1997 Acta Structilia Vol 4 No 1 lnternasionaal International Extended-stay lodging: A new high-return product Reduced payroll and supplies costs make favorable return rates possible Peggy Berg & Mark Skinner Summary "In the USA a relatively new real estate product called extended-stay lodging should become as established a finan­ cial asset as limited-service hotels or apartment complexes. The potential for superior financial performance is based on assump­ tions of tightly controlled development costs, rapid 'lease-up,• high occupancy, and low operating expenses. The lower end of the extended-stay market has been pioneered by apartment companies, while the mid-market is being promoted by hotel companies that have recently entered the picture." Keywords: Extended-stay lodging, apartments, hotels. VERLENGDE VERBLYF-EENHEDE: 'N NUWE KONSEP VIR 'N HOE-OPBRENGSPRODUK Opsomming In die VSA het die konsep van verlengde verblyf-eenhede begin posvat. Meer as 1 biljoen dollars is reeds no raming sedert 1996 tot nou in die nuwe ontwikkeling bele. S6 'n eenheid bestaan uit 'n ten voile toegeruste woonstelletjie wat veral byval vind by persone wat vir kort of longer termyne weg van die huis moet bly. Die kombuisie is veral 'n groot pluspunt wat die huurders betref, terwyl dit vir die verhuurder lae onderhoud met 'n goeie inkomste inhou. Sleutelwoorde: Verlengde verblyf-eenhede, woonstelle, hotelle. Permission was granted by authors to publish fhis article in Acto Structilio. It was written by Peggy Berg, CFA, ISHC, president and Mork Skinner, MSRE, market and financial analyst of the Highland Group, Hotel Investment Advisor Group Inc. a hotel industry consult­ ing firm based in Atlanta, GA, USA as well as the publishers of the Real Estate Review, Warren, Gorham & Lamont, Boston, USA. Berg & Skinner/ Extended-Stay Lodging M ore than 1 billion dollars will be spent in 1996 and 1997 in the USA to develop a relatively new real es­ tate product called extended-stay· lodging. Within two years the product should be available in markets across the country, and the sector should become as es­ tablished a financial asset as limited-service hotels or apartment complexes. Investor interest in extended-stay lodging has been generated by anticipated unleveraged internal rates of return that exceed 20% and by leveraged returns that are above 50%. The potential for superior financial performance is based on assumptions of tightly controlled development costs, rapid "lease-up," high occupancy, and low operating expenses. At the lower end of the extended-stay market (in which av­ erage rates range from $25 to $30 per night), the use of sec­ ondary sites, often behind retail and restaurant outlets, and apartment-quality construction keep development costs relatively low. As room rates increase and the extended­ stay product becomes more upscale, the use of higher value sites and improved development quality is man­ dated. The lower end of the extended-stay market has been pio­ neered by apartment companies, while the mid-market is being promoted by hotel companies that have recently entered the picture. Some of the larger current investments are being made by newly formed public companies. The mid-market is expected to have average daily rates be­ tween $45 and $70. Currently the upper end of the market is defined by the well-established Residence Inn chain, which commonly has daily rates of $80 to $100. As rates increase and services are expanded, apartment operating policies are being replaced by hotel operating policies and operat­ ing costs are increasing. A hypothetical pro forma Exhibit 1 compares the statements or income and ex­ pense for a stabilized year of two hypothetical extended- 46 1997 Acta Structilia Vol 4 No 1 stay properties: ( 1) an economy property and (2) a mid­ priced property. Typically, an economy-price facility achieves stabilized performance after its first few months of operation. For a mid-priced facility, stabilization is likely to occur in the second year. Economy facilities tend to reach stabilized occupancy more quickly than their higher-priced counterparts because they require less mar­ keting and have a longer average length of stay. In the lowest price economy facilities, a substantial component of the market is essentially residential. Each line item in Ex­ hibit 1 is categorized according to the Uniform System of Accounts for Hotels. Assumptions The economy-priced facility is assumed to have 125 guest units and a small lobby/office area. It has no pool or other public space. The property is a ,two-story wood-frame building with exterior corridors. Each guest room is a single bay ranging in size from 230 to 310 square feet. Each guest room has one bed, a comfortable chair, a dresser. closet area, a full bathroom, and a kitchenette with sink, full-size refrigerator, microwave, two-burner cook-top, cabinet space, and cooking and dining utensils. The mid-priced building is a low-rise structure with ground­ level parking. It could have interior or exterior corridors. The lobby/office area is larger and better appointed than the one in the economy-priced property. Guest units would range in size from 300 to 