The hotel investment market continues to recover, and the pace of hotel transactions is picking up, particularly on middle-market assets trading in the $5-million-to-$40-million range. Hotel buyers and sellers are figuring out true value in the new normal of slow growth and limited debt availability, and they're coming closer on value, which leads to closed deals.

That said, the primary issue affecting almost every transaction is the cost of what is called a Product Improvement Plan, which is the cost to renovate a hotel to current brand standards upon a change of ownership. The other critical element is the availability of an extension of the current franchise for the new owner. If a primary brand that is desirable, such as a Marriott Courtyard, or a Hampton Inn, is faced with losing its flag upon a change of ownership, the impact on value is considerable.

Franchise companies are also renewing flags for a period of anywhere from five years to 15 years, depending on the situation, which often presents challenges for the current owner and new investor in terms of value, financing and exit strategy. We recently conducted a survey of hotel owners, management companies and other key players in the hotel investment arena on PIP and franchise issues. While non-scientific, the results are indicative of market sentiment. Here is a summary of the results:

Please describe your role within the hotel industry.

Thirty-three percent of respondents were affiliated with a hotel management company, and 25% were private equity investors. The remaining respondents were a mix of other investors (opportunity funds, REITs, etc.); lenders; advisors; and other hotel industry players.

How long does it take to produce a PIP from the time you request one?

Twenty-six percent stated that it took two to three weeks; 40% said three to four weeks and 22% said it took five to six weeks. The upshot is that this process takes time, and it is best to order a PIP well in advance of taking an asset to market.

What is the average cost of producing a PIP?

For 33%, it cost less than $5,000, while 44% put the cost between $5,000 and $10,000. Some 23% indicated that they typically shelled out more than $10,000.

What are your feelings on the actual cost of implementing the PIP?

About 38% responded that “The PIP costs have been fair but need to be phased in as the industry continues to recover.” But 46% responded that “PIPs are overreaching and the costs imposed by the brands do not produce a good return on investment.” Obviously the industry is divided on the fairness of PIP costs.

How negotiable are PIPs in the current environment?

Ninety percent indicated that PIP costs are somewhat negotiable.

What items in a PIP are most/least negotiable from a timing perspective?

The most negotiable items from a timing standpoint were food-and-beverage facilities (25%); meeting space (32%); exterior renovations (39%); and mechanical items (39%). Conversely, soft goods, furniture, fixtures and equipment, refresh and hotel lobbies were the least negotiable from a timing perspective.

What items are the most/least negotiable from a cost perspective?

On the “most” side were soft goods/FF&E (26%); meeting space (28%); and exterior renovations (35%). But soft goods/FF&E also came up as least negotiable by 50% of the respondents, along with lobby (39%). The conclusion is that it likely depends on the flag and age of the property on whether brand standards and costs can be flexible.

When you invest in an asset, what must the term of the franchise agreement be to ensure an adequate return on your investment?

Only 17% indicated five years or less. Some 43% indicated 10 years, 31% chose 10 to 15 years, and 16% responding 15 to 20 years.

For the majority of your assets, what level of impact do you feel a hotel losing its flag will have on asset value?

For 21%, a loss of flag means a negative impact of 10 to 20%, 34% said it had a negative impact of 20 to 30%, and 21% of respondents indicated a negative impact of 30 to 40%. A mere 11% indicated that losing the flag would have a positive impact, since it made other flags available for renovation and repositioning. Obviously it is the goal of hotel owners to maximize return on investment and that of franchise companies to be a valuable partner in the hotel venture, but to do so they must ensure brand standards. A large number of needed renovations have been put off during the recession, but no doubt a greater balance must be struck between owners and franchise companies on PIPs and franchise extensions.

Geoffrey E. Davis is president and senior principal at HREC Investment Advisors in New York City. He may be reached at [email protected]. The opinions expressed here are the author's own.