The Debate for the Highest & Best Use of Hospitality Properties

Shifting economic and demand cycles often prompt investors and owners to question whether a hotel is the highest and best use for a given piece of real estate.

Speakers on a panel at the recent Distressed Hotels Forum talked about the factors at play that may prompt an investor to explore conversions from hotels into multi-family housing or senior housing, as well as opportunities to convert hotels into mixed-use developments.

In most cases, speakers said, demand drives these types of conversions, and economic cycles can make them more or less favorable.

Multifamily and Senior Living

Right now, high demand for affordable housing is prompting conversions from hotels to multi-family housing, said Andy Stewart, managing partner at investment firm Argosy Real Estate Partners.

“We’ve looked at all these older extended-stay hotels with kitchens and approached brands to talk about moving older hotels out of their systems,” he said. “The business plan when we bought our first portfolio 10 years ago was to harvest cashflow from extended-stay hotels until the [brand agreement ends], then shift them to multifamily housing.”

“Today, hotels aren’t cash-flowing, and the conversion potential is more immediate for us,” Stewart said. His company currently is pursuing deals for about five hotels for such a conversion opportunity.

Underwriting first-generation branded extended-stay hotels has been pretty straightforward, Stewart said.

“Flags typically have been well-maintained, so we can focus spending where tenants will see it,” he said. “The kitchen’s already there, the plumbing’s already there.”

For conversions from hotels into senior living housing to make sense, replacement cost per door and room size are the key factors, said Clare Duan, vice president and director of acquisitions for the senior living company Senior Resource Group.

“We go for high-barrier markets where replacement cost is so high that it’s not feasible to develop senior housing on a per-unit basis,” she said. “Now it makes sense, if I could pay $400,000 to $500,000 per door, to buy a good-location, good-bones hotel.”

Her firm also looks for large room sizes and overall key count of more than 150, because typically they lose about half that in the conversion to senior residences, she said.

Duan’s company is also particular when it comes to brands — no brand-name hotels that require termination fees, and no unions either, she said.

“But we do care about the amenity space,” she said. “All that space that multifamily doesn’t want — restaurants, commercial kitchens — we love that space.”

Duan explained that underwriting a deal for a hotel into senior living requires a little more complex understanding of how the deals are different.

“We focus on luxury senior housing and the average operating margin is 40% to 47%,” she said. “We have a lot less volatility compared to hotels. Rent is much higher than multifamily, but my margin is lower.”

Mixed-Use Opportunities

Speakers also talked about the opportunities converting traditional-use hotels and hotel complexes into mixed-use developments that go beyond the typical hotel/residential/retail aspect of mixed use and instead incorporate elements like student housing, extended-stay, furnished and unfurnished units, and even space for short-term rental providers, like Airbnb.

Chris Beavor, CEO of CAI Investments, described his company’s conversion of the Harrah’s Reno Hotel and Casino, which announced plans in January to purchase the property from VICI Properties and Caesars Entertainment for $50 million. The complex, originally built in the 1930s, spans more than seven acres and includes three towers, all built at different times.

Beavor said determining the highest and best use for this piece of real estate involved debating a lot of possibilities driven by the unique demands of downtown Reno.

“We had demands from every sector,” he said. “Downtown has a shortage in student housing. It has a general housing shortage, given the tech in our region. The city has conventions booked for the next five to 10 years and needed hotel rooms to hold these events.”

Beavor said it all came down to the financials. Options included a dual-branded hotel, and also Airbnb space, which he said “wasn’t quite understood yet by financing.”

The project will include hotel rooms, both furnished and unfurnished residential units that can be rented for different time periods, and office space.

“When we say this is truly mixed-use, we looked at every amenity we have to try to drive rent and every option,” he said.

“We know, for example, that we’ll get some students there for nine months. And we know the Reno market is busier in the summer months, and most demand is when students aren’t there,” Beavor said. “So, we looked at the market and said we are going to provide this product and let the market reign.”