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A RECENTLY COMPLETED STUDY BY THE INTERNATIONAL SOCIETY OF HOSPITALITY Consultants (ISHC), a group of approximately 100 of the industry's leading advisors, proves what many in the hotel business have known for years; the traditional 3 percent of gross revenue capital expenditure (CapEx) reserve is insufficient to keep a hotel competitive over its life span. However, with well-planned capital expenditure reserves, a hotel can become a low-risk and highly profitable venture.

The ISHC study called "CapEx" is the first definitive research on hotel capital expenditures in more than 50 years. Among the study's major conclusions are:

* Full-service hotels averaged 6.88 percent of gross revenues on CapEx from 1983-1993.

* Limited-service hotels averaged 3.66 percent of gross revenues on CapEx from 1983-1993.

* CapEx planning should be based on an item-by-item fixed-asset register, not on an arbitrary percentage of gross revenues.

* Lenders will insist on higher CapEx reserves than in the past, and reserves will be actually funded rather than accrued.

Lenders to the hotel industry are well aware of the problems associated with foreclosing on hotels that fail to meet debt-service obligations. Inadequate planning for CapEx was a major contributing factor to the hotel industry upheaval during the late 1980s and early 1990s. Hotels with insufficient reserves did not get needed renovations, could not compete effectively and lost their business. As their revenues dropped, still less money was put into CapEx and properties went on a downward spiral ending in bankruptcy. As a result, many lenders were left owning hotels in need of costly renovations, forcing write-downs and sales at bargain-basement prices.

An eight-month research project

The results of the ISHC CapEx study, an eight-month research project in which historical information on 302 hotels was analyzed, present hotel lenders with a unique opportunity to reduce their risk exposure. The current system, whereby hotel management companies dictate the level and timing of CapEx only later to require owners to approach lenders for CapEx funds because pro forma reserve estimates were woefully inadequate, can now be replaced with something better. The new system will be guided by better understanding and cooperation between the three entities seeking a return on hotel investment. Lenders are in a good position to foster cooperation between the parties by requiring the following as conditions for granting a mortgage on a hotel:

* A detailed CapEx plan for at least the period of the loan requested.

* A CapEx reserve account funded according to the CapEx plan.

The detailed CapEx plan should be based on the replacement costs and estimated useful lives of all assets that comprise the individual hotel being considered for financing. This step is critical because CapEx spending is not constant over time, as shown in Figure 1.

[Figure 1 ILLUSTRATION OMITTED]

The spikes around years 9, 13, 16, 18, 21 and 25 reflect major renovations, including replacing large items such as chiller, boilers and HVAC systems later in the life of the property. CapEx breaks through the traditional 3 percent reserve line around year five and never again drops below it. In the ISHC research, average CapEx for all hotels was 5.77 percent of gross revenues over 25 years. More disturbing for underwriters and leaders, CapEx can exceed 40 percent of gross revenues during major renovations in some individual hotels meeting the following standards:

* Located in the continental United States.

* Well-maintained throughout their lives.

* Typical reproducible in today's marketplace.

The data base, the largest ever collected for studying CapEx, contained hotels from 42 states, 40 hotel brands and several independents operators. Comparisons with other hotel industry data bases hotel showed the ISHC CapEx research sample to be an accurate reflections of hotels constructed in the United States over the past 50 years. Hotels analyzed ranged from 3 to 51 years old, with age proving a very significant factor in budgeting for CapEx.

CapEx increases as a hotel ages. Therefore, determining the appropriate reserve level a condition of financing depends on both the duration of the loan and the age of the hotel under consideration. This presents a very real problem for the lender because the traditional method of being CapEx on a percentage of gross revenues ignores the effects of:

* Fluctuations in revenues from year to year, while CapEx continues to increase with normal aging of hotels.

* Periods of high and low utilization and the effect of that on wear and tear.

* Mix of business and the impact on wear and tear by different types of hotel guests.

* Changes in market demands.

These issues can be addressed by itemizing the components of a hotel that will need renovation or replacement, and estimating than costs and timing of these improvements. The prospective section of the CapEx study followed this methodology by analyzing current replacement costs and estimated useful lives on more than 750 hotel items and components. Hospitality industry professionals including architects, interior designers, purchasing companies, project managers and hotel can chain technical service departments contributed the necessary information, which was consolidated into 250 component parts comprising a typical hotel renovation and refurbishment.