400 square feet and have a higher level of finish and better quality furnishings than do the units in the economy-priced product. However, each guest unit still has only one bed, a table and chairs, desk area, televi­ sion with remote control, full bathroom, and a similarly equipped kitchenette. Both property types have telephone systems that permit unlimited local calls and long-distance calls on a credit card basis. Guests could receive telephone calls that are 47 Berg & Skinner/ Extended-Stay Lodging transmitted directly to their room, or calls may pass through an "auto-attendant" that directs calls to guest rooms. Front office operating hours in the economy-priced prod­ uct are from 7 a.m. to 8 p.m. At the mid-priced property, the office operates from 7 a.m. to 11 p.m. Each facility provides maid service once weekly, and changes towels and re­ moves trash twice weekly. Revenues Exhibit 1 assumes that stabilized occupancy in the economy-priced property is 90%, whereas in the mid­ priced property stabilized occupancy is 87%. Because the mid-priced property has fewer "residential" guests, and average stays are somewhat shorter, these facilities are more subject to weekly and seasonal fluctuations in travel than are economy-priced properties. Although Exhibit 1 reports average daily rates, rates at extended-stay facili­ ties are typically quoted on a weekly basis. No more than two people are expected to stay in a room. In the exam­ ple, the rate for the mid-priced product is the average for a modestly wide selection of room types. In the economy product, the price for one person would be, for example, $180 to $190 per week, but the average room rate includes some nightly business at a higher rate, for example, $50 per night. The facilities would also be making some incremental charges for double occu­ pancy. Thus, the average daily rate of $30 in the econ­ omy property implies average weekly income of $210 per week. For the mid-priced product , the average daily rate of $51 ,50 equates to $360 for a week. This average in­ cludes a component of transient business that is higher than that allocated to economy facilities. The transient rate is assumed to be around $70 per night, while the sin­ gle extended-stay weekly rate would be in the $310 to $340 range. Total room revenue is computed as: 48 Occupancy rate x average daily rate x 365 days x the number of guest rooms 1997 Acta Structilia Vol 4 No 1 At similar occupancy levels, extended-stay properties have a lower RevPar (revenue per available room per year) than hotels with similar development costs, but reve­ nues are higher than those of apartment buildings with similar development costs. Occupancies are typically higher than in hotels, but rates are lower. Conversely, oc­ cupancies are the same or lower than those of apart­ ments, while rates are considerably higher than apart­ ment rents. Rooms departmental revenue represents most of the revenues of extended-stay properties, generally more than 90% of gross revenues. EXHIBIT 1 COMPARISON OF INCOME AND EXPENSES FOR HYPOTHETICAL ECONOMY-PRICED AND MID-PRICED FACILITIES 1 Economy-priced facility Mid-priced facility OCCUPANCY 90% 87% Average rate $30,00 $51,50 Revenue Amount Amount Total as ratio per avail- Total Ratio to per sales Available to sales able room Room REVENUE Room revenue $1222020 91.76% $9 855 $2 027 720 92.49% $16 353 Telephone $61 101 4.59% $493 $83 548 3.81% $674 Rentals and $48 669 3.65% $392 $81 115 3.70% $654 others income TOTAL REVENUE $1 331 790 100.00'lli $10 740 $2 192 384 100.00'lli $17 681 DEPARTMENTAL EXPENSES Rooms $132 308 10.83% $1 067 $216 29 910.67% $1 744 Telephone $52 954 86.67% $427 $70 976 84.95% $572 TOTAL DEPART- $185 262 13.91% $1 494 $287 275 13.1D'lli $2 317 MENTAL EXPENSES 49 Berg & Skinner/ Extended-Stay Lodging COMPARISON OF INCOME AND EXPENSES FOR HYPOTHETICAL ECONOMY-PRICED AND MID-PRICED FACILITIES UNDISTRIBUTED OPERATING EXPENSES Administrative & $98 704 7.41% $796 $169 950 7.75% $1 371 general Marketing/ Sales $33 295 2.50% $269 $87 695 4.00% $707 Franchise fees $0 0.00% $0 $87 695 4.00% $707 Energy $96 132 7.22% $775 $143 732 6.56% $1 159 Property opera- lion and mainte- $64 728 4.86% $522 $118 821 5.42% $958 nance TOTAL UNDISTRIB- UTED OPERATING $292 859 21.99% $2 362 $607 893 27.73% $4 902 EXPENSES GROSS OPERAT- $853 668 64.10% $6 884 $1 297 215 59.17% $10 451 ING PROFIT FIXED COSTS Property. taxes $78 664 5.92% $636 $125 93 25.74% $1 016 Insurance $21 700 1.63% $175 $34 61 21.58% $279 Replacement re- serve $61 265 4.60% $494 $97 523 4.45% $786 NET OPERATING $691 839 51.95% $5 579 $1 039 148 47.40% $8 380 INCOME Debt service $303 658 22.80% $2 449 $506 096 23.08% $4 081 PRE-TAX CASH $368 181 29.15% $3 130 $533 052 24.31% $4 299 FLOW Telephone revenue shown in Exhibit 1 is based on the as­ sumption of $1,50 per occupied room night in the economy-priced model, and $2, 12 in the mid-priced model. These revenues would vary widely depending on the type of telephone equipment and service used. The longer the average stay in a facility, the lower the tele­ phone revenues are likely to be. 50 1997 Acta Structilia Vol 4 No 1 Rentals and other income in Exhibit 1 are