Routes to ROI: Financial Considerations Behind New Build and Conversion Options

In today’s commercial real estate landscape, buyers and sellers are at odds in terms of their price points and expectations. Many sellers are reluctant to sell because they are in a loan that was locked in at a lower rate prior to rate increases, so they want to stay in their loans and continue to do business as usual. On the flip side, we’re seeing a lot of cash-rich buyers who are patiently sitting on the sidelines and not in an urgency to move their money. This scenario equates to a slower market with much less activity. Historically, in a hotter market, buyers would pounce on a deal if they had the financing in place, but today, buyers are far more patient and willing to wait for the right deal.

However, although factors such as high interest rates and construction costs are contributing to a slower transaction rate, we are still seeing activity. Whether it be in the form of a new build or conversion, there are buyers and sellers across markets who are identifying deals that make financial sense. If you’re interested in making a move within one of these areas, here are the top considerations to keep in mind.

New Builds

When factoring pricing on a new construction, many different variables come into play. On a macro level, you must consider geopolitics when your manufacturing is being done overseas. If the product does not get to you in a timely fashion because of tariffs or supply chain issues, there can be a significant impact on the pricing of a construction deal. On a local level, labor wages are on the rise, and these increases can greatly impact construction as it costs more to get people onsite. Given these factors, the cost of building one unit or property can be difficult to predict.

Another key component of a new build is the barrier to entry. This is not necessarily dictated by the size of a city; it’s more about considering the city’s nuanced characteristics. For example, when evaluating Sedona, Arizona, for a new build, it’s important to know that the city does not have a large labor pool, meaning you would have to bring in most of the people who are working on the project from elsewhere. Additionally, Sedona has many design constraints that contribute to a higher barrier to entry. You’ll also need to look at demand generators. A larger city is more likely to have the demand generators needed for a new build. If you’re going to drive a particular RevPAR, you must zero-in on the Monday-through-Friday business; it’s not just about the weekend travel anymore.

Factoring in inflation is also key. On a national average, we are experiencing construction costs that far exceed where they’ve been historically. Depending on which market you’re located in, construction costs may be upwards of $200,000 per key.

Considering the discrepancies that often exist between development costs and RevPAR, extended-stay hotels are becoming a more popular asset. With their ease and efficiency of operations, extended stays create balance by maintaining lower operational costs and achieving a higher RevPAR as compared to full-service properties.

Conversions

Deciding which type of conversion makes the most sense for you is all about analyzing your property, the market you’re operating in, and whether your deal makes financial sense. Changing flags under the same brand might make sense if you’re concerned about streamlining operations and avoiding disruptions. For example, if your property is aging and operating as a Hampton, Hilton may not allow you to keep the brand. In this instance, you may have the option to convert it to a Spark. The beauty of this type of conversion is that you would get to stay within the Hilton brand and potentially enjoy significant savings given you’re operating under the same brand standard. You would also benefit from the strength of the same reservation system, which allows for easier synergies between the hotel and its guests. Additionally, if there is more opportunity in your market, the brand could propose giving you another flag. In this case, you could potentially have two assets in the same market.

On the flip side, cost is a critical factor when weighing how to convert. If you find yourself in a situation where the brand notifies you that you’ll need to spend money on the property in the form of an updated design package or a PIP if you want to continue operating, you will have to determine whether it’s worth putting money into your investment. With distressed properties, some owners don’t want to put more capital in, so they might look into converting to a flag that is more cost-effective. Going from a Marriott property to a Choice brand or from a Hilton asset to a Wyndham franchise is a common practice when properties start to age out. While such a move can provide significant cost savings, the downside is that you will lose the ability to command a higher ADR, which in turn gives you a higher RevPAR in most cases. This is the biggest consideration when deciding how to go about your conversion.

Despite a tough market with high construction costs and equally high interest rates, the hotel industry is driving forward with thoughtful ownership and creative minds who are exploring different opportunities from rebranding, development, and adaptive reuse perspectives. As we’ve seen in the past, the cyclical nature of real estate tells us that buyers and sellers will soon enough align and give the market a much-needed uptick.