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By Altus Group | July 2, 2020

As COVID-19 reconfigures global markets, owners and operators of hotels in Canada are anxiously anticipating what the travel and tourism sector will look like in the months and years ahead.

With only a small minority of this country’s hotels currently open, this wait-and-see period is an optimal time to prepare to succeed in the emerging marketplace. If change is needed, this is the time to do it. Later, there may be fewer options.

Already, lenders are reviewing their hotel portfolios to determine where readjustments are required. Hotel owners and operators are experiencing massive revenue losses, while fixed costs remain relatively unchanged and future demand for hotel rooms is uncertain.

Lenders may have to make choices to support certain operators at the expense of others. For properties with no cash flow coming in and burgeoning carrying costs, they will likely require owners to provide a plan to transform or sell. In fact, these discussions have already commenced in some secondary and tertiary hotel markets, as well as Alberta, which is experiencing an additional economic blow to the oil and gas industry.

Recovery of Canada’s hotel sector is not expected to be immediate, even when travel and social distancing restrictions are lifted. Given this uncertain future, this may be the ideal time to pivot.

While the hospitality sector struggles, demand for multi-family housing – including affordable, market rental, seniors and student housing – remains relatively robust. Most major markets are under-supplied with affordable options despite the recent and anticipated decline in home prices and rents.

Converting hotels into multi-family housing can help to meet this demand by enabling owners and investors to quickly move supply into the market. As well, City councils look positively on these types of developments because they help to ease the housing and economic needs of residents. There is also a growing track record of conversions that demonstrate how to successfully deliver these projects.

This is an optimal time for hotel owner-operators to determine if your properties are positioned to be winners in the marketplace that will emerge – or whether an alternative use for these assets, such as conversion to multi-family housing, might be a more financially rewarding option.

Here are the key factors to consider when assessing the feasibility of a conversion.

 

Demand in the new hospitality industry

The pandemic and its related restrictions on business and leisure travel have had an unprecedented impact on the hospitality industry. Fear of community spread of the novel coronavirus has led to cancellations of flights, events and room bookings that have decimated hotel occupancy rates – and profit margins. This spring, Canada’s hotels experienced a 90% drop in revenue as occupancy plummeted to less than 5% [1].

While the duration and depth of this downturn continues to be unclear, it is clear that industry recovery will be a long process. Hotels are only gradually reopening on a selected basis, which varies significantly from market to market.

The Hotel Association of Canada and the American Hotel and Lodging Association recently released health and safety protocols for new pandemic standards. With extensive requirements for cleaning and physical distancing, these represent heavy additional costs for the industry.

Some portion of business travel will never return, replaced by video calls and virtual conferencing. Many hotels generate significant revenue from renting space for meetings and events, which also affects guest room bookings.

It is a similar situation with international travellers. More than 22 million people visited Canada last year. But with a pandemic that experts predict may endure for two years, fear of travelling and enforcement of social distance protocols may linger even longer.

The good news is that while international and business travel will be limited in the short to medium term, local and regional travel is likely to increase as inter-provincial travel restrictions are eased and Canadians opt for drive-to destinations to reduce travel risks.

 

Realistically evaluate strengths, weaknesses, opportunities and threats

Will your property have a stake in this new hospitality market? Or will it be able to gain a stake?

To find answers and develop an appropriate plan, a SWOT (strengths-weaknesses-opportunities-threats) analysis is a good place to start. This enables you to identify the threats and opportunities for your hotel assets in the context of this newly forming marketplace, as well as to assess the strengths and weaknesses of your property that will propel and/or inhibit optimal performance or growth.

An analysis should reveal answers to questions such as the following. What are the characteristics of your market? What was your market share pre-COVID? Was it growing or shrinking? What was your property’s pre-COVID market segmentation: corporate, leisure, international, national and/or regional? Where do you believe demand in your market will come from? What do your projections indicate for the next two, three and five years?

Can the hotel’s physical infrastructure accommodate physical distancing requirements? Or can it be altered sufficiently with a reasonable capital investment? Can it meet the evolving needs of guests and brand standards? If you invest the funds, what returns can you expect? If you continue operating, will the hotel brand support you? Will your lender?

