Could debt problems and delayed PIPs lead to more opportunities for hotel investors?

Hotel brands allowed hotels to delay action on Property Improvement Plans (PIPs) scheduled during or shortly after the COVID-19 pandemic. Supply-chain issues also made it difficult to complete PIPs started prior to the pandemic, according to Washington D.C.-based Tom Rowley, executive managing director and national practice lead for Hospitality and Leisure at Cushman & Wakefield. 

While brands have been slow to demand owners complete PIPs, now that hotels are “back on their feet,” so-to-speak, he said, “we are seeing a greater push to get PIP programs back on schedule to ensure a consistent level of offerings throughout the flag.”

If funding is required to complete the PIP, hotel owners are continuing to delay PIP requirements due to the high cost of capital, Rowley added, noting that delayed PIPs have not had a significant impact on occupancy yet. “But as competing hotels begin to renovate, we do expect an impact on achievable rate, more than occupancy, at hotels that have not renovated,” he added. 

“Overall, lodging demand has been strong and new supply is limited, so generally speaking, occupancy has not necessarily been impacted in the immediate term, concurred Chicago-based Adam McGaughy, senior managing director in JLL’s Hotels & Hospitality Group.  He noted that how guests rate a hotel depends on the cycle of the PIP. “Guests have become very sophisticated on brand standards, and if a hotel hasn’t been renovated for say 10-plus years, they will often find a substitute hotel in the same brand family to move their allegiances until renovation work is completed.”

Some hotel owners have always looked for reasons to delay PIPs, suggested Atlanta-based Steve Schrope, senior director of Hospitality Project Management-CBRE Hotels, but the main reason now is cashflow. “They may not have enough funds to execute the level of PIP the brand requires,” he said, noting that higher interest rates and maturing mortgages also may be causing delays in PIPs.

Refinancing wall

Similar to other property types, a significant number of hotels have mortgages maturing in 2024 and 2025 that need to be refinanced. According to the latest report from the Mortgage Bankers Association, 38 percent of hotel and motel mortgages will mature in 2024 alone.  

“Due to uncertainty in capital markets over the near term, cash preservation may be required to pay down near-term debt refinancing,” Rowley said. The higher cost of capital and challenge posed by refinancing debt, coupled with so many PIP requirements that were delayed and the higher cost of completing PIPs, has put a strain on hotel ownership, he added, noting that the continued push by brands to bring hotels up to brand standards is increasing the number of owners exploring a sale. 

The confluence of loan maturities combined with needed PIP capital to be invested is causing more owners to list their properties for sale, said McGaughy. “In my opinion, the market still seems somewhat light in terms of quality product on the market, but I anticipate the pace to pick up considerably in the second half of 2024.”

Low transaction activity

Meanwhile, transactional activity remains very slow due to a wide bid/ask spread between buyer and seller right now, primarily due to the current cost of capital for buyers, Rowley said. “I have not seen a significant number of hotels put on the block due to a required PIP, but we are seeing numerous hotels quietly being marketed throughout the nation and a considerable increase in interested sellers over last year. That being said, for all the reasons noted, actual activity is limited,” he added.

Schrope also noted that with the high cost of capital and lack of transactional activity, owners aren’t making the typical capital improvements associated with potential sales. This complicates both a maturity event and potential sale, he explained, because any new lender underwriting debt refinancing or a loan for a buyer will want to understand the condition of the property and the brand’s PIP requirements.

Schrope suggested, however, that if the seller is capital constrained, there is potential for an opportunistic buyer with the capital to acquire the asset and complete the PIP. This type of transactional relationship has the potential to increase going forward, but if debt becomes more attractive, owners in growing markets will finance the PIPs, and opportunities will remain limited, he explained.

McGaughy agreed, noting that owners with capital concerns often look to test the market for a sale to avoid investing additional capital into an asset nearing the end of their hold period. There has also been pushback by owners that are seeking an extension on brand-prescribed, seven-year refresh PIPs given the low occupancy levels during the COVID pandemic, he continued.

