We are all familiar with the concept of caveat emptor, which puts the onus of inspection and transaction risk squarely on the purchaser’s shoulders. We also know from experience that decisions made during the acquisition process are directly related to a buyer’s ability to achieve desired investment returns, so sound underwriting and due diligence practices are imperative.
Hotel buyers must understand the asset and the market, identify risks, determine the value-add components and/or strategic initiatives, estimate returns and manage expectations, typically all within in a limited amount of time. The process of strategically evaluating deals, while managing the many aspects of the due diligence process can give pause to even the most experienced of industry professionals. We all have our methods of controlling the chaos related to acquiring a hotel, but the following critical steps could have a material impact on the process and outcome, if overlooked.
Assembling the right team early on
Hotels are unique from all other forms of real estate—from their operation to valuation and everything in between—and they require industry-specific expertise. Buyers should seek to surround themselves with the right team, including operational consultants, market and economic feasibility consultants, property condition inspectors, ADA experts, property tax advisors, insurance consultants, hotel-experienced local counsel and employment specialists, at a minimum.
Having the right experts on your team early on will also help identify issues upfront to avoid costly mistakes or prolonged expenses on a deal which may not materialize.
Planning an exit strategy prior to acquisition
Buyers need to be thinking about their exit even before they purchase. This includes developing a positioning statement, capital strategy and realistic independent pro forma prior to submitting a bid or signing a letter of intent. As the buyer, you might see opportunity, but is your investment thesis brilliant, or is it mission impossible? Consulting a team of experts will validate whether your plan can actually be executed within your intended hold period.
Understanding what is being sold
Reviewing the LOI with an eye toward what you are buying is as important as understanding what is not included in the sale. Is it fee simple or a land lease? Is all income attributed to the asset or are select components owned separately (food and beverage, individually-owned room units, etc.)? Are there out-parcels being acquired as part of the sale? Are there easements you should be aware of? Are there development entitlements that pass to new ownership? Let your expert(s) review the acquisition and loan documents and opine on the value of the assets and operational sections such as prorations and loan covenants.
Identifying what might be missing
Buyers receive financial and related operating information and likely will—and should—focus on developing a reasonable projection of future performance, factoring in the specific strategic plan (redevelopment, capital investment, management change, etc.), namely all of the value upside perceived in a given deal. Equally important for buyers is to consider what may be missing from the historical financial statements or areas of the operation that pose a significant risk once the asset trades hands. What capital has been deferred? Operationally, what “unsustainable” cost containment was implemented to boost net operating income for the benefit of maximizing sales price? What expenses may be carried on another set of books? Will property taxes and insurance be affected by the sale? What equipment is leased? Are there HOA term escalations or ground lease resets that will impact future periods? Is the asset encumbered by existing contracts?
Have your experts opine on potential liabilities and increased costs associated with new ownership. Revisit the capital budget and pro forma (again) and make sure the deal remains feasible.
Understanding the local market
Buyers who are new to hotels might be lured to invest based on the relative health of the national lodging industry, while failing to dive deep into market-specific dynamics, which vary wildly by location. Do you understand the supply dynamics? Are the major demand generators projected to be steady (e.g. convention center under renovation? Have any competitive hotels closed for renovation—or currently underperforming due to deferred maintenance that could be corrected? Are any significant business generators downsizing or relocating? It only takes one “miss” to completely derail a deal and anticipated investment returns for years.
Insuring the pro forma isn’t chasing the deal
It is often the case that the post-acquisition pro forma is based more on what it takes to justify the deal than what is rational and reasonable for the asset and the market. Aggressive increases in room revenue or F&B might be warranted if the property is being repositioned, up-branded or has been badly mismanaged in a demonstrable way. One valuable litmus test is to determine how the market performed at its historical peak and how the hotel performed against its comp set in that time frame. No matter who authors them, pro formas don’t pay the bills.
Clarifying brand product requirements
Typically, brands have approval authority over the buyer and may use this leverage to demand an aggressive product improvement plan. Brands will say their PIPs are non-negotiable, but experience has shown that certain items can be amended based on the unique needs of the property or market. Buyers should obtain independent pricing on the PIP, while also seeking clarification in writing from both the brand’s PIP representative and quality assurance inspector to be sure everyone is clear on the scope required. Think about what else could be done while the hotel is under construction. Consult the property team to identify areas for enhancing guest service or operational efficiency that could be addressed through specific projects, which should be considered as part of the plan.
Realistically calculate your full cash requirements
Estimate prorations, renovations and closing costs up front and update them as you get better information. Prepaid taxes, insurance and loan escrow requirements can add up to a lot of money and buyers need to be prepared.
In the end, buyers should resist the urge to commit too early or become too vested in a particular hotel or portfolio of hotels. Remain skeptical throughout the process and be willing to walk away. Due diligence is more than just a checklist and buyers should stay focused on how each box fits into the overall proforma and investment goals.
Lastly, be prepared to answer this question over and over: Do we still want this property and, if so, at what price?
Celeste Ledoux (CPA) is managing director and CFO of CHMWarnick, a leading provider of hotel asset management, owner advisory and accounting services. The company asset manages over 70 hotels comprising approximately 28,000 rooms valued at roughly $15 billion. CHMW’s owner advisory services cover virtually every aspect of the hospitality industry, and all phases of a hotel’s life cycle, including specialized ownership accounting services. For more information, visit www.CHMWarnick.com or follow on Twitter @CHMWarnick.
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