4 Essential Elements of a Hotel Deal Structure

Hotels derive their value from the built environment and operations. They rely more on sales, marketing, and efficient operations than physical improvements to enhance profitability. Therefore, a good understanding of a hotel deal structure is essential to make the move from Big Four CRE to hotel investing.

Commercial real estate investments all rely on good operations and efficient capital structures. The hotel deal structure relies heavily on who’s involved plus market and operational positioning. An astute deal sponsor understands the four levers to pull to optimize asset value – working parties, capitalization, market positioning, and contract encumbrance.

Working Parties

A hotel deal structure is very similar to any other real estate deal from a high level. The sponsor coordinates the deal with one or several investors and a lender. A variety of players come in and out of the deal depending on where you are in the investment lifecycle, such as attorneys and third-party consultants. However, daily operational needs set the asset class apart.

Brief History

Hotel investments evolved over time to divide the risk and specialization among a variety of stakeholders. Companies like Marriott and Hilton owned and operated their hotels from inception through the 1970s. This included everything from branding to day-to-day operations and asset management.

The first evolution separated brands from management in the 1980s to scale the sales and marketing platform through franchising. Hotel REITs emerged in the 1990s to allow further separation of investment and operational risk for these big brands.

The growth of private equity in the 2000s pumped new capital into the industry and accelerated the separation of duties to form foundation of the modern hotel deal structure.

Three Biggest Stakeholders

A modern hotel deal is composed of the following:

  • Owner – The deal sponsor leads the ownership group with a joint venture partner or a syndication of limited partners making the bulk of the investment. This role is like any traditional real estate ownership organization but with a specialization in hospitality.
  • Operator – The operator manages the day-to-day hotel operations, including guest satisfaction, revenue management, and property maintenance. The management company may be an affiliate of the deal sponsor or a third-party.
  • Brand – A brand adds value through sales, marketing, quality standards, and training support. The guest’s perception of the brand largely drives hotel positioning in the market.

Each investment strategy has a different mix of involvement from these stakeholders and other material working parties. These three could collapse into a single entity or any combination.

Many upstart brands come with management and a sliver piece of equity ownership. This allows for more control over guest interaction and market positioning. Pure third-party brand management or franchising emerge once the sponsor establishes a well-tested brand and operation platform.

Interests Aligned

Every real estate deal requires an alignment of interests between different stakeholders. Most deals rely on equity contributions – skin in the game – to build that alignment. Brands and pure third-party operators often don’t have the financial capacity or desire to be investors in every deal. Therefore, they use different arrangements to enhance accountability.

Owners are in an adverse position under the traditional revenue-based compensation for brand and management companies. Revenue maximization comes at a cost, and efficiency at customer acquisition defines an operator’s strength. After all, owners are interested in bottom line profitability, regardless of revenue.

Brands have a wide variety of sales and marketing tools at their disposal. They pay for these with an equal number of fees within the licensing agreement. The biggest fees beyond a royalty fee are related to system/marketing fee and loyalty program fees. A limitation on these as a percentage of gross room revenue provides a check on the brand expenses.

Operators have more control over profitability than brands. They can pull a variety of levers to reduce customer acquisition cost and increase operating efficiency. Incentive fees and other contractual mechanisms can help achieve balanced interests.

That said, owners are responsible to ensure that the brand and operator have an asset that of the quality that demands the highest possible revenue. This requires a commitment of capital and allocation of resources to place the hotel in its best light. Therefore, owners have the most important role in the hotel deal structure because of their capacity to move the pieces where they belong.

Capitalization

A hotel is a capital-intensive investment. Hotels receive a daily barrage from guests moving in and out and employees working to make the business successful. This all comes in addition to normal wear and tear from time and the elements.

Periodic capital expenditures in the form of brand-mandated property improvement plans (PIPs) go some of the way toward maintaining standards. Capital reserve requirements are usually inadequate to complete a full PIP, and a capital reserve is not the most efficient use of investment proceeds. Therefore, a sale is the most opportune time for brands to compel a new owner to make the necessary revenue-enhancing investments.

Very few hotel investments perfectly fit the criteria for a core risk strategy. Most hotel investments require some level of capital investment beyond the purchase price and closing costs.

