Repositioning a Limited-Service Hotel

New hotel developments can prove too costly or unfeasible in markets laden with oversupply or poor performance. The following article looks at some key considerations to successfully repositioning an existing hotel.

By Dan McCoy

October 5, 2010

Repositioning an existing property may be an investor’s best option to maximize returns, given today’s trends in hotel lending and performance. Although many developers believe they have successful new-build projects on the drawing board, most lending sources are not yet willing to get back in the construction game. In truth, some markets don’t have strong enough demand fundamentals to justify new development. However, demand levels have begun to bounce back from the lows of 2009, giving hotel lenders and owners confidence in maintaining control of quality assets, rather than divesting them at depressed market values. At the same time there is a rising tide of equity and debt investors eager to take advantage of the ebb in the hotel real estate cycle and ride the next wave up. For investors armed with the right combination of industry and market intelligence, repositioning a second- or third-tier property could be the most profitable way to take advantage of a forthcoming upturn in the market.

Honing in on the Right Property and Market

A primary concern for successful hotel repositioning is choosing the right property in the right market. An investor must determine if a property’s underperformance has been a result of correctable flaws in managerial or structural integrity, or if the hotel has suffered from forces that are beyond control or remedy. A cost/benefit analysis sheds light on the conditions of the hotel and what upgrades and changes are feasible. For example, dated furnishings can be replaced and ineffectual marketing can be supplanted with a viable strategy for outreach and sales. But a hotel with an obsolescent layout or visibility obstructed by an overpass may prove too time- or cost-prohibitive to pursue.

Investors should also have a thorough analysis of a market’s demand generators and existing and proposed hotel supply in their toolbox when seeking to reposition a limited-service hotel. During the recent recession, many markets were negatively impacted by reduced demand from traditional sources and increased competition from newly constructed properties. While some markets with strong and diverse demand generators are already bouncing back, others have suffered long-term setbacks and may never return to their pre-recession performance levels.

After an ideal market and a potential turn-around property have been identified, investors need to know what changes are required to improve the hotel’s market position, as well as the priority and cost-effectiveness of those changes. Market research and field work, including interviews with the current management, major accounts, the convention and visitors bureau, and economic development officials, provide perspective on past performance and future potential. Identifying any product or brand niches in the market may reveal opportunities for a specific service level, product scale, or brand family that is underrepresented. Evaluating the needs of area demand generators, especially how those needs may have changed in the recent recession, helps determine where the best opportunity lies.

Profit Potential

The key to a successful project is weighing the increased returns of an updated product with the cost of repositioning the property. This balancing act requires accurate cost estimates and realistic performance projections resulting from sound, thoroughly tested methodologies. Repositioning costs can be estimated through a cost-estimating service or through actual contractor bids, which are generally more accurate. In addition to costs for labor, materials, and project management, there are often fees associated with terminating and/or securing management and franchise agreements. Performance projections can be difficult to establish and substantiate, and an agent from a hotel-specific consulting firm is the best source for a thorough and objective market study.

Two Scenarios

A detailed investment model is essential for evaluating multiple cost and performance scenarios and determining a realistic expectation for return on investment. The tables below show two potential scenarios for the same investment. Each scenario assumes that the hotel can be purchased for $2 million with the same market financing, the same ten-year holding period, and the same terminal cap rate (determining the reversion sale value); the variables are the amount of equity invested for repositioning and the property’s resulting performance. The Best-Case Scenario shows a project that came in under budget and exceeded performance expectations. The Worst-Case Scenario shows a project that ran over budget and did not realize its expected potential.

 

 

The 25.0% equity yield shown in the first table clearly illustrates a successful project, whereas the 14.5% equity yield in the second table indicates that the investment rewards may not have been worth the risk. The property, market, supply, and demand characteristics described above determine these yields, which can either make or break an investor.

Conclusion

When navigating through this maze of potential profits and pitfalls, even savvy investors can lose their way, and an expertly researched, documented, and executed market study is the Ariadne’s thread through this labyrinth. Contact an experienced hotel consultant with expertise in your market for advice on which projects can yield maximum profitability from your investment in repositioning a hotel.

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