The Boston economy continues to prosper as a leader in education, biotech and finance, and the hotel market’s recovery from the Great Recession in 2008-2009 has been impressive. According to CBRE, hotels in Boston have recorded an average occupancy of 74.1% over the past six years compared to the 30-year average of 68.4% reflecting the healthiest demand trend the market has experienced in decades. Most hotel experts believe this trend will continue but occupancy levels could be impacted by new supply in certain sub-markets. The city’s hotel development pipeline is robust with several thousand rooms under construction or in planning with the highest concentration in the Seaport/Convention Center district.
Given construction costs at a historic high with a shortage of labor and a backlog in all asset types (hotel, office, residential and retail), it is puzzling how projects are being financed and underwritten as feasible. One answer is that investors are willing to accept lower returns on investments in Boston as they believe in the long-term viability of the market and recognize that there will always be high barriers for future competition. A common rule of thumb for a hotel developer that is underwriting a new suburban project is having a realistic proforma that delivers an unlevered return on cost (ROC) of 10% by stabilization which is typically year three after opening. ROC is defined as Net Operating Income (NOI) before debt service divide by the total project cost. Hotel developers with projects in downtown Boston or Cambridge, for example, may be willing to underwrite to an 8% to 9% ROC and take the risk of lower cash flow for potential long-term real estate value. Another approach towards making the numbers work is combining uses to maximize a site’s potential. In high density markets like Boston, often the first floor of a project is more valuable as retail space and the upper floors can be programmed as hotel, residential or office. Doing so can allow a developer to allocate the land and construction costs of a project to the different uses to achieve acceptable ROC metrics. Given that they typically are subject to less market volatility than hotels, retail and residential developers are usually willing to accept lower ROC hurdles for those uses. If a project has ground floor retail that can be developed for a 6% ROC and a hotel above that requires a 9% ROC then the combined uses can be more feasible. Another dynamic in combining uses is the potential benefit of shared parking and/or amenities. The parking use and traffic pattern of retail space can often compliment a hotel’s usage.
If a project has combined uses in the same building or on a site that cannot be easily sub-divided, developers often use a condominium structure to legally bifurcate the uses so that they can be financed and sold separately. If a condominium structure is not well documented and thought through, issues can arise relating to shared costs or even financeability. The following are some basic rules of thumb in forming a mixed-use condominium:
• Development of the condominium map – it is critical to have all parties agree on what areas are designated as common elements of a project and what should be allocated to the specific uses on their own. Each use represents a separate unit in the condominium.
• Governance – a condominium board needs to be established to govern any conflicts or issues that might come up in the project.
• Allocation of costs – it is best to establish the percentage of costs that each unit is responsible for upfront in the condominium structure. In most states, this can be done prior to the completion of the development. However, in Massachusetts, the condominium law is somewhat arcane as the percentage of cost allocation cannot be finalized until construction is complete and the unit is added to the condominium regime. In fact, it is even more complicated in Mass. in that the percentage allocation is based on value of the real estate as a function of the demand and use of the unit. If the governance of the condominium is not well structured from the beginning then disputes of future allocation of costs can be an issue.
• Development guidelines – if different developers are responsible for construction of separate units in the same condominium then it is important to have agreed upon guidelines on the quality of construction, timeline (milestone dates for completion) and in some cases, even the use. This issue usually only applies if it is a project with various parcels with different uses. If there are multiple uses in one building then typically there is only one lead developer who has an obligation to deliver space at a designated number to other unit owners.
• Condemnation and casualty – the probability of a project being condemned by the government or damaged in a major casualty is very low but lenders pay close attention to this language as they need to make sure their position is protected in the event of a catastrophic event. This can be a tricky balance to make sure each condominium interest is covered and there are adequate requirements to restore property in a partial casualty as this can impact the use or value of other units.
In the prior cycle, Boston had several hotels that were developed as a component of a mixed-use project, in most cases residential condominiums (e.g. the W Hotel and Intercontinental). Retail is a more common use with hotel in the current cycle. Some of the uncertainty around the retail market and online trends make these projects particularly tricky to underwrite and most of them involve primarily “experiential” retail like restaurants, fast casual dining, cinema and destination activities like bowling.
Only time will tell what is the right mix for each location.
Jim Luchars is chief investment officer for Stonebridge Companies, a hotel development and operating company. Prior to joining Stonebridge, Luchars was a principal at AEW Capital Management overseeing all hotel investments. Luchars has over 25 years of experience in the hotel business and commercial real estate.
Founded in 1991 by Navin Dimond, Stonebridge is a privately owned, innovative hotel development and hospitality management company. They manage a portfolio of 45 hotels across the United States, and provide investor opportunities, hotel development services, hotel management services, and hospitality career opportunities to our partners and associates. Currently, their hotel portfolio is comprised of 7,000 guest rooms across multiple select-service, extended stay, mid-scale, and full-service hotel brands located in primary and secondary markets.