An efficient capital strategy is consistent with most real estate transactions. The key difference in the hotel deal structure lies in how and when you spend money to improve the asset.

Investments in guest-facing improvements, like paint, carpet, and FF&E, provide the most immediate value in terms of revenue enhancement. However, improvements to building systems and envelope ensure a consistent guest experience for years to come, and you ignore them at your peril.

Be mindful about how you capitalize your investment to match the business plan.

An efficient capital structure that takes account of debt maturities and prepayment costs, in addition to common and preferred equity, will contribute to ultimate profitability. An expensive transitional loan is a drag on a long-term hold strategy, but a high-octane bridge loan with the flexibility to freely prepay is a perfect fit for a fix and flip strategy.

Market Positioning

Hotels in major markets rely less on brands than they have in the past because guests are so reachable on online social platforms, like TripAdvisor, Yelp, and online travel agents (OTAs). Still, hotels in secondary and tertiary markets rely heavily on the brand to attract guests.

Hotel brands define the quality of the guest experience regardless of the actual quality of the hotel given its location and physical characteristics. Therefore, your ability to drive rate and occupancy is bounded by the brand perception in the market.

Market Segmentation

Smith Travel Research is the leading intelligence provider in the hotel industry. They publish chain scales annually that slot brands in a peer group based on their prior year’s global, system-wide average daily rate (ADR). From highest ADR to lowest, with examples (2018), these are:

  • Luxury – Four Seasons, Fairmont, JW Marriott, Ritz-Carlton, W Hotel
  • Upper Upscale – Marriott, Hilton, Kimpton, Renaissance, Sheraton
  • Upscale – Courtyard, DoubleTree, aloft, Residence Inn, SpringHill Suites
  • Upper Midscale – Holiday Inn, Country Inn & Suites, Hampton Inn, Home2 Suites
  • Midscale – La Quinta Inn & Suites, Ramada, Wingate by Wyndham, Candlewood Suites
  • Economy – Motel 6, Red Roof Inn, Super 8, Extended Stay America

You probably notice some critical distinctions between the brands listed, aside from cachet of the brands in the luxury and upper upscale chain scales. Most of the economy and midscale brands are limited/select service or extended stay offerings, while brand flagships are usually in the upper upscale segment.

Brand standards drive guest perception and decision to book at one hotel over another comparable property. Loyalty programs definitely have an influence with a big segment of travelers, but the chain’s consistency has a tremendous impact on where guests slot these brands in their mind.

Brand Proliferation

Upper midscale and upscale brands are popular with guests and affordable to build. Luxury and upper upscale properties are costly to build, and the service offering is more aligned with urban and resort locations. Therefore, most new hotels align with upper midscale and upscale brands.

Hotel brands are in the distribution game. The more dots they have on the map gives a greater opportunity to grow their loyalty program and grab traveler attention. Therefore, new chains are a strategic lynchpin in their growth plans.

Market positioning is all about right product, right location, right time. Guest preferences change over time. Still, an astute sponsor can repurpose space to meet new demand and maximize profitability even in the face of new supply.

Contract Encumbrance

Hotels operate with nightly leases. This allows the owner to take advantage of rapid economic improvement and inflationary pressure. Many labor and service agreements, on the other hand, fix pricing for periods of a year or more. This inflation arbitrage allows for healthy profit margins in good times, but they can be a major challenge in a downturn.

Your bills are due regardless of your revenue picture, including big ones, like real estate taxes, insurance, and debt service.

Contracts have a material impact on your market positioning in addition to your financial position. The brand licensing agreement and management contract may have restrictions that make it expensive for you to take full advantage of shifts in the market. Further, revenue contracts, like those with major corporate guests or social groups, consume rooms that would otherwise be available in periods of high demand.

Contract strategy is an overlooked and important contributor to market value.

Guests and investors want to know that they’re getting the most from their stay or investment. From a revenue perspective, you must ensure that the hotel can attract the right guest at the highest price. Similarly, the market value of a hotel is fully dependent on the next owner being able to do the same to enhance profitability.

Aim for maximum contract flexibility for a potential buyer. Therefore, look to limit contract terms and provide options for termination upon sale, or negotiate universally advantageous deals with revenue and service providers.