Hotel deals and financing: When's the best time to pay the PIPer?

As debt maturities come due for a hotel, the focus is understandably on interest rates, the financing stack and other deal conditions that it would take to refinance a property, as well as prevailing cap rates that inform the overall hold-sell decision.

However, an important part of that decision tree, whether to hold or to sell, is that aging properties may have fleeting franchise term. In addition, these older properties may have meaningful PIP requirements. As time moves on, these property-improvement plans will be more extensive and expensive due to inflation, tariffs and ever-increasing construction costs.

But what happens if you punt on the decision to sell today? Overall, as indicated, an aging hotel could translate into a more extensive PIP and a shorter franchise term. This could lead to a significant decrease in value. Also, if you are in a market with flat to moderate growth in net operating income, you may have an exacerbated problem.

To repeat, if I go to the hotel brand and I try to get a new franchise today, the brand might give me 15 years. But if I wait two, three or four years, maybe that term shrinks to 10 years. And my hotel's PIP is bigger, especially if I defer any substantial capital projects in the interim. Sound familiar?

Let’s look at an example to help ascertain which is better: dealing now or waiting.

Consider a 100-key Hampton Inn, built in 2000, that was purchased by the current owner in 2015-2017. At time of purchase, the current owner completed the PIP and financed the acquisition with a 10-year CMBS loan. The brand provided a 15-year license agreement at that time.

Fast-forward to today.

Currently, the hotel is achieving $105 RevPAR, roughly $3.9 million in total revenue, achieving a 31.5% NOI margin; or $1,226,400. The CMBS loan matures within the next 12 to 24 months, and, remember, the last major renovation was completed in 2015 to 2017.

With respect to the franchise situation, there are three to five years left on the remaining franchise term. Hilton indicates that it might provide a 15-year term today. One consideration here is that any developer willing to develop a new hotel would expect a 15-year franchise term, given the cost of new construction, so Hilton may be open to a 15-year agreement for a renovation and re-up.

As it stands now, with an estimated PIP cost of $3.5 million — about $35,000 per key — the value formula (revenue/cap rate) works out like this: Value formula – 8.5 Cap Rate less the PIP cost = $14.4 million less $3.5 million PIP = $10.9 million.

Owner options as a function of debt:

• If the debt is less than $7 million, the owner would likely have cash-neutral financing options that would cover the cost of the estimated $3.5 million PIP.
• If the debt is greater than $7 million, then the likelihood of a cash-neutral financing goes down and/or the pricing of debt capital goes up.

As a result:

• If the owner sells today they can expect to net $10.9 million less the current debt.
• If the owner does not sell the property and does, instead, complete the PIP, they would need to clear $10.9 million + $3.5 million, or $14.4 million total, in the future to equal the net proceeds today. In order to achieve a $14.4 million price, NOI would need to be maintained.

However, the risk in situations like these is that in three to five years, Hilton may no longer be willing to offer a 15-year license. This would likely result in the cap rate moving 100-200 basis points; and will, without a doubt, limit the buyer pool on disposition. Importantly, in order to achieve net sale proceeds, equal to what they would be today, NOI would need to grow to between $1.35 million and $1.5 million. This does not factor in an appropriate discount rate.

One corollary of the decision tree faced by many owners today relates to the proliferation of near-brands that would allow owners to slide into a new flag, which can mean down-branding their aging, “needs-a-lot-of-work” properties as debt maturities come due. On the flip side, these circumstances could ease the way for solid property owners with operating finesse to upgrade their brand flag.

We advise hotel owners to stay in close contact with one’s brand. This is no time for hide and seek. What we hear may not be heartwarming, but it is better to know the brand’s true position on an asset. Consider how location and type of property, the competitive environment, property condition, adherence to brand standards and guest scores all factor into the brand’s outlook on a given property and its ownership. As indicated, brand proliferation means there is more room than ever for repositioning of any given asset.

The bottom line is when considering a refinancing or potential sale, we need to understand how franchise terms may affect the value of that hotel and an owner’s strategy. In that way, we won’t fall off the franchise term-PIP cost teeter-totter.

Andrew Broad is a managing director with RobertDouglas.

The opinions expressed in this column do not necessarily reflect the opinions of CoStar News or CoStar Group and its affiliated companies. Bloggers published on this site are given the freedom to express views that may be controversial, but our goal is to provoke thought and constructive discussion within our reader community. Please feel free to contact an editor with any questions or concern.

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