HM Executive Roundtable: Conversions in the hotel industry

A look at conversions in the hotel industry came into sharper focus at Hotel Management’s recent executive roundtable sponsored by Choice Hotels International. The event, held at the JW Marriott Desert Ridge Resort & Spa during The Lodging Conference in Phoenix in September, brought together a mix of hospitality movers and shakers who examined the variety of influences driving the financing of PIPs, conversions and reflagging, and diversifying your portfolio.

The pandemic did a number on many hotel owners’ and operators’ renovation plans, particularly in the economy segment, where hoteliers were basically looking just to make ends meet. Now, a new normal is settling over the industry as it recalibrates post-Covid, and property improvement plans are being prioritized.

“It was the economy and mid-scale segments that drove strong revenue to Choice during the pandemic,” said Tom Nee, Choice Hotels International senior vice president of franchise sales–conversion brands. “They were the go-to hotels. From then to now, the economy and mid-scale segments have had record RevPARs. Developers in these segments have been making money in their hotels, their investments, and they are now looking at a place to take that money and invest in another hotel. And so, they're turning to a proven model, which is the economy and mid-scale segments.”

To see a good investment return in this market, Nee said people are turning to conversion hotels, looking at open and operating assets and then converting them. “Right now the conversion game is it. There are two investors in the conversion segment: one is existing owners who are looking to reposition their existing assets through conversion, and there are developers who are looking to acquire more hotels in the economy and mid-scale segments because they see how well it has been doing.”

Nee added that before a franchisee enters the Choice system, they first must focus on the brand hallmarks, ensuring that the hotel is clean and updated, with nothing worn or broken. Once PIP financing for the hotel is secured, “there's a 'maybe' list of items that eventually need to be attended to, but as long as those improvement items don’t affect the guest experience, we will allow them to implement them over time and, as a result, they can do it from loans or out of cash flow after entering the system.”

Renovation-only loans are hard to come by, noted Melissa Butler, senior vice president for lending at the State Bank of Texas. “There's financing available for conversion opportunities, if you have an existing owner [who] wants to convert, that's going to be trickier because that borrower may already have a loan,” she said. “Always go to your bank and check with your existing lender to see if the funds are available if you're not doing it from cash flow.”

If a renovation-only loan cannot be secured with the existing lender, Butler said, the question could become whether the lender would allow a second mortgage behind the first. “Chances are, the answer is no. A lot of first mortgage lenders don't want subordinate debt behind themselves, because they don't want to create more risk from a cash flow perspective.”

Nee shared that Choice has a team that is focused on acquiring financing for licensees. “You've got to make sure the debt makes sense for your project and that your existing bank will work with that. If not, we have dedicated internal resources for our franchisees to help find debt that makes sense to complete the PIP renovation. I like to say I'm the conversion king. I've been doing conversions for many, many years. From start to finish, we can get a property into our system in as few as 100 days. Our system is set up to move it right through.”

Hospitality brokerage firm Marquee Commercial Lodging Advisors President Damian Gordillo said that financing can sometimes be found in unexpected places, such as through furniture manufacturers. “We're pricing the PIP out on a hotel in Arizona,” he said. “The FF&E costs are about $286,000. They are offering 12-month, 18-month, 24-month terms on being able to acquire. So that's always an avenue to explore. It's probably not as perfect as going to a local lender and getting some five-year, 10-year, 15-year advertised debt, but it's at least something to maybe help shoulder until you go back in the season.”

Reflagging and Accessing Key Money

If a branded property isn't performing up to speed, some economy hotel owners may look to convert to a different flag. The current outlook for reflagging financing depends on the reason for the reflag.

“You have to look at the overall deal and the situation,” Butler said. “Is it a brand problem or is it an operator problem? Is changing flags going to fix the issue? From that perspective, there may be money available, but you're going to have to present the whole case.” Butler noted that this is where a franchise person may be able to help. “They provide you with the market information and brand information. They may be able to help you explain to your lender, ‘this is the reason why we should convert. That's the reason this is not working. And this is what we can do to mitigate those reasons.’”

If there's too much of the same type tier, for example maybe there's too much mid-scale, there may be an opportunity to bring it down to something more in the economy or lower mid-scale, she added.

