Post by Karan Narang, Director of Financial Analysis, Hospitality Ventures Management Group
Capital Expenditures (Capex) have a significant impact on a hotel both during the project and after completion. With rooms out of order and other potential complications, it can be quite a challenging process. Apart from obvious considerations like seasonality, there are other factors that are even more important when timing a hotel’s Capex.
In most situations, money spent on Capex depends largely on your Exit Strategy. For an investor that plans on holding the property for long term cash flow value, a 10-year Capex cycle based on brand and property requirements is typical.
But, for an investor that purchased the property to renovate, ramp up, stabilize and sell, timing Capex becomes crucial. If, as an owner, you have successfully executed the first three stages of the strategy (renovate, ramp up and stabilize) and the property is in need of cyclical Capex (either brand required or general) then it becomes crucial for the owner to delay that Capex until sale and leave it for the next in line. That’s because any return on incremental Capex is minimal in that situation.
If certain Capex items cannot be delayed, consider leasing them. Even though leasing is normally costly in the long term, it might be a better option in the short term while you negotiate a sale. Also, buy-out options in a lease contract can mitigate some of those long term concerns.
Normally when a new hotel breaks ground it creates a panic in the competitive set and puts in motion a ticking ‘time bomb’ for the competitors. With everything else being constant, if the only differentiator between the new build and competition is the condition of the existing property, then investing Capex into that property while the new build is under construction can negate much of the downfall when the new build opens. This is especially true if the subject can finish its ‘refresh’ prior to the opening of the new build.
Also, if the competitive set is in disrepair and the market is looking for a renovated product and can support that increase in rate, then being the first mover in the market and getting a head start on your Capex can provide significant gains in both demand and rate.
“Be brave when others are afraid, and afraid when others are brave” – Warren Buffet
With an economy in recession and demand evaporating, owners typically spend time figuring out a way to delay any required Capex. Given that revenues and margins are retreating causing FF&E reserves to shrink as well, allocating sufficient funds for any Capex can be a daunting task. But if an owner has the ability to invest additional equity on Capex, there could be significant returns once the economy rebounds.
Brands are typically lenient with PIP given the increase in brand changes/losses during downturns. This gives an owner the ability to negotiate with brands, defer certain brand requirements and receive waivers on others. Also, suppliers generally are easier to negotiate with and procurement is quicker during a slow economy.
Competition will typically start renovations once economic conditions have improved, therefore putting them off cycle to the recently upgraded property and allowing that property to gain penetration as the others renovate and keep rooms off market as the economy rebounds and demand increases. Also, the fear of new supply mitigating the renovation gains is not present as typically a downturn stalls new supply.
A renovated and stabilized product post-recession also is a very attractive buy for both the private and public markets as the deal market heats up. Additionally, it provides the ability to refinance post downturn with minimal Capex requirements and much easier terms. Obviously, everything I just explained depends largely on the financing and leverage on the property as well.