Capital planning is one of the top strategic priorities for hotel owners, given its significant impact on short-term cash flow and long-term investment returns. Owners are constantly challenged to balance “spend now” tendencies, which may be influenced by hotel brands (particularly now when capital reserves are relatively healthy given eight plus years of RevPAR growth); versus saving to “spend later,” which may encompass a significant renovation or reinvestment in a future year.
While contributions to FF&E reserves may be the primary source of funds for capital projects, hotel owners generally have other tools at their disposal in the event of a capital shortfall, such as additional owner infused capital, refinancing or, in some cases, selling the asset and leaving the capital expenditure to the next owner.
Public-sector hotel owners, namely cities, counties, agencies and authorities responsible for publicly-financed hotels, typically do not have the same alternative funding tools available to them as their private-sector counterparts. Hotels that are publicly owned have complex, long-term financing structures, and in all likelihood may never transact, as these assets typically serve to support economic objectives tied to other facilities such as convention centers or airports.
While public entities may be accustomed to owning real estate, the operationally-intensive and volatile nature of hotels makes them unique from other asset classes, requiring specific strategies to insure funds are available for future capital needs.
This article highlights some key factors in capital planning that are unique to publicly owned hotels, as well as some strategies for successful implementation.
How do publicly owned hotels differ?
Capital intensive assets: Publicly owned hotels are typically large facilities, both in room count and square footage (i.e. they include large amounts of meeting space, restaurants, etc.). Their size and scale alone make these hotels extremely capital intensive. In capital planning discussions, the old algebra equation “x times y = z”, where x is a unit cost (per room, per square foot, etc.), y is the number of units and z is a big number, is used frequently. It is amazing how quickly each item added or replaced in a guestroom can add up when you are dealing with an 800 to more than 1,000-room hotel, and that doesn’t include refurbishment of meeting, F&B and public spaces. In short, the total dollars required to adequately fund capital reserves for these hotels can be staggering.
Underwriting true capital costs: Given their size and high dependency on group business, large convention hotels may take several years to reach that enigmatic “stabilized year.” FF&E reserve guidance for new hotels typically reflects a gradual step-up in terms of contribution (lower percentage of revenues in earlier years). The resulting low level of capital reserve contributions in a hotel’s early years can magnify shortfalls in years seven and beyond given the size and scale of these operations. This is an area often missed or at least understated in underwriting, which will only serve to create funding shortfalls in the long run.
Bond structure: While nearly all hotels (regardless of ownership) have a debt component to their capital stack, many publicly owned hotels are 100 percent bond financed. As such, there are unique requirements set forth in bond covenants that are overseen by an asset manager and trustee, outlined in bond documents that may be more stringent than that found in more typical financing structures. As such, the owner may have limited flexibility to divert funds for future capital needs, a common strategy within the private sector. In the absence of a more traditional “owner fund,” all expenditures are funded from capital escrows or FF&E reserves, highlighting the need for extremely careful planning.
Public perception: While standards and acceptable conditions may vary by ownership group, the high-profile nature of these hotels may warrant a higher level of capital reinvestment. This can impact not just the capital expenditure, but also decisions on deferring to spend funds. At the same time, publicly funded hotels have come under major scrutiny in recent years, with competing needs for project funding within cities and counties. All aspects of these projects are in the public eye and often heavily reported, so it’s imperative that the operation is not only self-sufficient, but that capital dollars are spent prudently and to the benefit of the operation in the form of performance enhancement, as well as asset preservation. Capital planning strategies for publicly-owned hotels
Look long-term: To mitigate these factors, public owners need to have a long-term time horizon; one that often looks to not only the next renovation in five to seven years, but also takes into consideration building funds earmarked for expenditures that may not arise until 20 years into the future.
Adjust reserves: While future renovations may be the last thing owners want to think about when opening a brand new hotel, it is imperative that funding starts from day one. While most new hotels open with a “stepped-up” reserve (2 percent year one, 3 percent year two, up to 4-5 percent of revenues), in our experience, it is best to determine long-term capital needs and reserve accordingly. Reserving at a higher level from the start serves to counter lower revenues associated with initial operating years, as well as hedges future cycles in which performance may potentially be below expectations and/or project cost escalation.
Monitor and strategize: Early identification and communication of possible future year shortfalls can allow for more prudent capital decisions in a hotel’s early years. Additional funds should be committed and set aside where possible and permissible for dedicated hotel use. These additional contributions can come both in terms of an increased reserve contribution (likely with the increase to come subordinated to bond and other payments); or one-time excess funds (if available) after other contractual commitments are met. Other options for consideration may be understanding those that may arise from bond refinancings, both for the hotel and/or any other bond offerings that may arise.
Alternative funding options: Other strategies to balance or fund capital projects may include one or more of the following:
- Seeking a loan from your brand partner;
- Negotiating a delay in certain aspects of the capital plan with the brands;
- Pushing back on brand standards that may not make sense or add value given a specific market or operation;
- Transferring excess distributions not used for obligations (loans, taxes or insurance to name a few) to the FF&E reserve;
- Exploring opportunities to maximize the use of rebates before going forward with projects (even waiting to the next year to avoid paying full price);
- Adding more time to the renovation process to allow for improved planning and avoidance of costly mistakes;
- Being prudent with capital spending from day one, and where necessary charge operations, if applicable.
Larry Trabulsi is an SVP at CHMWarnick, the leading provider of hotel asset management and owner advisory services globally. Trabulsi brings 25 years hospitality asset management experience and expertise in advising public-sector clients on the successful planning, opening, operation and strategic capital planning for convention center headquarter hotels. CHMWarnick is an advisor to public-sector hotel owners, with more than 15 of the nation’s largest convention center headquarter hotels in their asset management portfolio. The company asset manages more than 70 hotels comprising approximately 29,000 rooms valued at roughly $15 billion. CHMWarnick’s owner advisory services include asset management, hotel planning and development, acquisition due diligence, owner-entity accounting, management/operator selection and negotiation, capital planning and disposition strategy. It has eight offices nationwide.