” It is spending that keeps the property in “ship shape and competitive.”

Berins wrote an article for the CapEx 2018 study. He urges the industry to think differently about the standard cash reserve.

The traditional 4 percent of revenue recommended by Berins and Berg in in 1997 does not cut it in today’s industry.

“Using a percentage of revenues as the metric by which you set aside reserves for future capital expenditures is flawed right from the beginning. It’s almost irrelevant,” Berins said.

Depending on a percentage of revenue means when business slows, the hotel has less to spend on CapEx. The irony is when a hotel is struggling to attract business is when it needs to spend money on renovations and refreshes.

“The bottom line is you need to be prepared for expenditures based on the useful life of each type of asset,” Berins said.

ISHC’s 2018 CapEx report surveyed 902 properties across 139 U.S. markets. Property types were 459 full service; 127 select service; and 316 extended stay. The chart that appears in the report shows the percentage of property types and their ages.

Shareholder Influence

One major change in the hotel investment landscape is the growth of REITs. They’re the main drivers of the increase spend in CapEx. The 2018 report shows REITs consistently spent more than non REITs, Pastorino said.

That’s because:

  • they typically hold their properties longer than non-REIT investors;
  • they can afford the CapEx; and
  • they consistently upgrade their assets to maintain value for shareholders.

The only year that was not the case was in 2017, when privately owned hotels dedicated 8 percent of their revenue on CapEx and REITs spent around 5.5 percent.

Pastorino said researchers attribute the change to the high number of transactions among private equity investors which prompted renovations.

That year was an anomaly, and publicly held companies continue to define the spending terms as shareholders pressure REITs as well as hotel companies to improve and grow.

Each CapEx study covered several years and gathered data from different comp sets of hotels. The 900 hotels included in the 2018 report is the largest comp set ISHC and HAMA have studied.

Identifying Trends, Reality

Alan Benjamin co-chaired the effort with Chad Sorenson of CHM Warnick.

Founder and president of Benjamin West, a hospitality procurement company, Benjamin helped lead the 2007 and 2014 CapEx studies. The projects were labor intensive and time consuming, taking about 18 months from start to finish. “I always learn something,” he said, which makes him better at business and a valuable industry consultant.

The goal of each study is always the same, Benjamin said. “And that is, what are the trends in capital spending. And not only what are the trends, but what is the reality.”

Benjamin also authors an article in the 2018 study. He writes the industry is in a period of both record demand for FF&E and global supply chain uncertainty because of world trade issues. Though facing challenges, hoteliers should focus on the fundamentals of FF&E purchasing process.

Benjamin wrote the article in 2017. The uncertainty persists in 2019.

“It has definitely gotten more complicated,” he said.

But the procurement pro is confident the hotel industry will survive current political and economic trends. After all, he noted, import tariffs are not new to the industry. “We’ve had tariffs on FF&E since 2004. A lot of people who have been in the industry for a long time have forgotten that. This is not exactly a new topic.”

Cost Guide

CapEx 2018 features a cost guide to help hoteliers budget for PIPs and other improvements.

The guide was introduced in the 2014 study in response to owners’ need to grasp the level of re-investment into an asset.

The report authors write when data was being collected for the previous CapEx report, the hotel industry was still shaken by the Great Recession.

During the recession, capital resources were low and owners missed renovation cycles. As the industry recovered, hoteliers began doing piecemeal upgrades. They shopped around for the best deals.

Recognizing the trend, two design firms, Jonathan Nehmer and Associates and HVS Design, teamed up to create the cost guide.

CapEx 2018 gives an estimate of overall costs for full and part renovations of hotels across the different price segments. It also features line items and their cost ranges.

Finding Financing

Knowing what a renovation or major improvement might cost is obviously smart business. The next step is finding financing.

Access Point Financial was established after the recession as hotel developers sought money to close equity gaps. The firm provided short-term financing to owners who earmarked the hotels’ FF&E as collateral. Today, the company lends for new hotel construction, bridge financing for mortgages and FF&E.

Dilip Petigara, new CEO of Access Point Financial, co-authored an article in the 2018 CapEx report that outlines the different financing scenarios faced by hotel owners planning a PIP.  The article says capital reserves required by lenders and franchisers is far from sufficient to cover the cost of a PIP.

Matthew Hick, director of underwriting at Access Point Financial, said the amount a hotel owner sets aside depends of the property and the project. In most cases, hoteliers who come to Access Point seek to finance the whole FF&E package. “Hotel owners don’t necessarily need a reserve anymore because they are paying for [improvements] as they go,” Hick said.

The loan term is typically seven years, coinciding with the average life of a PIP. Once the loan is paid off, it’s usually time for another capital project in need of financing.

The cost of FF&E is driven by different factors, including shipping. It forces owners to seek additional financing beyond their escrowed capital fund. The trade war with China is increasing costs of FF&E, Hick said, but many owners are turning to other countries for their goods, including U.S. manufacturers.

Both Hick and Berins advise owners to invest in the upkeep of their hotels in the face of an anticipated performance slump.

Hick noted the influence of social media and publicly posted reviews about hotels in which a guest writes the hotel is “dated” or “tired looking.” Such comments can be a drag on business performance.

“My advice would be to at least start planning for a downturn,” Berins said. “It can be months or even a year away, but it’s smart to stay ahead of competition.” Typically in an economic slowdown, the costs of materials will decline. That’s a good time to invest in renovations and other capital improvements, he said.

NOTE: To buy a copy of “ISHC CapEx 2018: A Study of Capital Expenditures in the Hotel Industry” visit ISHC.com.

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