Three prototype models were developed, a 100-room, limited-service hotel; a 200-room, moderately priced full-service hotel; and a 300-room, upscale full-service hotel. The moderately priced full-service hotel profiled here, which might be franchised as a Radisson or Holiday Inn core brand in today's marketplace, has the following principal features:

* 200 guestrooms

* Three-story, interior-corridor building

* 325-square-foot sleeping rooms

* 2,000-square-foot lobby

* 3,000 square feet of meeting space

* 600-square-foot boardroom

* 460 square feet of prefunction area (space surrounding outside of meeting rooms and ballrooms)

* 150-seat three-meal restaurant

* 120-seat lounge

* Two sets of public restrooms

* 250 parking spaces.

Each area of the hotel, such as sleeping rooms, lobby and building systems, was examined, and an itemized replacement and renovation cycle for the entire hotel was developed. Figure 2 illustrates this replacement cycle for 25 years.

FIGURE 2 Replacement and Renovation Cycle: 200-Room, Moderately Priced Full-Service Hotel
 Total Average Average Replacement/
 Replacement/ Renovation Cost
Year Renovation Cost per Room
 1 $0 $0
 2 $0 $0
 3 $0 $0
 4 $0 $0
 5 $251,850 $1,259
 6 $262,900 $1,315
 7 $811,719 $4,059
 8 $721,335 $3,607
 9 $367,281 $1,881
 10 $476,786 $2,384
 11 $169,538 $848
 12 $667,389 $3,337
 13 $0 $0
 14 $827,784 $4,139
 15 $251,850 $1,259
 16 $1,618,539 $8,039
 17 $0 $0
 18 $937,036 $4,685
 19 $0 $0
 20 $466,786 $2,334
 21 $811,719 $4,059
 22 $169,538 $848
 23 $0 $0
 24 $1,908,017 $9,540
 25 $251,850 $1,259

Total $10,980,917 $54,905




Source: International Society of Hospitality Consultants

CapEx is nonexistent to negligible in the first four years, after which significant funds are needed almost every year. After major renovations occur, such as in years 16 and 18, CapEx is very small, reflected by the zero dollar amounts entered for years 17 and 19. In practice, however, renovations and replacements are often staggered over a period of time to ensure minimal disruption to guests. The timing of renovations will also depend on actual wear and tear, management philosophy, quality of construction and initial building components and seasonality of the individual hotel. The CapEx study found about a three-year range in the estimated lives of components and used the middle year as optimal for planning.

The detailed CapEx plan will vary according to the particular circumstances of the hotel being considered for financing. If the hotel is an acquisition, the plan should reflect the condition and estimated remaining lives of the hotel components from the time of proposed purchase. The situation profiled here assumes the 200-room, full-service hotel referenced earlier is 8 years old at the time of financing, and has been maintained according to the optimal replacement schedule in the previous table. The type of financing being sought is a typical hotel loan amortized over 20 years with a seven-year balloon or refinancing option.

In this situation, the lender would request a CapEx plan from years eight through 14, the term of the initial loan. To keep the hotel competitive for this period the estimated cost in current dollars is $3,239,113 (total of average replacement/renovation costs for years eight through 14 shown in Figure 2). An inflation forecast is necessary to account for future price increases before determining the level of CapEx according to anticipated timing. Once this has been calculated, it is fairly simple to work out how much needs to be set aside to meet future CapEx obligations. Assuming 3 percent inflation, expected CapEx is $3,530,285 for years eight through 14.

At this level of CapEx, the lender has reasonable assurance that the asset value will be conserved over the term of the loan, thus significantly reducing the risk associated with the loan. A CapEx reserve account, similar to an escrow account for property taxes and insurance, is set up as part of the normal operation of the hotel. The amount and frequency of payments to a CapEx reserve depends on the timing and level of cash outflows and the amount of interest earned by the account. Reserving for CapEx in this way benefits hotel owners, management companies and lenders in many ways including:

* Minimizes surprise CapEx cash calls for owners.

* Provides management company CapEx needs with fewer disputes.

* Better protects lenders interest in the event of foreclosure.

* CapEx is no longer simply "the next owner's problem."

* Keeps the hotel competitive in the marketplace.

* Preserves asset value.

Under these conditions, failure to fund CapEx reserve accounts could be an event of default under the terms of a mortgage. Residential loans typically stipulate that the homeowner keep the residence in good repair. Hotels are valuable real estate and, when well developed and managed, highly profitable businesses. As a result, they can offer unusual returns and represent excellent investments.

Traditionally considered higher risk than other forms of investment-grade real estate, hotels carry stricter underwriting criteria and higher capitalization rates. In large part, this has been due to inadequate CapEx planning and the resultant risk of large cash calls for capital expenditures. Through effective CapEx planning, the risk associated with hotels can be greatly reduced, and these properties can become desirable lending opportunities.

