The opportunities to repurpose hotels into other uses have increased during the past year, but the strategy doesn’t come without some challenge and risk.

Eric Jacobs, chief development officer at Marriott International for its select brands in North America, said during a Distressed Hotels Virtual Forum panel discussion about repositioning, repurposing and renovating assets that older extended-stay hotels have performed well amid the pandemic.

That is in part due to the home living opportunities that were introduced, such as workforce, low-income and homeless housing in that segment.

“A majority of hotels that we’re seeing converted out are really the ones that are being bought by local and state municipalities, like in California, where Project Homekey is buying up hotels to convert for the homeless,” he said, adding he sees value in that from a social perspective.

However, it’s difficult to underwrite from a capitalization-rate perspective. Most of these municipalities are paying multiples similar to 2018 or 2019 levels.

“You’ve got to scratch your head a little bit about the cost,” he said.

Jacobs said one of the biggest hurdles is zoning rights. A lot of municipalities also rely on the occupancy tax rate that hotels generate as well as the multiple days that a hotel guest will spend in a market with retail and sporting events.

Converting a hotel to a housing unit has an effect on multiple other areas, and cities are struggling without those typical business transactions that hospitality and tourism industries bring.

“There’s going to be a challenge; cities are going to have to be selective about changing the zoning,” he said, and Marriott, too, has been selective about which hotels it chooses to recycle out and build new.

Jacobs isn’t seeing a large exit of hotels. He said another challenge lies within big cities that are also experiencing an exodus of people who don't want to live in urban markets now, noting it will be interesting to see how New York, Chicago and San Francisco underwrite hotels into multifamily or micro units.

The jury is still out for how much supply will get converted, he said.

Andy Stewart, managing partner at Argosy Real Estate Partners, said his company has been active in hotel-to-housing conversions, noting that many are enamored by this strategy now.

Argosy Real Estate Partners is an institutional diversified real estate fund manager and invests in all asset class types. Five years ago, company officials started thinking about the strategy of converting hotels into apartments.

“We always look at existing assets and say, ‘Is there a higher and better use of this asset?’” Stewart said.

While redeveloping a full-service hotel in an urban market isn’t quite attractive now, his company is, over the long term, interested in purchasing older-generation extended-stay hotels at favorable cap rates and holding until a development site is found for a new hotel.

Once that site is determined, the older hotel would come offline and convert into apartments. Stewart said he’s discussed projects like that with hotel brands.

“I think that strategy has become more front and center for us in the COVID environment because there’s been more distress entering the system where we can get more favorable pricing,” he said. “But what we try to do is create a win-win for our investors, for the brands and also for renters.”

Sarang Peruri, chief operating officer at Oxford Capital Group, a real estate investment and private equity firm, and partner of Oxford Hotels & Resorts/Oxford Living, said he likes the cap rate arbitrage of converting from a hotel to an apartment. However, that’s offset by the fact that a hotel in a normalized market would typically generate higher net operating income than an apartment.

“There is an offset, but particularly now when hotel performance is depressed and it’s going to take some time to come back, and you get that cap rate arbitrage, that is compelling for the right opportunities,” he said.

The deals that are closing are those in markets that lenders favor, with sponsors that lenders like and with simple business plans, he said. The toughest deals now are ground-up construction.

Peruri said the key to conversions or adaptive reuse is finding well-located buildings with good bones that may not be functioning at its highest and best use.

Oxford Capital Group has had success in converting Class C office buildings — which might have been built as a Class A office 100 years ago but have "fallen down the food chain” and become underutilized — into hotels.

He said his company would rather purchase a Class C building because Class A buildings are worth more, meaning it's tougher to justify the time, money and risk at that higher basis to convert into another use.

Some of the same philosophies apply now as people are looking for hotels as other uses.

“If you’re in a market that you think is going to recover and you think that hotel over time is going to improve cash flows … there’s value there,” he said. “To justify the cost and the risk of conversion, it really depends on the basis.”

His company is selectively looking at micro-apartment business plans, which include adding kitchenettes to the hotel units, changing the guest profile and extending leases.

Audrey Matlock, principal at New York-based Audrey Matlock Architect, said her company started several hotel projects around the same time COVID-19 hit, including working with a hospitality group to develop a new lifestyle brand.

Her company is also looking at a ground-up opportunity in North Carolina and a conversion project in New York City. In recent months, her company has studied converting hotel rooms into micro apartments.

She said converting to apartments has upsides, because the dimensions and square footage of a hotel room are ideal for a micro-living unit.

“You’re able to utilize virtually all of the infrastructure of the hotel, the vertical and horizontal circulation, also plumbing risers, HVAC systems," she said. "So simply adding a kitchen into the existing plumbing infrastructure, resurfacing the interiors of the spaces and installing pre-fab furnishings."

In addition to cost savings, she said it also creates a sustainable conversion.

Richard Millard, managing director at Highgate, a global real estate investment and hospitality management company, said the best opportunities coming out of the pandemic will ultimately come down to market, supply and asset. He anticipates that for development, secondary and tertiary markets will shine over big cities like New York and Los Angeles.

“There’s an expression in the hotel business that we’re not overdeveloped, we’re underdemolished. This gives us an opportunity to get rid of those things that should have been demolished a long time ago,” he said.