By year-end 2014, U.S. lodging industry occupancy and ADR levels had both returned to pre-recession levels. Hotel developers are approaching that stage in the lodging cycle when they need to decide if it is more prudent to construct a new property or purchase an existing one. Based on the March 2015 edition of PKF’s Hotel Horizons report, lodging supply is projected to grow by less than 2 percent per year through 2016. This indicates that numerous developers are still opting to buy versus build.
Some properties being bought will require extensive renovations. Renovations are more prevalent because of the lingering existence of recession-induced deferred maintenance. In addition, the major lodging chains are reducing the number of forbearances they are giving to owners, and they almost always require new owners to perform a PIP in order to meet brand standards. Accordingly, when purchasing a hotel today, a buyer must understand the impact of the renovations on the value of the property in order to determine a proper purchase price.
Each year, CBRE and PKF appraisers value hundreds of hotels on behalf of buyers. Given the increased incidence of renovations associated with the purchases, we have developed a large database of transactions that depict the impact of the proposed renovations on hotel purchase prices.
In today’s market, buyers of hotels that are two to three years old and do not require extensive renovations expect to achieve a leveraged internal rate of return (IRR) in the teens. However, buyers of underperforming assets in need of a renovation or PIP should be able to achieve a higher rate of return to take advantage of the upside. In these incidences, we are seeing IRRs in the low 20s. The higher rates of return associated with the purchase of an underperforming asset in need of renovation are a result of repositioning within the market and the continued expectation of overall growth in RevPAR in the market.
The accompanying tables present two case studies that show how the payback of a required PIP helped give buyers assurance to spend the required renovation funds over and above the purchase price.
In both studies, it was assumed that the PIP would allow the properties to achieve a healthy increase in ADR. Given the high flow-through of revenue increases driven by ADR growth, it was reasonable to project significant improvement on the bottom line, as well. The net result in both circumstances was an increase in the capitalization rate, which implies a higher IRR. It is the expectation of a high IRR that gives the buyer the confidence to spend the additional funds for the PIP.
While the two case studies are typical of most of the transactions we have observed the past few years, hotel renovations do not always result in improved profitability and high IRRs. The required PIP dollars vary from brand to brand. Therefore, the buyer must select the proper brand for the subject market that will result in the necessary improved performance. The choice of brand must either improve RevPAR yield within the property’s existing competitive set, or move the property into a higher position within the market.
For investors looking for a five-year hold, the opportunity still exists to achieve IRRs in the low 20s. It is true that the rock-bottom prices of 2009 and 2010 are a thing of the past. However, we still see properties that, after a proper renovation and repositioning within the market, will justify paying both the purchase price and the required renovation funds.
Scott Smith MAI and Scott Bradford contributed this column to Hotel Management's April 7 issue. Scott Smith is located in the Atlanta office of PKF Consulting USA, a CBRE Company (www.pkfc.com). Scott Bradford is part of the Atlanta practice of CBRE Valuation and Advisory Services (www.cbre.com/valuation).