Can You Use a CMBS Loan to Fund a Hotel Property Improvement Plan?
Hotel property improvement plans (PIPs) are a series of specific renovation guidelines for franchise hotels and motels, intended to bring the property up to the brand’s latest design standards. PIPs are typically optional, but in some cases, they may be mandatory, specifically if a property is a certain age or has fallen below a certain quality standard. They may also be mandatory if a hotel transfers to new ownership or wishes to expand its footprint on its current property. In some cases, CMBS cash-out refinances can be used to fund property improvement plans.
What do Hotel PIPs Actually Entail?
Before getting into the financing aspects, let’s look at what a hotel PIP actually involves. In most cases, a hotel PIP can entail changes to nearly all aspects of a property. Some of the most common areas that may require PIP upgrades include:
Guest rooms and corridors
Landscaping
Parking
Meeting rooms
Food and drink facilities
Plumbing and electrical systems
Mechanical systems
Elevators and stairways
Interior and exterior lighting
Fitness centers
Swimming pools, spas, and other amenities
Security, safety, and communications systems
The Problems with CMBS Loans and Property Improvement Plans
While CMBS financing can sometimes be used to fund a property improvement plan, there are some considerations to take into account first. Most CMBS loans have strict limitations that prohibit changes or improvements to a property during the loan’s term, even if those improvements increase the property’s cash flow and reduce the risk of loan default. In fact, making unauthorized improvements to a property financed by a CMBS loan could actually cause the borrower to go into technical default, which could end in disaster.
Much of the time, loan covenants regarding the property are set in stone due to regulations involving the REMICs (real estate mortgage investment conduits) that are used to pool CMBS loans together into bonds that are sold on the secondary market.
However, in other cases, the ability to make minor improvements may be negotiated during the closing process by altering the loan’s pooling and servicing agreement (PSA). This means that lighter property improvement plans that may only involve changing furniture, interior decorations, and signage may be more likely to be approved than PIPs that involve substantial rehabilitation, such as replacing roofs, HVAC systems, electrical systems, tearing down walls, or making other major property improvements.
Therefore, getting CMBS financing to fund a PIP may be best if you own multiple properties, and want to enact a PIP on a separate property not financed with a CMBS loan. For instance, if you owned two properties, one financed with a bank loan and the other financed with CMBS, you could potentially use the cash-out funds from your CMBS loan to make property improvements on your other hotel.
Are Property Improvement Plans Actually Worth It?
Before you decide to use creative financing to conduct a property improvement plan, you should ask yourself whether a PIP is a smart decision in the first place. PIPs can be prohibitively expensive, though costs vary due to factors such as brands, property sizes, and locations.
For example, Holiday Inn Express’s Formula Blue, one of the most popular PIPs on the market, generally costs between $10,000 and $25,000 per room. With the average Holiday Inn Express location having 75 rooms, the total cost of the PIP would be between $750,000 and $1.875 million in total costs. Hotel industry experts estimate that most PIPs will cost 7-8% of a hotel’s overall revenues over a 10-year period, though these losses may be front-loaded.
Before deciding to invest such a high amount of capital in your property, you’ll likely want to ask a variety of questions first, some of which include:
Will your PIP actually increase your profits via increased room rates?
Is there a demand for the new amenities or qualities that your PIP will add to your hotel?
How much will your PIP impact your guests or profits during the renovation process?
How long will your PIP take?
How much experience do you have with construction and renovations?
For example, if your hotel or motel is used primarily by business travelers near an airport in a secondary or tertiary market, guests may not be willing to pay more for luxurious accommodations. Therefore, your PIP could be a waste of money. In contrast, if your hotel property is located in a higher-end market, such as the downtown area of major MSA, or a popular tourist destination, a PIP could make your property more competitive and allow you to raise rates significantly.
In addition, the planned holding period of your property may also influence whether a hotel PIP is a good idea. In most cases, PIPs are only worth it if you plan to hold onto your hotel for an extended period of time (5-10 years+). In contrast, if you’re looking to sell your property within the next few years, the time and money it takes to invest in a PIP may not be worth it.
In general, PIPs can often take years to complete, and it's best to do your most significant renovations in the off-season so that they disrupt the least amount of guests possible, reducing the PIPs impact on your short-term profits.
As an aside, hiring a third-party PIP or hotel consultant may be a good idea when determining whether, or how, to enact a PIP for your property. A good consultant will have experience with hotel PIPs ad construction cost analysis and may be able to determine if enacting a PIP is a good idea in the first place.
De-Flagging a Hotel vs. Enacting a Property Improvement Plan
With hotel PIPs being so expensive, if you want to make serious improvements to your hotel, you may want to consider de-flagging it instead. This means breaking your franchise agreement with your hotel franchise and re-branding your hotel. This can help you save money by enacting property improvements in the way you want-- not the way the franchise wants. This can be an especially good idea if your brand is forcing you to enact a highly expensive PIP, which some brands do, particularly for properties that are 10 years or older.
However, it’s important to note that if you de-flag your hotel, you may incur new costs during the marketing and re-branding process. Since your hotel or motel no longer carries a national brand name, you will need to rename it and potentially create a new marketing campaign based on the hotel’s new name and attributes.
In other situations, you may be able to reflag your property to a different franchise, which may have lower quality expectations. This can help your property retain a popular brand name while reducing your PIP costs or eliminating your need to enact a PIP altogether.
SBA 504 Loans May Be Superior for Property Improvement Plans
While CMBS loans can be an incredibly attractive option for hotel owners, they’re far from the only option out there. In many cases, an SBA 504 loan could be a better option. SBA 504 loans are loans guaranteed by the U.S. Small Business Administration (SBA) and are issued via a partnership between private, SBA-approved lenders and local non-profit lending institutions called Community Development Companies (CDCs).
SBA 504 loans are specifically designed for owner-occupied business construction, renovations, and heavy equipment. 504 loans for construction and renovation typically have 20-year terms and are issued at highly competitive rates.
In PIP or property upgrade situations that require minor improvements and not major renovations, an SBA 7(a) loan may be a superior option. SBA 7(a) loans can be used for both commercial real estate and working capital, and can generally close faster and with less paperwork than SBA 504 loans.
Since SBA loans are specifically designed for owner-occupied businesses, they don’t have the strict rules associated with CMBS loans, which can make enacting property upgrades much easier. However, it should be noted that SBA loans are typically full-recourse financial instruments (unlike non-recourse CMBS financing) and do carry significantly higher interest rates than their CMBS counterparts.
Some Hotel Franchises Offer PIP Financing
Finally, it should be noted that some, but not all hotel franchises actually offer financing for their franchisees to complete PIPs. These financing options may or may not be as attractive as SBA, bank, or CMBS loans, but hotel owners should always check in order to aware of all of their options.