Capital planning has always presented a unique set of challenges for hotel owners aiming to balance spend with investment returns.
Over the past 18 months, these challenges have been further magnified in light of depleted reserve accounts and significant cost increases, serving to upend planning cycles. In many instances, this has forced owners to delay renovations in the name of cash preservation.
While certainly not optimal, the pause or temporary hiatus in capital spending can also be viewed as an opportunity for reevaluating and revising plans, and a very necessary reset of expectations for hotel capital expenditures. Strategic reevaluation of capital plans takes into consideration not only brand standards and property condition, but also prioritizes spending based on opportunities for optimizing operations and enhancing value given the near-term outlook.
It is a time of reflection to get away from “how things have always been done,” rethinking next steps and planning accordingly to attune capital projects with current investment objectives. Some key considerations for hotel owners in managing their capital-expenditure spending include the following.
Step Back and Align the Project With the Current Investment Strategy for the Asset Prior to starting any major capital project or hotel renovation plan, it is imperative that hotel owners match up the capital plan with the overall investment strategy of the asset. Given the immense impact of COVID-19 over the last 18 months, the overall investment strategy to hold, renovate, sell or refinance the asset may have changed due to unforeseen owner cash injections required.
Traditionally, the way to access additional funding for renovations was through a refinancing of the asset. This strategy is now less of an option and much harder to complete given the more challenged recent hotel performance. If the capital will be coming out of pocket, the scope and objectives of the capital renovation need to be understood within the context of the current investment strategy and timing. A disposition timeline of less than two to three years would most likely require a revised investment given the payoff and cash injection. Instead of a planned multimillion-dollar rooms renovation, maybe a more modest soft goods and “touch up” renovation could actually produce a more favorable overall investment return.
Review and Understand the Current State of the Capital Reserve Account Most major hotel brands — and lenders — worked with hotel owners on side letter agreements to use the funds within the FF&E (furniture, fixtures and equipment) reserves as emergency funds for operations during the lowest points of the pandemic. This was agreed upon with the expectation that by a certain date, those funds would need to be replenished, in many cases by the end of 2021 or 2022.
Brands are expecting those funds to be replenished, and given the relaxing of brand standards over the last year and a half, it is safe to assume that they will be seeking to cure any deferred maintenance or renovation requirements at some point in the not-too-distant future. Additionally, many hotel owners have opted to either waive or defer funding into the FF&E reserves until the agreed-upon time. This means that very little funds have been going back to replenish these reserves. Careful planning that encompasses a horizon over 10 plus years will be essential to developing a funding strategy even for the near term.
Don’t Let the Operations Budget Overshadow the Capital Budgets This Year Most years, hotel owners are primarily concerned with the operational budget that the property team provides, and for obvious reasons. Pushing gross operating profit and earnings before interest, taxes, depreciation and amortization are vital. This year, however, make it a priority to discuss with the property team in detail their expectations for the capital budget and ensure a long-term plan is provided and reviewed so that expensive, major projects are not overlooked down the road and there are few surprises.
Get It in Writing If a major renovation or capital plan is the best option for the asset and ownership’s investment strategy, ensure that the invested capital gets added to the overall investment basis. This in turn has an impact on the incentive fees paid out to the management company outlined in the hotel management agreement. Ensure this is looked at and appropriately papered upfront so there are no surprises after a significant cash injection.