While delayed PIPs may cause more hotel product to be taken to market, value-add investors can still expect to pay a fair but attractive price on a per key basis, compared to a ground-up project, McGaughy contended, noting that even traditional hotel developers/operators are now looking at buying existing hotels due to the cost variance.

Soft brand switch

Some hotel owners with financial issues may consider converting to an independent brand to get rid of brand fees and avoid sinking capital into PIP requirements, but Shrope noted that this also means losing all the power a brand provides. Therefore, he suggested, hotels may be more likely to convert from a luxury to a “soft” lifestyle brand like Hiltons Curio, as well as Marriott’s Autograph brand or Hyatt’s Unbound Collection.

Soft brands involve an affiliation between an independent hotel and hotel chain, which can provide hotel operators with lower costs and added flexibility when compared with traditional franchise agreements. This arrangement allows independent hotels to retain their existing branding and identity while benefiting from the chain’s marketing power and distribution resources, as well as economies of scale, such as supply purchasing power. It also may provide owners greater flexibility in what and when PIPs are completed.

Soft brand agreements are less strict than traditional franchise agreements, providing owners greater independence, operational flexibility, and ability to retain more unique features like the hotel’s original name.

Shrope said for, example, that lifestyle brands like Hilton’s Curio Collection and Marriott’s Autograph Collection are focused on adding elements that are unique to that property, like unique food and beverage components, as well as technology upgrades, like faster WIFI and digital check-in. Within guest rooms, they may require just normal finish improvements like fresh paint and moving TVs to the wall, but it could be simple things like adding more electrical outlets, he added.

Rowley said that Curio and Autograph allow operators to enroll a hotel into the brand’s proven distribution channel, while maintaining the hotel’s individuality and providing enhanced back-of-the-house standards and options. “This has been a successful program for both the operator and the traveler,” he added, noting that there are many unique and beautiful hotels throughout the country that are attracting the business traveler with the brand’s loyalty program or the guest who is seeking a unique experience.

A good example is Southern California’s Hotel del Coronado a historic, 132-year-old Victorian-style hotel on Coronado Island‘s beachfront in San Diego County. After becoming a member of Hiltons Curio Collection in 2017 the hotel retained its name and unique identity, and since 2018 the owner, Blackstone, Inc., has invested $550 million in renovations and other upgrades.

“There is undoubtedly a desire for experiential travel, and these hotels are fulfilling that need,” Rowley continued, “So the brands have to walk a line between providing the level of quality and service that the brand represents, while protecting the individuality of the hotel that attracts guests.”

Different investor types

McGaughy also noted that most value-add investors aim to up-brand their hotels versus down-brand them, as there is a much greater ROI associated with ADR growth achieved when going upscale. “Typically, if we see a hotel convert to a lower brand it is usually a forced strategy where the current brand has likely terminated their franchise agreement or the term is near expiration,” he said.

Shrope also pointed out that the decision to downgrade from a four- or five-star hotel to a brand with a lower price point may be a strategic move to attract a different guest income group or compete with other brands in markets with low demand for luxury hotel rooms.

As for opportunistic buys, McGaughy suggested that there has been more anticipation for distressed assets coming to market than actually presented. “Since the onset of the pandemic and even going back as far as the GFC (Great Financial Crisis), there has been significant money raised under the theory that there would be a tremendous amount of distressed buying opportunities in the hotel market,” he said, noting that an avalanche distressed opportunities never occurred.

“Operating fundamentals have continued to improve and traditional lenders have very limited desire to step-in and take over ownership through foreclosure or other remedies, McGaughy continued.  “But right now, we are staring at roughly $217 billion in hotel loans that are scheduled to mature by 2025 across the globe,” he added. “We will see how this plays out, but with interest rates expected to start falling later this year, my sense is that the majority of this debt will be worked out in some fashion,”

McGaughy noted, however, that there will be some lender-controlled buying opportunities, especially from the special servicers currently working through about $1.4 billion in foreclosed CMBS hotel loans.