This article discusses recent trends in the Canadian lodging industry and their impact on capital expenditure and property improvement plan (PIP) requirements. Elements of an effective PIP and different PIP scenarios are also examined.

Property Improvement Plan (PIP) & Capital Expenditure Decisions for Canadian Hoteliers

The physical condition of a hotel property is one of the most important determinants of operating performance and, ultimately, market value. When faced with capital expenditure, property improvement plan (PIP), or re-branding decisions, hotel owners must make the right decisions in order to maximize operating performance, market value, or the return on a property at the time of sale.

This article provides an overview of recent PIP trends in Canada and identifies the elements of an effective PIP. The associated benefits, risks, and key considerations to be made when re-branding or deploying a PIP are also discussed.

Current Market Conditions in Canada's Lodging Industry

The slow rebound of the Canadian economy has resulted in a lengthening of the recovery stage in the Canadian hotel market cycle. As a result, new room supply, a key driver in the cycle, has been slow to enter the market despite growing lodging demand. As shown in Figure 1, the growth in demand has consistently outpaced the growth in supply over the past three years, and this trend has held steady through the first five months of this year.



This extended market cycle, exacerbated by demand growth outpacing the growth in supply, has led to a number of brands, investors, and lenders amending or delaying capital plans and PIP deployment in recent years. These delays have occurred because either excess capital has simply not been available or improvements in operating performance and the low risk of new supply in the competitive market have outweighed the need to implement such plans.

As the Canadian lodging industry continues to emerge from a recessionary period characterized by poor lodging fundamentals and capital constraints, excess capital is beginning to become available for expenditure at the property level. In addition, the extended recovery in the hotel market cycle has led to pent up supply increases, and the threat of new supply entering the competitive market is now increasing.

In order to remain competitive, a growing number of hoteliers are facing crucial capital expenditure and PIP decisions, especially since brands, investors, and lenders are now looking to update compliance requirements, which were relaxed in recent years during the economic downturn. As shown in Figure 2, the total number of rooms added to supply has trended downwards since 2009; however, looking ahead, the development pipeline shows that national room supply is poised for growth.



It should be noted that the above projections include projects in all phases of development (in construction, final planning, and planning). A number of projects in the pipeline are speculative and the availability of financing, the issuance of permits, and other factors will alter completion dates or cancel projects.

Nevertheless, development and construction activity is expected to remain strong in the near future as a result of strengthening fundamentals and low lending costs. This increased activity will require hoteliers to address delayed or amended capital plans and determine the most effective PIP deployment strategies in order to remain competitive.

Elements of an Effective PIP

An effective PIP should help a property gain market share, increase guest satisfaction, drive revenue performance, and enhance profitability. In order to successfully do so, capital investments must be properly timed within an asset's life-cycle, be supported by sound due diligence, and be distributed appropriately to those areas that demonstrate considerable return on investment (ROI).

To effectively evaluate ROI, owners must assess not only the potential upside of the renovated asset but also the impact of reductions in ADR and occupancy, construction delays, and the entrance of new supply in the competitive market. For some properties, an effective PIP is a soft refurbishment of FF&E, whereas for others with large capital reserves a more extensive upgrade project can be undertaken if required.

For many owners, a number of scenarios, including repositioning, re-branding, or disposition, may have to be considered in order to determine the best option for the property's future. The feasibility of each option should be evaluated based on the property's current value, the PIP cost, and the property's value after a capital expenditure on the PIP.

Property Improvement Plan Scenarios for Branded Properties

Continue with existing brand and complete the brand's required PIP
Often, this scenario increases a property's ability to capture ADR and occupancy, improves operational performance, and enhances income potential. Potential synergies and cost-savings also exist if this update is part of a brand-wide initiative. Staff turnover is likely to remain consistent with historical levels and have minimal impact on guest satisfaction.

The capital investment, however, is usually substantial, and financing may be required. The timing and length of the update can have a negative effect on both cash flow and guest satisfaction.

Transition the property to a comparable brand
Under this scenario, brands are typically more flexible with respect to the timing of capital expenditures involved in a PIP, as concessions may be offered in order for the brand to gain presence in a new market. Assuming a comparable brand will require a similar quality renovation as the existing brand, it can be anticipated that top-line performance will be also be similar following a conversion. Again, staff turnover is likely to remain consistent with historical levels, and there is potential to increase market reach if the comparable brand has operations that are more geographically extensive.

On the other hand, the PIP of a comparable brand may be more comprehensive, resulting in a higher overall cost. Increased fees may be incurred if both franchise and management agreements are required, and additional fees and expenses may be required for legal, marketing, signage, property management systems, collateral, amenities, and linen. A new brand may also require a new management company. An owner must consider the risk that the new management company may not be as competent and could negatively impact operating performance. Market reach may also be lessened if the comparable brand has operations that are less geographically extensive.

Transition the property to a higher-positioned brand
This transition likely involves a higher-quality renovation, increases a property's ability to capture ADR and occupancy, and improves income potential. Brands may offer more flexibility with respect to the timing of capital expenditures, and staff turnover is decreased, which helps to drive guest satisfaction.

The overall capital investment is likely to be the highest in this scenario. Other risks will be similar to that of a transition to a comparable brand, including increased fees and the potential requirement for new management. The conversion may create instability and a corresponding dip in operating performance. Brand choice may also be limited by what currently exists in the market and what the market can bear.

Transition the property to a lower-positioned brand
The overall capital investment is likely to be lower than all the aforementioned transitions, and brands are likely to be flexible with respect to the timing of capital expenditures.

However, profitability is likely to be reduced while increased fees, additional costs, increased staff turnover, and instability are also risk factors to consider.

Transition the hotel to an independent property (no brand) and management company
This scenario may require no capital investment and reduces franchise fees and also potentially management fees.

Revenue generation is likely to be reduced. Base demand often deteriorates through the loss of a central reservation system and brand relationships with national accounts. A new management company may also need to be contracted.

Sell the property
This scenario avoids the need for capital investment, but it is reliant on the amount that an asset has appreciated during the holding period.

The sale of a hotel is highly dependent on the current market for hotel transactions. It is also likely that a buyer will want to continue to operate the hotel with same the brand and would expect to spend the capital required for a PIP. As a result, the price that the buyer would be willing to pay would include a deduction for this capital expenditure.

Conclusion

The Canadian lodging market continues to strengthen. High RevPAR levels and low lending costs have also created an attractive environment for development activity. With the entrance of new supply on the horizon and the improved availability of capital for expenditure and PIP deployment, capital planning strategies and requirements are being updated.

In order to increase property income and overall return on investment, hoteliers will be faced with a number of decisions related to property upgrades, repositioning, or conversion. The best decisions will be made by those who effectively distribute capital, maximize ROI, and support decision-making with sound due diligence. PIP and capital expenditure programs that are well-thought out and properly timed will yield the best results, allowing Canadian hoteliers to drive operating performance and market value.

About Graham Coe
Graham Coe is a hotel Consulting and Valuation Associate with the HVS Vancouver office in Canada. Graham received his Bachelor of Management with a Specialization in Finance from The University of Western Ontario. He also holds a Certificate in Hotel Real Estate Investments and Asset Management from the School of Hotel Administration at Cornell University, and has held various positions in hotel operations and development in Canada and China.

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