Reflaggings Slow in Difficult Operating Environment

REPORT FROM THE U.S.—The continued difficulty in getting financing will drive the conversion movement.

“It’s going to be very, very challenging to easily secure financing to build hotels,” said Brad Garner, VP of operations/client services for Hendersonville, Tennessee-based Smith Travel Research. “For someone to assume that risk, with the financial institutions’ current mindset, conversion will be a big buzzword taking place near to mid-term.”

Brad Garner, Smith Travel Research	Chuck Pinkowski, Pinkowski & Company

Historically, this cycle is following cycles that occurred during the late 1980s and earlier this decade. “It’s a heck of a lot harder to sell a new franchise,” said Chuck Pinkowski, founder of Pinkowski & Company, a consulting company based in Memphis, Tennessee. “All the major brands have teams of franchise salespeople and they have quotas to sell.  When you get into a recessionary period, demand isn’t what it used to be, so they sell a franchise and get them to change the brand.”

Garner said the fact that it’s much cheaper to convert existing hotels than build new ones factors into the decision to reflag a property.

“It’s immediate gratification on the supply side,” Garner said. “You build critical mass quickly. If (a brand) can convert some properties, it can get an infusion of cash from franchise fees. That might look good on the bottom line.”

But right now, the number of conversions has dropped compared with last year, according to Bjorn Hanson, a clinical associate professor in the School of Hospitality, Tourism and Sports Management at New York University. There are three reasons for that, he said, the first being cooperation with brands.

Source: Smith Travel Research “Many reflaggings occur because hotels are not meeting brand standards or their (property improvement scores) are below the minimum required to retain the affiliation,” he said. “In this environment, many of the brands are being much more flexible in granting exceptions and deferrals regarding brand requirements.”

The second reason is that many reflaggings happen when the hotel is bought and the new owner wants to reposition it, but the dearth in transactions has led to fewer reflaggings. 

Cost also is a factor. 

“The cost of conversion is substantial and with profits in 2009 being half of what they were last year, owners aren’t looking to incur the investment involved in reflagging,” Hanson said. “There is less cash flow available.”
 
That reduced cash flow works both ways, according to Pinkowski.

“A property that is coming up to the end of its 20-year franchise agreement typically in a decent market would relicense the property for another 10 years,” he said. “But because the costs are too high to meet the standards, they are going to go to another brand.”

Bjorn Hanson, New York University

As the performance of the industry slowly begins to change direction, the number of conversions could take a new tack, as well.

“As we start the recovery in this cycle initially you’re going to see a lot of people try to supply-in through conversion, much like the previous cycle,” Garner said. “The financial options are the wild card now. Although they’re similar, the way they’re going to get financed if you’re going to build rather than convert is going to be completely different.”
 
Garner said during the last cycle, deals still were getting done and hotels still could be built.

“But in this recovery, I don’t know anyone who is going to take that risk,” he said. “It’s going to be interesting how people get it done now.”
 
Hanson said there will be a slow but steady increase in the number of conversions starting in late 2010.

“There will be a blip, but because the recovery of the industry is expected to be slow and gradual rather than an accelerated recovery, individual owners will make the decision to reflag as conditions warrant,” he said. “The economics might not support it for some time. The demand will be there, but maybe the economics will not.” 
 
-The trend to conversions can have some downsides.

“In the eyes of the consumer, newer is always better,” Garner said. “You wonder when you convert what the outlay is to get it up to brand standards and get it looking newer.”
 
And how long until an owner or management company can expect to see results from a conversion? Garner said that typically it’s a year, versus a two-year ramp-up for a new property. But it could take a little longer right now because of the industry’s lack of pricing power, he said.

Pinkowski said initial results should occur within six months.

“We’ve seen a property go from one brand to another and go through the roof in six months after the rebranding and others we’ve seen make a change and nothing happens,” Pinkowski said. “A prudent developer going through the right due diligence and review process could expect to see some material improvements within 6 months. They should be at a stabilized level within 12 to 18 months.”

Gloria McCollum, Pinkowski & Company

Hanson co-authored a study in August titled “Hotel Rebranding and Rescaling: Effects on Financial Performance,” which found that in many cases hotels saw an initial decline in financial results, but that decline was followed by a gradual recovery. The study also found that hotels that changed brands without changing their scale reported no significant change in financial results. “There might be an underestimation (by owners) of the initial decline, but there often is an underestimation of the favorable performance after the first year,” Hanson said. “When we take the absolute incremental investment combined with the less favorable first year, conversions are more expensive than anticipated. The good news is that the (long-term) performance is usually better than estimated.”

But as with every other aspect of running a hotel, success depends on more than the name on the sign.

“If a property is poorly managed and has a poor location in the market and all they do is put a brand on it, it’s not going to be successful,” said Gloria McCollum, a consultant with Pinkowski & Company. “It still matters if the person behind the desk greets you with a smile and is happy to see you.”