From that leaky roof that must be replaced to brilliantly conceived and executed guestroom furnishings and public space renovations, capital expenditures (CapEx) are extremely important contributors to a hotel’s reputation and service delivery and, ultimately, its performance in the competitive market.
In addition to operations and marketing, capital expenditures are a key component of hospitality budgeting and investment decisions. In fact, many assert that investing in capital expenditures is the most potent lever a value-add investor or developer possesses to enhance the returns on a hospitality investment.
OVERDUE FOR A MAKEOVER
The current focus on investing in CapEx follows on the heels of the pandemic when, in cooperation with lenders, many ownership groups and their asset managers diverted funds from FF&E reserves and capital budgets to the more pressing needs of making payroll and servicing restructured debts. Overall, the industry performed admirably during extraordinary times and there were far fewer defaults than many had anticipated as the pandemic unfolded.
However, many renovations were deferred far longer than planned while brand standards and consumer expectations continued to march steadily forward. The well-known series of CapEx studies released by Bjorn Hanson, now a hospitality consultant, who for years was the leader of PwC’s hospitality practice and is also the former divisional dean of NYU’s hospitality program, reflects this dynamic. Hanson estimated that U.S. lodging industry capital expenditures grew steadily from $3.8 billion in 2011 to $7.3 billion in 2019, then plunged to $2 billion in 2020.
For 2022, Hanson forecasted approximately $3.4 billion in capital expenditures, still “the lowest amount since The Great Recession more than a decade ago.” While these studies do not include new construction, room additions or major construction to convert a hotel to another use, the data show clearly that the hospitality industry is falling behind in making necessary physical improvements via capital expenditures.
STORM CLOUDS AHEAD
This far into the industry’s recovery, many hotel properties find themselves drained of CapEx and FF&E reserves. At the same time, substantial investments are needed as major brands are anxious to resume regular property improvement schedules.
As they ponder how to upgrade their properties, owners are further challenged to improve their guest-facing technology and to transform fit and finish. It is an expensive proposition, but there needs to be a commitment to material capital expenditure to drive future growth in net-cash flows. This will ultimately determine value for a property and the debt that it can support.
This recent fallow period for CapEx investment is exacerbated by a common industry strategy of “running lean” when it comes to sizing CapEx reserves. Many owners and asset managers will agree with their lenders and franchisors to annual reserves of 4% to 5% when in many cases 6% to 8% may reflect more realistic long-term investment requirements.
How, then, does an owner bridge the gap when there are large CapEx requirements that exceed established reserves? The answer is that for the past 40 years a long-term trend of declining interest rates that ultimately reached 0% allowed owners to finance their CapEx shortfall by taking out bigger and cheaper loans.
Like many real estate investment classes, declining interest rates have masked some structural capitalization issues in the hotel industry that are now being uncovered as interest rates are suddenly 300 to 500 basis points higher and credit has tightened. This tempts further deferral of CapEx—or even a move to move properties to alternative franchise affiliations that require less CapEx.
FURTHER COMPLICATIONS
Next, according to Goldman Sachs, in 2023-2024, about $1.1 trillion of commercial real estate debt is maturing, of which about 10% is for hotels. Also, given recent turbulence in the banking sector, 32% of this maturing debt is reportedly held by banks, which are under pressure from regulators and tightening underwriting standards for new financing. Another 25% of the debt has been packaged in the form of CMBS and sold to institutional investors, which is strictly governed by special servicers.
Long before the pandemic, non-bank lenders (i.e. debt funds) became more prominent sources of liquidity to the hospitality space, especially for riskier, value-add investments and new development. The market share of debt funds that demand high yields will likely increase further now that the stocks of regional banks, traditionally an important construction lender for hotel developers, are experiencing high levels of stress. This can only serve to further curtail liquidity.
Add in material and wage inflation pressures on operating margins and the dramatic rise in the Federal Reserve’s benchmark lending rate pushing the resultant cost of floating rate debts ever higher, and we face a challenging market for hospitality lending and investment.
SOMETHING HAS TO GIVE
The reality is that the owners of many hotels are not sufficiently well-capitalized to both meet the demands of securing refinancing for maturing debt and making overdue CapEx investments. In the scramble to refinance, not every owner will be successful. Many investors have already raised capital and are waiting to pounce should truly distressed situations materialize.
Is this the time that so many “opportunistic” investors have been waiting for? Or, will borrowers and their lenders again find mutually beneficial outcomes that don’t involve bankruptcy and fire sales?
Fortunately, hospitality is a favored commercial real estate sector at present as asset values are relatively high yielding and, thus, have the most cushion to absorb the current cost of market rate debt.
Though we don’t want to underestimate the financing challenges that await individual owners, we expect continued strong interest in hospitality investment opportunities, especially by well-seasoned, value-add investors.
As a result, we anticipate strong interest by both institutional and entrepreneurial investors in any under-capitalized properties with maturing debt and significant capital expenditure requirements that might otherwise make an opportunistic investor a fortune.
Story contributed by Stephen O’Connor, principal and managing director at RobertDouglas.