Properties that combine lodging, apartments and workspaces make increasing financial sense
By Jay Litt,
Principal, LittKM Group
The hospitality and travel industry is one of the largest business sectors in the world, generating an estimated $3 trillion per year across the globe and about $600 billion in direct spending in the U.S. Of the total U.S. revenue, nearly $200 billion is funneled into the hotel industry.
Due to the COVID-19 pandemic, hotels have had to reinvent themselves in different ways in recent years. This includes new cleaning protocols, fewer amenities and a greater introduction of digital technologies. Another trend that appears to be gaining traction — and one for the commercial mortgage industry to watch — is the move toward hybrid hotels.
A hybrid is defined as the creation of something new by combining two different elements — a mixture. When it comes to hotels, a hybrid version can take various forms. A common model is a property where a certain number of rooms remain as traditional hotel accommodations while the rest are reconfigured into office spaces. Another popular trend includes properties that offer hotel rooms on some floors and multifamily housing on others. Both models offer hotel owners new cash streams while diversifying the tenant base.
Commercial real estate services company Colliers, for one, advises hotel operators to harness the remote-working trend and adapt their properties to provide office space as an added amenity for guests. “Hotels creating a place not only to sleep and eat but also to rent out space to meet, collaborate, socialize and work is a key way that underperforming areas within the building can be optimized from a revenue and income perspective,” said Dirk Bakker, head of hotels for the company’s Europe, Middle East and Africa region.
The Airbnb effect
The hybrid hotel model comprised of short-term lodging and apartments is a natural fit. After all, longtime hotel residents are nothing new. In recent years, another version of mixing private and public residences has been popularized by companies such as Airbnb that allow people to rent private accommodations. This movement has been phenomenally successful, and it continues to grow and mature on other platforms, such as VRBO, which is generally geared toward vacation-home rentals.
Home-rental services are quite different from a general hotel format. The location could be a detached home or an apartment building. There is no front desk, limited amenities and few, if any, employees. These alternative lodging options are proving to be a successful trend that has momentum and is posing a growing challenge to the conventional hotel format.
The alternative lodging industry, led by Airbnb, typically does not get involved with the real estate lending community, with the exception of some larger businesses. Sometime soon, as this alternative lodging format becomes more institutionalized, this is likely to change and commercial mortgage originators will have to take the time to decide how to evaluate such operations.
Hybrid hotels that include a multifamily component may be a way for hotel chains to compete with the Airbnbs of the world. These changes also may play a role in addressing the lack of housing supply that is currently impacting the country.
Successful conversion
Mortgage brokers should be prepared to talk with clients about how the hybrid option could potentially turn around poorly performing hotel assets. Here is an example: A 250-room hotel goes on the market. The hotel has a restaurant and 10,000 square feet of meeting space. The hotel suffers from a low occupancy rate and is losing money on its operation. The property seems destined for foreclosure.
Five years earlier, the real estate was valued at $10 million, based on its net operating income (NOI) of $1 million and a cap rate of 10%. The cost to replace the building and its contents is a minimum of $175,000 per room for a total cost of $43.75 million. A buyer can purchase the hotel at the discounted price of $45,000 per room or $11.25 million.
The buyer decides to use a hybrid hotel format, opting to split the hotel up into typical hotel rooms and a multifamily component. The buyer closes the hotel’s restaurant and builds a large deli-style eatery. The hotel’s meeting space is transformed into alternative uses.
For 100 of the rooms, the buyer finds a hotel brand franchise that does not require extensive conversion costs. The other 150 rooms are converted into studio apartments and one-bedroom suites. The studio conversions include a pullman-style spare kitchen, eating area, bed and television. The one-bedroom units require the conversion of two hotel rooms to provide a living room, full kitchen and an adjoining bedroom.
So, 25 one-bedroom suites would utilize 50 rooms. As such, the finished property now has 225 rooms and apartments for rent. A rough estimate on the conversion costs is about $35,000 per room, depending on the building and configuration.
Increasing profits
What does this mean? Using the same example, the hotel pro forma calls for a market rate of $85 per night at 68% occupancy for a revenue of roughly $2 million. The NOI is 35% or $700,000. Using a cap rate of 10%, the hotel’s value is $7 million.
The apartment pro forma projects 65% occupancy with a blended monthly rate of $1,000. Revenues would be roughly $1 million and the NOI at 75% would be $750,000. Using a cap rate of 4.5%, the apartment component could be valued at $16.6 million. In this example, the combination of the hotel value and the apartment value would be $23.6 million.
The hybrid model also saves money by allowing property owners to reduce labor costs for housekeeping and other staffing issues. The new delicatessen would cost less to run while potentially increasing revenue and profits. The 125 apartments also would help stabilize the property’s pricing and cash flow. Location is one of the most important aspects of this hybrid model. There needs to be demand for rental housing. Since the demand for multifamily housing is so strong, however, this shouldn’t be much of a problem.
Major hotel brands have successfully embraced the hybrid concept in Europe. Ace Hotels, Accor and Zoku, to name a few, have ventured into the hotel-office model to offer guests flexible workspaces. It may only be a matter of time before this hybrid property finds a larger audience in the U.S.
Commercial mortgage brokers and lenders now have a different hotel model to consider. The traditional hotel was often considered a risky type of real estate, with its daily turnover and lack of stabilized rents. But in the hybrid model, a multifamily component or an office space option offers more stability and can help ground the transaction.
The added value of the hybrid asset should give the lender more room and comfort for a given loan request. Mortgage professionals should be on the lookout for these types of hotel conversions in the coming years. Many projects are already converting hotels and other forms of real estate into apartments. Lenders and investors should find excellent opportunities to support these projects, and they should understand that this trend will likely continue into the next economic cycle.
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