Aggressive change-of-ownership PIPs put a pinch on the transaction process

During the recession, most franchise companies allowed their franchisees to defer renovation projects and maintenance because of the lack of available capital. But those days are no more. Franchisors are pushing big improvements, especially when a property changes hands, which is having a big impact on hotel values.

“What we’re seeing, particularly over the past two years, is the franchise companies getting very aggressive on [product-improvement plans], particularly change-of-ownership PIPs,” said Geoffrey Davis, president and senior principal with HREC Investment Advisors. “There has been, in [franchisors’] defense, a lot of deferred maintenance on assets during the downturn. They view a change of ownership as an opportunity to improve the quality level of each asset and up their brand standard.”

Harry Pflueger, principal with Maxim Hotel Brokerage, said there is a lot of concern on the part of borrowers and lenders. “The franchisors have been somewhat cooperative and allowed lenders to sell a hotel through receivership without getting outrageous in their PIP requirements or a lender could take a property back without hitting them too hard with a PIP requirement,” Pflueger said. “That seems to be changing. You can only kick the can so far down the road. It begins to damage the overall image of the franchisor if they let their properties go too many years without a refresh.”

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The work is required to be done in a shorter period of time, as well, according to Steve Kirby, principal with the Mumford Company.
“Certainly with a change of ownership, they’re not deferring anything anymore,” he said. “They want the work completed in relatively short order. They’re playing catch-up now.”

PIP hit
Because of the years of deferred work, franchisors are demanding, in many cases, large-scale projects that might not be expected.
“We may walk [into] an asset and say based on the last renovation we think it’s a $2-million renovation and the PIP comes back and it’s $6 million to $8 million because the brand company either wants to push it to a different brand, push it out of the system or give it a complete redo to be consistent with what they’re trying to do with their overall brand strategy,” Davis said. “It’s taken owners and investors a little bit by surprise.

“It’s not completely unjustified but we think there needs to be a balancing of aggressive PIPs with the reality of the market, which is that in most markets the recovery is still slow.”

In many cases, the large PIPs are because of special adds. “Everyone has their proprietary programmatic feature that the newly renovated properties have and if you’ve not done a recent renovation it becomes glaringly obvious to your guests that you haven’t renovated in awhile,” Pflueger said. “If you walk into a Courtyard that doesn’t have the Bistro lobby, immediately to the educated guest it’s going to feel like an older Courtyard.”

So how aggressive are franchisors about PIPs lately? According to Davis, the hit is significant. “When we do a value analysis on a hotel, whether it’s for a refinance or a sale, we calculate value and then basically the PIP is a straight dollar-for-dollar deduct on value,” he said. “If we figure value on an asset is $10 million and there’s a $2 million PIP on it, the value gets reduced to $8 million.”

Kirby agreed that PIPs are taking a chunk out of prices. “If it’s not dollar to dollar, it’s pretty darn close,” he said. “It depends on the level of it. If it’s a Courtyard, it’s probably not going to be dollar for dollar. If it’s a Days Inn, the Days Inn buyer is going in so much leaner that he has to get dollar for dollar for it to make economic sense.”

According to Pflueger, every deal is unique. “In situations where the broker can demonstrate that the hotel’s performance has been suffering because of its condition, you can show it’s underperforming the competitive set, then you can justify the argument that spending this money to improve the hotel will significantly enhance its performance,” he said. “If that’s the case, it becomes more of a turnaround deal and it’s not really a deduct on value.”

It’s a harder sell when the hotel isn’t underperforming. “In certain situations where a well-branded, upper-end select-service hotel is already getting a 120 [revenue per available room] index and the franchisor is requiring $2 million or $3 million be spent on the property, then that becomes more of a deduct on value,” Pflueger said. “The buyer is going to think that he has to spend this money and isn’t going to see much improvement in revenue because it’s already outperforming the competitive set.”

Deal action
So are transactions getting done despite the PIP impact? Kirby said it’s hard to find a payback when PIPs equal or exceed the value of the real estate. “You have to factor that into the value of what you can pay versus what the seller owes or wants to net out of the deal,” he said. “It’s definitely harder to find buyers for such products.”

But there are positive signs in the hotel market, he said, and he expects PIPs and selling prices to continue to go up. “We’re seeing a recovery in the selling prices right now,” Kirby said. “Slowly, but we’re definitely seeing some increases in terms of cap rates declining just a little. 
“Revenue multiples are going up.  That’s the key. As top-line revenues go up at a hotel then you’ve got a lot more to work with.”

Davis said deals still are taking place. “A lot of buyers and sellers, having gone through 2011 together, were much more realistic on both sides of the fence in terms of valuation, so we’ve got it kind of figured out as an industry now where value is so when something does come to market there’s a higher likelihood that it’s going to trade,” Davis said. “We’re seeing a trend toward tighter bid-ask between buyer and seller and some increased flow of debt capital for the right deals.”

Pflueger said that most markets are moving in the right direction. “There are still many hotel markets showing high single-digit or double-digit RevPAR growth,” he said. “Things become more financeable and people generally take better care of their properties.”

Davis said he is very bullish about the continued strong pace of transactions. “We have some clients who want to get trades done this year because they want to take advantage of the lower capital gains tax rate and then there’s some people who are taking a wait-and-see attitude about the impact of the election on the investment mindset and the investment community,” Davis said. “But at the end of the day, people will get past whoever wins and find a way to get deals done.”

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