Timely opportunities for hotel conversions

Conversion to affordable housing: Opportunities to maximize asset value, diversify risk or profitably divest

As the world continues transitioning to the next normal, pent-up demand for travel and lodging is expected to boost the hotel industry in the short-to-medium term.

At the same time, hotel values are at an all-time low while housing costs are rising across most jurisdictions in Canada. And there is significant and growing demand for affordable housing.

In 2018, at least one member of 283,800 Canadian households was on a waiting list for social and affordable housing. As a result, various levels of government have created programs to address the housing affordability crisis.

The federal government’s Investment in Affordable Housing (IAH) initiative matches funds with provinces and territories to improve access to affordable housing. As well, the provinces and territories deliver additional programs In the recent Federal Budget, the Government of Canada proposed to provide an additional $1.5B to the Rapid Housing Initiative, (RHI), on top of the $1 billion provided last year.

This funding is available to municipalities and not-for-profit organizations to either build new modular housing or convert existing assets such as hotels to affordable housing. They also announced an additional $300M in funding for the conversion of commercial property into affordable housing through the Rental Construction Financing Initiative.

Still, it’s challenging for municipalities to cost-effectively build this type of housing.

Conversions of hotels that are well located, especially in city cores, can present an attractive solution. Last spring, the City of Toronto signed contracts with numerous hotels for hundreds of rooms to ease crowding in homeless shelters. Mayor Tory said officials were also investigating whether some sites could be converted into permanent housing to help with the city’s affordable housing shortage.

The BC government purchased the 65-room Comfort Inn Hotel near downtown Victoria to provide temporary housing for the homeless amid the pandemic. BC Housing is one of the operators and is consulting with the community about a permanent conversion to an affordable housing site.

Under the Federal Government’s initial $1B Rapid Housing Initiative, Silvera for Seniors in Calgary purchased, and is currently converting, the Lakeview Signature Hotel to 120 affordable seniors housing suites.

Affordable housing presents a potentially profitable conversion opportunity for hotels with complementary footprints and infrastructure. Since this type of housing is independent of economic cycles, it’s a particularly appealing alternative use for hotel properties. Combined with government incentives, this may offer some owners an opportunity to maximize asset value and diversify risk or profitably divest from their hotel investment.

Conversion to apartment rental: Opportunities for stable, long-term returns

Apartment rental rates are at or near 10-year highs in almost every market across Canada. The national average vacancy rate at the end of 2019 was 2.0% and average rents for purpose-built rental units grew nationally by 4.1%. When the pandemic limited immigration and the need for student housing, occupancy rates climbed in 2020. But as the market normalizes moving forward, it is expected to regain strength.

In fact, there is unprecedented tenant demand and rental growth in apartment buildings across the country – which is why hotel-to-apartment conversions are gaining traction. North America’s first all-suite hotel, the 35-storey International Hotel in downtown Calgary, which had opened in 1970, was renovated in 2019 and transformed into 252 premium long- and short-term rental apartments.

The 45-storey Edmonton House apartment hotel was the second tallest building in the city when it opened in 1971. It was converted to a suite hotel in 2006 and then nine years later, into a 328-unit apartment building.

The key challenge for conversion to market rental is whether a property may require extensive and expensive renovation to meet the demands of today’s renters for high-quality amenities with features and services similar to those of upscale hotels.

Still, unlike conversions to condominium or commercial uses, conversions to rental buildings can deliver stable, long-term returns. Additionally, hotel owners may also capitalize on higher valuations for residential use by selling or allying with a strategic partner looking for conversion-suitable assets.

How to determine whether conversion is feasible for your property

To establish whether either of these options might be viable for your hotel property, a highest and best use analysis and a feasibility study conducted by an experienced CRE consulting firm will provide clear guidance.

Highest and best use analysis

This analysis can quantify the level of demand and supply for optional uses of a building within specific markets and project which option will likely add value and generate long-term returns.

It answers key questions such as: what is the macroeconomic environment of the area, i.e. employment, income growth, population growth, demographic characteristics? Current and future market demand? Sector profitability? Competitive landscape? Industry cost structure? Regulatory controls? The community’s position on potential redevelopment?

The results of this analysis can help to determine the best use of the asset – and inform design, financing and ultimately, the marketing of a project.

Feasibility study

The next step is a feasibility study. This can explore a range of options for a property to determine which one, if any, is the best approach. Or it can focus on a specific option to determine its viability – legally, technically and financially. A comprehensive, well-designed study encompasses the following components.

• Market feasibility: Building on the highest and best use analysis, this study takes an in-depth look at demand and supply factors for the proposed use of a property and its sub-market. It can identify market opportunities and provide recommendations related to market characteristics, such as product design, pricing and potential absorption. 

• Site suitability: A feasibility study can also determine whether a location is suitable for the vision, use and business model of a property. This includes identifying government ordinances and examining the need for and timing of zoning exceptions, variances or rezoning approvals. 

• Physical feasibility: All types of multi-family housing now require certain market-standard amenities. The feasibility study will determine whether a hotel conversion can accommodate this. A wood frame building, for example, is more easily renovated than a concrete building. Hotels built in the 1960s–1980s, which tend to have larger rooms, can be good candidates for conversions, especially those with a predominance of suites and abundant amenity space.

The feasibility study examines the physical characteristics of the property to assess potential financial ramifications.

• Building: condition of the building envelope; HVAC; electrical, lighting and fire systems; technology infrastructure; finishes

• Tenant space: floor plate size and shape; usable square footage; common area factors

• Legal/regulatory: building codes; insurance requirements; government regulations

Financial modelling

Since the operating model for each type of multi-family housing is different, financial modelling of the options is fundamental. This integrates the renovation costs that will have to be incurred, revenues that are likely to be achieved, operating pro formas and net financial returns. It also considers the current market value of the hotel that is being contemplated for purchase.

As well, financial modelling takes into account financing costs, including the availability of government incentive programs since these supports can have a significant impact on project financing and returns for each type of conversion.

Property taxes are another key factor in financial modelling. While hotels, for example, are taxed at a commercial rate, rental housing is taxed at a residential rate. In Toronto, the commercial rate is about 3.5 times higher than the residential rate. In many other jurisdictions the commercial rate is at least double that of residential.

Take the next step

Ultimately, equipped with a highest and best use analysis and feasibility study, along with a current valuation of a hotel property, determining the most profitable option for the asset quickly becomes clear.

Should you decide to convert a hotel asset to an alternative use, as with any successful development project, having the right partners is key. To determine whether there is value in partnering with a specialist in the affordable housing or market rental sector, consider the following questions.

• Is funding only available to a sub-set of the industry (not-for-profit, affordable housing developers/operators, etc.)?

• Do you have the in-house skills required to execute the conversion strategy?

• Do you have the financial resources necessary to profitably develop the opportunity?

• Do you wish to free capital for other opportunities?

Are there qualified parties at the table to buy the asset or partner in the venture? There may never be a better time to objectively assess the long-term prospects for your hotel property –and to determine whether conversion to affordable housing or apartment rental might present a desirable, and profitable, strategy.