The COVID-19 pandemic has had a profound impact on lodging markets throughout the United States, impacting hotels’ ability to generate cash flow to cover operating expenses and debt service.
Faced with low demand and high-fixed operating expenses, many hotels made the macabre calculation that they are better off temporarily closed than open in the low-occupancy environment. Many public spaces had closed in April, including more than 10 percent of hotel rooms, most heavily concentrated in the country’s largest cities.
Since then, many hotels have reopened to take advantage of the improvement in national lodging demand, but the pace of hotel reopenings is dependent on the market. While approximately 70 percent of all closed hotel rooms in the U.S. have since reopened, only about half of hotel rooms in America’s top 25 markets have reopened to date.
For some of the hardest hit markets, such as New York and San Francisco, reopening has been slow and jittery. However, in the case of New York City, we’re beginning to spot an increase in investor interest due to the city’s resilience and history of rebounding during past challenging times. Other markets may follow, but for some, hotel owners are starting to think creatively about their assets. Additionally, the current investor profile comprises traditional hotel investors as well as opportunistic buyers that have not been active in the hotel space prior to the pandemic.
Some of the creative investment strategies that hotel investors are considering include converting hotels to alternative uses. In working with them, we have identified nine key factors that tend to determine whether hotel use remains a property’s highest and best use.
1. Market Location
Hotels located in high-density gateway markets that rely on significant corporate, group or international travel demand are more exposed to long-term weakness in hotel operating fundamentals and more likely to merit redevelopment to another use as a result. In contrast, hotels in interstate markets that service essential travel or in secondary and resort markets that cater to leisure demand from drive-to markets are better positioned for a nearer recovery.
2. Hotel Positioning
Hotels that feature full-service positioning with a large number of guestrooms and significant meeting space are more susceptible to redevelopment than select-service hotels. Large full-service hotels typically require a significant base of group business to generate occupancy, drive rates, and support heavy staffing requirements. Considering that group’s total share of lodging demand has already been in decline for years, full-service hotels that depend on group demand for economic viability are at disproportionate risk of permanent closure.
3. Labor Structure
Hotels that are subject to labor agreements that limit operational flexibility and contribute to a higher cost structure are more likely candidates for redevelopment than hotels with more flexible labor arrangements. While the cost of terminating onerous labor agreements can be very high, the cost of maintaining the status quo is frequently higher in today’s challenging operating environment.
4. Brand and Management Encumbrance
Hotels that are unencumbered by brand or management are more likely to be candidates for redevelopment given that their permanent closure does not trigger termination fees. However, the drawbacks of brand management—high fee structures and a lack of operational nimbleness—likely are exacerbated in the current environment, while the advantages of brand management—strong group sales platforms and robust loyalty programs that drive corporate demand—are less pronounced. As a result, termination fees are less of an impediment to redevelopment in the current environment than has historically been the case.
5. Legal and Zoning Restrictions
Repositioning a hotel property to alternative use can be complicated by legal and zoning restrictions. Converting guestrooms to rental apartments, residential condominiums or office space may not be legally permissible, and if a hotel is landmarked, the scope of any proposed changes may be further limited.
6. Building Structure and Layout
The percentage of gross building area that can be converted to net sellable or rentable square feet, or the efficiency potential of a building, is often overlooked as a key determinant of its redevelopment potential. New construction with double-loaded corridors may boast efficiency ratios as high as 85 percent, while older buildings with U-shaped floorplates that lack double-loaded corridors may have efficiency ratios below 60 percent. A building’s efficiency may not necessarily increase following redevelopment depending on a multitude of factors. Additionally, a hotel’s typical ceiling height is an important consideration with low ceiling heights materially impacting rental rates or sales prices following conversion. Buildings with high ceilings and efficient floorplates are more likely to support a high value upon redevelopment.
7. Redevelopment Timeline and Costs
The amount of time required to secure necessary entitlements and redevelop a hotel to an alternative use may significantly impact projected investment returns. Properties that are likely to encounter a lengthy entitlement process or where redevelopment is more structurally complicated are therefore less likely to be strong candidates for conversion to an alternative use. It’s worth emphasizing that redevelopment costs are also a critical driver of a hotel’s redevelopment potential. If a hotel’s layout requires fewer structural changes to accommodate redevelopment, then its potential for conversion is likely much higher than if a more significant reconfiguration is required.
8. Market Outlook for Alternative Uses
Hotels may be the hardest hit of the real estate asset classes in the COVID-19 pandemic, but they are not alone in their vulnerability to it. Measuring the decline in lodging performance against the decline in performance for an alternative asset class and comparing their prospects for recovery are critical determinants of redevelopment potential and every market is different.
9. Risk-Adjusted Investment Return Expectations
Hotel owners’ risk tolerance for alternative conversion scenarios is often the decisive factor in determining whether a hotel is redeveloped. Converting a hotel to residential condominiums may result in the highest projected return on investment, but the higher projected return may not adequately compensate an investor for the significant risk inherent in closing an operational asset, committing significant capital for conversion, and projecting market conditions into the future. Alternatively, converting a hotel to office use or to rental apartments may result in a lower projected return on investment but given the relative stability of these sectors historically, an investor may deem such a scenario more compelling. As a result, hotel owners’ relative risk tolerance for different asset classes is key in assessing whether conversion to an alternative use is appropriate for them.
Kent Michels is SVP with JLL Hotels & Hospitality Group.