Renovating your property can be a financially tricky undertaking
Judging by recent activity in the hotel sector, operators are getting serious about renovation projects that have been on the back burner since the economic downturn. Fix your gaze on any Canadian city’s skyline and you’ll notice several cranes poised to do the heavy lifting.
Despite the fact occupancy rates are lower today than pre-2009 — considered a banner year by most in the hospitality industry — and the economy has not fully recovered, there has been a huge increase this year in renovation projects compared to the last two.
The reason, says Eric Malcolmson, director of Toronto-based HLT Advisory Inc., is operators are now thinking about positioning themselves so they’re in sync when the markets heat up. “Part of the move is driven by interest rates, another part is driven by overall improvements in the hotel market and economy in general,” he says.
Having spent several decades in the hotel renovation market, Peter D’Amato, president of HCL Group Inc. in Concord, Ont., confirms activity is on the rise. “We can usually gauge what’s coming six months down the road by what designers are doing today. A lot of owners put a hold on renovations around 2009, for good reason,” says the veteran hotel renovator. “We’re now seeing a huge turn as people are getting prepared for the summer and fall.”
Given that occupancy rates have yet to regain their peak numbers, new competitors are making a big splash on the urban landscape, and interest rates are better than the norm. The perfect time to begin reviving older properties is now, say hotel operators and developers.
“If you have the ability to go out and renovate in a down cycle, your hotel will be in a position to compete in an up cycle,” notes Scott Duff, senior director, Development, Canada and Alaska for Toronto-based, Starwood Hotels and Resorts Worldwide Inc. “You don’t want to take rooms out of service during key seasonal periods or robust economic times.”
As D’Amato sees it, smart operators are looking at the situation as a whole. “They’re keeping up with what the market and the economy is doing. They have their analysts looking down the pipeline and seeing that we’ve bottomed out now, and it’s time to put projects back on the front burner and get moving,” D’Amato explains. “They’re getting ahead of the game and having product that will be fresh and updated within six or eight months versus a year or more down the road. They’re starting to pull the trigger and make it happen,” he says.
The growing threat of competition from new branded properties cannot be underestimated either. Chuck Henry, president of New York-based Hotel Capital Advisers, Inc. warns that as brands such as The Ritz-Carlton and Shangri-La make their way into major urban Canadian centres, existing properties will have to wrestle with the best way to maintain their market share. That typically means a refresh in one form or another. “The good news is it costs a lot less per room to renovate compared to what it costs the new guys to build,” he says.
Hoteliers have to be mindful of their property’s appearance, reputation and overall curb appeal. While their neighbours are putting on their Sunday best, they themselves may appear a little worn out. The glitz and sparkle of a new property can make an older hotel look tarnished. “If you have lots of shiny new product being built around you that offers high quality, and your last renovation was a decade ago, you’re facing a big threat,” Duff says. “That’s when you have to undertake this type of investment.”
RETURNS OF A DIFFERENT MEASURE
Whatever the motive behind renovating or repositioning a property, the process demands a clear vision and strategy. Manlio Marescotti, vice-president of Lodging Development for Marriott Hotels and Resorts in Mississauga, Ont., says Marriott brand standards require major renovations every six or seven years. When deciding on the investment required, many basic questions are asked. “Can you justify the investment through the economic return you will be getting?” he says. “Do you need to make some major structural changes or add facilities such as a spa, additional restaurants or meeting spaces? How sustainable over the long term, is the market you’re in? And can you compete with new properties coming in?” ponders Marescotti.
While a financial ROI lies at the heart of any renovation decision, the outcome can mean different things to different players. “An institutional or Real Estate Investment Trust [REIT] investor is looking for assets that have a stable cash flow they can use to generate investment yields,” Malcolmson explains. “They’re looking for accretive growth and income streams. Private equity, or owner-operator-type investors are looking for high returns to create value from that investment, focusing on what needs to be spent to reposition the hotel to take it from point A to point B.”
However, Malcolmson notes that with today’s market conditions ROI expectations are lower than those prior to 2009. “ROI targets used to be 20 per cent or higher, but with the current market, it’s more in the mid-teens.”
Linas Saplys, founder and senior project manager at Oakville, Ont.-based Architecture and Planning Initiatives, agrees the Canadian hotel industry is better positioned for renovations and new builds. But, it has to look ahead. “People need to think about where they want to be over the next 10 years.”
THE INTEREST-RATE PLAY
Long-term planning also needs to take into account interest-rate fluctuations. While today’s low interest rates may help kick-start projects, it’s not a guarantee over the long-term, cautions Malcolmson. “The lower cost of borrowing makes financing favourable right now; but it’s important to plan on rates increasing in the future.” It may cost five cents to borrow $1 today, but what will it cost in three years?
According to Henry, while interest rates may be good, the debt/equity ratio demands have changed. “Five years ago you could borrow 75 per cent of the cost of a project at about a seven-per-cent interest cost. Today, at five-per-cent interest rates, you can only borrow 50 to 60 per cent of what a project costs.” Marescotti agrees, “You definitely need more equity going into a project.”
Since you can’t always assume you will be in a low-interest rate environment, a ‘stress test’ is in order when planning, Duff says. “Look ahead and determine how things would be if the rates go up to seven or eight per cent. Does your plan still make sense and is it feasible?” asks Duff. “One other caveat in a lower interest rate market is that construction costs tend to be higher,” he adds. “Lenders may be more conservative on leverage as well.”
Ultimately, while favourable interest rates can help, they’re not necessarily a deciding factor over the long term, Henry says. “There have been times when loans cost nine per cent and other times when they were 2.5 per cent. But rarely did those rates make a difference between success and failure. Ultimately, availability of capital is more important than the cost of that capital.”
Despite current conditions, renovations are simply a part of the business, says Adrian Mauro, president, of Burlington, Ont.-based Chamberlain Architect Services. “Brands are always looking to keep it current and stay ahead of the curve. In many cases, hotel operators are mandated to upgrade to a new look,” says Mauro, “but that’s a positive thing, because competition drives business. And brands are not prepared to accept second best.”