Being realistic is crucial. Smaller, older, owner-operated hotel properties, particularly those in secondary and tertiary markets, may not adapt well to a novel coronavirus world and could face a significant struggle to rebound. For these properties, weighing options is vital. Should deferred capital expenditures be at the point where there is unlikely to be a positive return over the long term, it’s time to determine the best use of these assets.

 

Evaluate the options

Affordable, market rental, seniors and student housing – these all represent potentially profitable conversions for hotels with complementary footprints and infrastructure. Conversions to multi-family buildings could also allow for a stable, long-term return, compared to condominium or commercial conversions.

The following is an overview for each type of housing, along with examples of successful conversions.

Affordable housing

Affordable housing: Most jurisdictions across Canada need more affordable housing, especially urban areas. In 2018, at least one member of 283,800 Canadian households was on a waiting list for social and affordable housing. [2]

After announcing Canada’s first-ever National Housing Strategy, the federal government allocated $55 billion in the 2019 budget to this 10-year plan to help reduce homelessness and improve the affordability, availability and quality of housing for Canadians in need. All levels of government are jointly delivering this strategy. Cities are supporting this initiative in numerous ways, including prioritizing the development of affordable housing, reducing or exempting fees and expediting permits for affordable housing developments.

Still, it’s challenging for municipalities to cost-effectively build this type of housing. Conversions of hotels with a complementary floor plate can present an attractive solution. At the same time, location is key because affordable housing is generally needed in city cores.

The BC government, for example, purchased the 65-room Comfort Inn Hotel near downtown Victoria to provide temporary housing for the homeless amid the COVID-19 pandemic. BC Housing is one of the operators and is consulting with the community about a permanent conversion to an affordable housing site.

This 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.

Recently, Horizon Housing in Calgary purchased a local hotel, The Elan, with plans to convert the hotel to offer 62 studio, one- and two-bedroom affordable housing units.

It’s helpful to keep in mind that affordable housing is independent of economic cycles so it’s a particularly appealing alternative use for hotel properties. Crucially, due to intense demand for this type of housing, financial and other support is available from various levels of government to induce supply.

Can the hotel’s physical infrastructure accommodate physical distancing requirements? Or can it be altered sufficiently with a reasonable capital investment? Can it meet the evolving needs of guests and brand standards? If you invest the funds, what returns can you expect? If you continue operating, will the hotel brand support you? Will your lender?

Being realistic is crucial. Smaller, older, owner-operated hotel properties, particularly those in secondary and tertiary markets, may not adapt well to a novel coronavirus world and could face a significant struggle to rebound. For these properties, weighing options is vital. Should deferred capital expenditures be at the point where there is unlikely to be a positive return over the long term, it’s time to determine the best use of these assets.

Market rental

Market rental: There is unprecedented tenant demand and rental growth in apartment buildings across the country. Rental rates are at or near 10-year highs in almost every market. The national average vacancy rate at the end of 2019 was 2.3% and average rents for purpose-built rental units grew nationally by 4.1%.[3]

Last year, North America’s first all-suite hotel, the 35-storey International Hotel in downtown Calgary, which had opened in 1970, was renovated 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 landmark building is currently for sale again, with notable interest.

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 a variety of high-quality amenities with features and services similar to those offered by upscale hotels.

Retirement home

Seniors housing: Reflecting the rapid growth of Canada’s senior population, the number of hotels being transformed into retirement homes and assisted living facilities has been growing over the past five years or so.

In 2016, there were 5,935,635 seniors 65 years of age and older, representing about 17% of the country’s population; this percentage is expected to increase to 24% by 2036. [4]  Within six years Canada will require 131,000 more spaces for seniors. [5]

 Hotels can often be good candidates for such conversions because senior residences do not necessarily require full in-suite kitchens and hotel dining and meetings spaces can readily be converted to dining rooms and amenities for seniors.

One example is the 23-year-old Peninsula Inn Hotel in Niagara Falls. It is currently undergoing a $5 million conversion into a wellness, supportive living and enhanced care residence. Amenities will include an indoor pool, tuck shop, fitness centre, activity room, chapel, and an outdoor patio and bistro.

Like hotels, many retirement and assisted-living homes operate on an owner-manager model. Using a third-party operator to manage a seniors facility can help to mitigate the risks associated with conversion.

