Factor cap rates and CapEx into the deal

Sotherly Hotels acquired Atlanta’s 326-room Georgian Terrace Hotel, an adjacent 698-space parking structure and a 0.6-acre development parcel for $61 million. As a part of the transaction, the company closed on a $41.5-million loan with Bank of the Ozarks and a $19-million loan with Richmond Hill Partners, LP and Essex Equity Joint Investment Vehicle, LLC.When the hotel industry is in full swing, it is reasonable to assume that hotel brands also take advantage of market conditions and begin to impose stricter standards when hotels are transacted.

But just what is the impact on terms of deals when brand standards enforcement heats up?

Picture: Sotherly Hotels acquired Atlanta’s 326-room Georgian Terrace Hotel, an adjacent 698-space parking structure and a 0.6-acre development parcel for $61 million. As a part of the transaction, the company closed on a $41.5-million loan with Bank of the Ozarks and a $19-million loan with Richmond Hill Partners, LP and Essex Equity Joint Investment Vehicle, LLC.

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Hotel brokers and analysts said capital expenditures are a crucial and integral part of pricing consideration. “It’s difficult to overstate the impact when talking about the limited-service and select-service brands,” said Ed James, principal at Mumford Co. “The impact is huge.”

James said it’s the overall impact on pricing that makes this an issue for the lower tiers; a $1-million product-improvement plan for a $5-million hotel is a big deal. “When ownership changes, that is the franchise’s best opportunity to improve the product in their system,” he said.

Bjorn Hanson, divisional dean of the Preston Robert Tisch Center for Hospitality, Tourism and Sports Management at NYU, forecast in October that 2013 CapEx spending would rise to approximately $5.6 billion. This is 107.4-percent higher than the $2.7 billion spent in 2010.

All of the brands are consistently trying to improve themselves, James said. “When we were in the recession, it was difficult for brands to go to existing licensees, and potential licensees to demand improvements, when it was difficult to get additional financing,” he said. “Today we’re in the opposite situation. Now is the time when a franchisor has the ability to try to improve the product.”

Daniel Beider, chairman and senior managing director at Paramount Lodging Advisors, said the cost of CapEx can be deducted dollar for dollar from the price, especially for deferred maintenance. “If it’s the roof or boiler or electric or plumbing, if a PIP needs to be implemented based on brand standards, in that sense [the price impact] is standard throughout the industry,” he said.

Cap Rates and CapEx

While market participants often talk about what the cap rate is based on (historical or forward-looking cash flow), the cost of capital improvements is often a hidden cost in transactions, according to Suzanne Mellen, senior managing director of HVS San Francisco, who released a study, “Hotel Cap Rates and the Impact of CapEx,” in which she derives a method for including CapEx in cap rates.

Mellen sought to examine the concept of how CapEx affects returns, because the extent of the CapEx (in dollars or percentage of value) can have a significant impact on an “as is” cap rate derived from a sale and an investor’s real rate of return when the CapEx is factored in, she said.

“If the cost of a PIP is extensive, then the ‘as is’ cap rate may be higher than what we would normally expect and could be misleading. It is only with understanding the extent of the CapEx that is required, and the cap rate on the ‘all in’ investment, that we can see what the real expectations are,” she said.

The “as is” formula builds the buyer’s anticipated CapEx into the cap rate, Mellen said. “The other way is to add the CapEx [if one can find out that information] and add it to the sales price to derive a cap rate ‘all in’—but it is generally difficult to ascertain if any upside was anticipated from the CapEx,” she said. “No way is perfect, but anyone using cap rates should be aware of the impact of CapEx and try and research that component of the sale that they are analyzing for better clarity.”

Licensing Factors

Beider said a factor that may help in today’s environment is brands that are providing a traditional full new license agreement or even longer license agreements after PIP/refresh programs are completed. He said Paramount understands Hampton’s Forever Young initiative is going to allow properties to obtain up to a 15-year new license in certain cases.

“If an asset qualifies, a PIP is in hand, which upon completion would provide for a full or extended license agreement. Sellers and buyers benefit regardless of who completes the PIP and when,” Beider said. “Getting additional years can provide higher levels of comfort and certainty, compress cap rates and help in properly timing PIP completion. Any additional years may result in greater cost, but the asset can be held longer, yield longer and still have value upon a subsequent sale.” 

➔ “When ownership changes, that is the franchise’s best opportunity to improve the product in their system.”

Ed James, principal, Mumford Co.

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