Some will argue why not simply increase the percentage of gross revenues for capital expenditures, or simply pay for CapEx when it's needed? From the lender's point of view, these are risky approaches compared to formal CapEx planning without any compensating increase in yield.

While it is true that owners may have other investment opportunities with higher expected returns than interest earned on a CapEx reserve account, the lender shares in the risk that alternative investments might fail to generate expected cash flows, but receives nothing in return. Obviously, the lender also risks that capital expenditures will be deferred, leading to a vicious cycle of declining hotel revenues, increasing deferred capital expenditures and noncompetitiveness of its assets in the marketplace.

Increasing the percentage of gross revenues set aside for CapEx is only half the answer--even with a fully funded reserve. CapEx is neither constant over time nor consistent across all types of hotels. Figure 3 illustrates the large differences in actual CapEx spending between full- and limited-service hotels.

[Figure 3 ILLUSTRATION OMITTED]

The CapEx study also revealed major differences in CapEx spending levels according to location, age, size and average room rate within the same types of hotels. Also, the pattern of CapEx over time presents very real risks of underfunding a percentage-based reserve when major renovations are required. Full-service hotels averaged 6.88 percent of gross revenues for CapEx, but average CapEx exceeded 9 percent of gross revenues in years 13, 15, 16, 18, 20, 21, 23, 24 and 25.

The large variances in CapEx per year make forecasting capital expenditures increasingly subject to error the less attention is paid to the condition of the physical components in the hotel. Different types and ages of hotel require different CapEx planning that cannot be covered by a single industrywide standard replacement reserve.

Lending to new owners of an existing hotel brings additional problems to forecasting CapEx as a ratio to gross revenues. Simply continuing with an arbitrary industrywide standard is very risky without making reference to how much was spent previously. More important, both prospective owners and lenders need to know the timing and direction of previous capital expenditures on which components and/or area of a hotel CapEx were made.

This can present problems because the CapEx study revealed that many hotels have failed to keep CapEx records. Only approximately 60 hotels (20 percent of the research data base) kept detailed CapEx records, breaking down spending into components such as those shown in Figure 4.

[Figure 4 ILLUSTRATION OMITTED]

The CapEx study found sizable differences in actual CapEx between full-service and limited-service hotels. CapEx on rooms and corridors represented the biggest segment for both types of hotel. However, limited-service hotels spent 30 percent of CapEx dollars on the building, whereas full-service hotels spent proportionally only half as much. CapEx for compliance with the Americans with Disabilities Act (ADA) and life safety regulations, such as a sprinkler system, was negligible among limited-service hotels. On average, these hotels are newer than full-service properties, and many are yet to go through major renovations.

Compliance with ADA and life safety regulations is mandatory when certain renovations are made. Therefore, as these properties age, regulatory requirements will become a bigger portion of CapEx. A prospective approach to CapEx takes these and other issues into account. The CapEx study also revealed proportional CapEx differences according to hotel location, rate, size and amount of public space.

The ISHC expects this new information on capital expenditures to affect the way business is done in the hotel industry with particular benefit to investors and lenders. The ISHC expects:

* Detailed CapEx record keeping to be come the standard.

* Evaluation of CapEx plans over the life of the loan to become part of the underwriting process.

* CapEx reserves to become reasonably budgeted based on the physical attributes of the hotel and market conditions.

* CapEx reserves to be funded.

No one in the hotel industry, least of all lenders, wants to see a repeat of the debacle of the late 1980s and early 1990s when an estimated 35 percent of U.S. hotels went into foreclosure. In many cases, properties taken back by lenders had significant levels of deferred CapEx and had to be sold at well below their replacement costs. As a result, lending on hotels all but dried up.

The hotel industry has rebounded, however, with national average occupancy approaching 70 percent, average room-rate increases surpassing inflation once again and lenders returning to the hotel market in ever-increasing numbers. When the next downturn comes, those lenders having the foresight to ensure that CapEx reserves are funded according to the particular requirements of their hotel assets will be the best placed to withstand the shake-out. The results of the CapEx study are a very important step in the right direction.

EDITOR'S NOTE: The full CapEx study is available for $125 by calling the ISHC office at (901) 683-1806.

Peggy Berg, CPA, ISHC, is president of The Highland Group, a hospitality consulting firm based in Atlanta. Mark Skinner, MSRE, a research analyst on assignment with the ISHC for CapEx, is a hotel consultant with The Highland Group.
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Copyright 1995 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Cover Report: Commercial Real Estate; hotel capital reserves
Author:Berg, Peggy; Skinner, Mark
Publication:Mortgage Banking
Date:Jul 1, 1995
Words:2568
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