For more insights into seniors housing values going forward, refer to our article “In the time of COVID: A snapshot of Canada’s seniors housing industry.”

Student residence

Student housing: Developing off-campus rental housing for Canada’s growing student population is close to 15 years behind the US and the UK according to the Real Estate Investment Network. Only three per cent of Canadian university students live in purpose-built off-campus student housing compared to 10-12% in these countries.[6]

While demand has been accelerated by international students, which the COVID-19 crisis has dampened in the short term, it is expected to pick up again.

Over the past few years, there have been numerous successful hotel-to-student housing conversions across the country. Colleges and universities are increasingly partnering with private developers to build residences that the secondary institution subsequently owns, operates and occupies. Partnering with an institution reduces risk and opens access to government incentives.

One of the earliest examples was the 11-storey Hotel Ibis in downtown Toronto. Purchased by Ryerson Polytechnical Institute in August 1993, it was repurposed into housing for 270 students and a home for the Hospitality and Tourism Management Program.

In downtown Montreal, Parc Cité, a former 140-suite Quality Inn hotel opened as a student residence for McGill University students in 2014. And in Ottawa the following year, a Holiday Inn across the Rideau Canal from the University of Ottawa, reopened as the 1Eleven residence for 420 students.

Hotels with a high suite count present good conversion options. Most important though, is location. Housing for students needs to be within a short walk of campus or readily accessible by transit.

Determine whether conversion is feasible for your property

To determine whether any of these options might be viable for a hotel property, a highest and best use analysis and feasibility study are essential.

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 the following.

  • What is the macroeconomic environment of the area: 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

This next step is a feasibility study. This can explore a range of options for a property to determine which one, if any, are 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 a highest and best use analysis, this study takes an in-depth look at the demand and supply factors for the proposed use and its sub-market. The study can identify market opportunities and provide recommendations related to market characteristics, such as product design, pricing and potential absorption.

Site suitability: The study can determine whether the location is suitable for the vision, use and business model. This includes identifying government ordinances and examining the possibility and timing of securing any required zoning exceptions, variances or rezoning approvals.

Physical feasibility: All multi-family housing – no matter what type – now requires a certain set of 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 had larger rooms and tend to 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 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 would integrate the renovation costs that will have to be incurred, revenues that are likely to be achieved, operating pro formas and net financial returns. This will also take into consideration the current market value of the hotel that is being contemplated for purchase.

Retirement homes, for example, must meet extensive building code standards as well as other standards for resident care and safety including fire prevention and protection. When it comes to operations, lease-up may take a year or two, impacting cash flow for a significant period. This is a particularly important consideration during the pandemic when the regulatory environment is evolving.

Financial modelling also takes into account financing costs, including the availability of government incentive programs. For instance, there is a wide variety of federal, provincial and municipal incentives available for the development of affordable housing. When it comes to student housing, secondary institutions have access to capital at rates that are significantly more attractive than those available to private sector borrowers. And Canada Mortgage and Housing Corporation offers programs for affordable and/or market rental, seniors and student housing. These supports can have a significant impact on project financing and returns for each type of conversion.

Property taxes are another significant 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.

Use this transition time to position your property for long-term prosperity

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 can quickly become clear.

This information will also be invaluable in lender discussions. With the market experiencing a contraction in demand, and a concurrent contraction of capital available for acquisitions while lenders more cautiously weigh risks and rewards, a property sale at this time would likely yield lower values. Should you decide instead to move forward with a conversion option, your lender can be an invaluable ally in helping you realize the potential of your property.

As with any successful development project, having the right partners is key – capital partner, consulting partner, development partner, and operating partner. Gather the expertise needed to realistically assess your property and to determine how it fits into the current market and how it might fit into a new market. Then use this transition time productively to position your hotel asset for long-term prosperity.

[1] Hotel Association of Canada

[2] Canadian Housing Survey, 2018 – Statistics Canada

[3] Canadian Multifamily Mid-year Update, September 2019 – CBRE – CMHC Housing Market Information Portal

[4] Report on housing needs of seniors, June 2019 – Federal/provincial/territorial Ministers Responsible for Seniors

[5] Future Care for Canadian Seniors: A Status Quo Forecast, 2015 – Conference Board of Canada

[6] The University Effect, 2019 – The Real Estate Investment Network

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