Nee agreed, saying that if it's difficult for a franchisee to get a second on their debt or backup financing, Choice will look at key money “to see if that we can offset that.” In-house, he said, “not only do we have a financing team to go out on the street and look for opportunities, we will use our own key money to help.”

Valerie McCormick, vice president of development and hotel retention for Aimbridge Hospitality, asked Nee whether Choice would suggest repositioning into a different brand if a hotel is not performing up to speed under a certain flag.

“We want to maximize the revenues in that property,” Nee said simply. “The revenue’s in that.” But for the most part, he noted, Choice sees conversion opportunities with either independent hotels that are looking to go to a brand for identity or for consolidation of services.

“I've had a couple of situations where it's an acquisition or it's a refinance and they're converting or rebranding a property and key money was involved,” Butler said. “As a lender, it may be prudent in that instance that the key money is transferable to the lender to pay down the loan, and that's where you can get your lender comfortable to extend the funds for the conversion. The money is being used for the intended purpose. The lender’s mitigating their risk, but you're also mitigating your overall obligation.” Butler added that lenders want to make sure the purpose of the loan is intended for that property and not to go acquire another property.

“There’s a ‘street corner nature’ to each of these decisions,” said Ed James, managing principal at Mumford Company. “It really does vary from block to block. But in the case of Choice, in a small interstate market in West Virginia, we just did that. The local market leader there was a nicely renovated Holiday Inn Express that was performing well. We approached the owners as part of our disposition work for an older Econo Lodge in the market that had real up-branding potential. The owners chose to purchase the property, renovate it completely and reposition to Quality Inn. This transition for the submarket was a win-win for the owners, especially when comparing the cost of the finished product to ground-up replacement cost.”

Getting in the Game

Historically, economy properties have been viewed as gateways to the lodging industry due to their relatively affordable buy-in. For first-time economy hotel investors, Gordillo said there is a basic roadmap to follow, and it's been done many times. “You acquire the asset, maybe do a renovation, maybe do a conversion, you hold it for five to seven years—the industry average for an economy hotel. You sell the asset, you recycle the capital, and you move on to something bigger and better.”

Success is, of course, everyone’s goal. “We want to make sure that they're successful,” Nee said, and shared that Choice offers a program for those who are new to the industry. “We just can't assume that everybody knows how to operate a hotel.”

Management companies are a way to mitigate this lack of experience, and they can also fill a need for the larger portfolios with multiple properties or, said McCormick, high-net worth individuals who are looking to park their cash somewhere.

“It’s important for every investor to keep in mind that diversification also means to make sure that you have a good economy or mid-scale product in your portfolio. The economy and midscale products, through the pandemic, were really the ones that carried some of these larger portfolios,” advised Nee.

“I like to say like a good return is a good return,” Gordillo added. “Don't be afraid of buying an economy product. If you diversify your portfolio, when things change and market disruptors happen, you are in a better position to survive and prosper than if you're not diversified.”

McCormick agreed, adding that the pandemic showed people exactly that. “When the business traveler fell out, there was the essential worker left, there was logistics, there was nursing, and there were [many] businesses that would gravitate towards the off-the-road motels, or the hotels that were still open.”

Every market is different, so there’s no revenue generator profile for markets in which economy properties do well, but Nee said Choice always looks for the holes in the market. “In the economy segment, I like to look for hotels that are heavily mid- or upscale and ones with a lot of new construction hotels for the upper mid-scale, because [an economy brand will be] a disruptor in the market.”

“Mid-market and economy hotels are resilient and can adapt to market conditions quickly and remain profitable. Demand for these assets remains fairly constant in good time and bad," James explained, stressing that he has found there are always going to be interested investors who want to get in the hotel business to take advantage of these situations.

Of course, there’s also the issue of inflation.

“The cost of the granite, the glass, the steel, the plastic, and the labor itself… It's incredible that we haven't more softening of demand, but we have not. I don't have an answer for it but still think we're going to see a soft landing before the next up cycle starts in earnest,” he said.

“It's tough. There are banks out there, credit unions, local banks. There are regional banks that are still lending in hospitality. But when you get to this time of year, their buckets are getting full,” said Butler. “You might see a little bit of softening right now and then it will pick up after the first of the year, when they can add back to their coffers. But, as Ed says, you've got to have the equity. It's equity for the win. That will usually find you some debt somewhere. Now, it may not always be exactly what you want, but it shouldn't kill a deal, because the money's out there for hospitality."