derived largely from vending and commissions. Other income also includes minor amounts of interest and income from occasional sales of small items for salvage. Because extended-stay guest units include kitchens and do not offer room service, restaurants, or gift shops, vending sales can be substantial. Vending machine revenue varies according to the selec­ tion of machines offered and on the availability of alterna­ tives, like convenience stores within walking distance. In Exhibit 1, miscellaneous income of a little more than $1 per room night occupied shows that the economy-priced property has limited vending, primarily soda pop machines and a sundries machine. Miscellaneous revenue in this de­ partment of just more than $2 per room night occupied in­ dicates that the mid-priced product has a wider selection of items, possibly sundry and snack machines. Extended-stay hotels usually offers guests laundry facilities that longer-term guests may use extensively. Revenue from washer and dryer machines can add up to a substantial component of the "rentals and other income" category. Total revenue from all departments in the economy-priced product at stabilization is $1,3 million annually, while the mid-priced project earns almost $2.2 million in gross rev­ enues yearly. Departmental expenses Rooms department expense usually includes payroll and related expense for housekeepers, laundry staff and front desk staff. Also included are linen, guest supplies, and cleaning supplies. Costs of cable television and compli­ mentary breakfast (if offered) are also typically included in rooms departmental expenses, and when a reservation service is used, reservation charges are included. Rooms departmental expenses in the emerging extended-stay properties are expected to be in the range of 10% to 12% of room revenue, whereas rooms departmental expenses 51 Berg & Skinner/ Extended-Stay Lodging at limited-service hotels average 24% to 28% of rooms revenue.2 The relatively low costs of rooms department expenses may be attributed to lower levels of required service. Exhibit 1 as­ sumes that maid service is once per week and towels are changed twice per week, a service level that requires sig­ nificantly less labour expenditure than that of a hotel that offers housekeeping. In addition longer lengths of stay result in fewer check-ins and check-outs, which enables extended-stay hotels to operate with only one person at the front desk. Front desk hours are limited, and in many fa­ cilities the manager operates the front desk shift for a pe­ riod. The economy-priced product should have cable television, but might not carry premium channels. Mid­ priced facilities would be expected to carry one or two pre­ mium channels. Because guests stays are relatively long, to­ tal cost of guest supplies is low. Soap is not replaced daily, and the facilities need not offer room amenities, like sham­ poo, mints, etc. The expense figure in Exhibit 1 assume a lim­ ited continental breakfast at the mid-priced property, but no food at the economy-level property. The difference in check-in and check-out traffic between most hotels and extended-stay properties makes a signifi­ cant impact on operating costs. A limited-service hotel with 125 rooms and a 1 ,2 day average stay would have 25 OOO to 30 OOO check-ins and check-outs, and changes of guest room tenants annually. An extended-stay property with 125 rooms, but a four-week average stay, would have to han­ dle only 1 OOO to 2 OOO of these encounters per year. In the economy-priced model, telephone departmental expense is 87% of telephone revenues and a slightly lower percentage in the mid-priced model. This is a higher ex­ pense ratio (lower profit margin) than is typical of a hotel. In extended-stay hotels, long-distance usage is lower be­ cause they have a lower transient component, and tele­ phone pricing is value-orientated. 52 1997 Acta Structilia Vol 4 No 1 Undistributed operating expenses The category "undistributed operating expenses," in Ex­ hibit I are the overhead items required for operations. They include administration, marketing, energy, opera­ tions and maintenance, and other overhead items. a Administrative and general costs. Administrative and general costs include payroll and related expenses for the general manager, accounting staff or service, secu­ rity (a highly variable requirement), office supplies, travel, bad debts, commissions, and other administra­ tive expenses. Administrative and general expenses vary widely among hotels, depending on their manage­ ment structure. Limited-service hotels with 125 rooms in­ cur approximately $1 200 to $1 600 of such expenses per room per year. The economy-priced extended-stay property in Exhibit I incurs annual administrative and general expenses of only $800 per room. At an extended-stay property, office supplies, travel, bad debts, and commiss_ions are minimal. Accounting is simple because there are relatively few transactions, and payroll is tightly controlled. In some cases, although not in the Exhibit I models, the general manager lives on-site, reducing payroll cost. Guests processing charges are low because the number of individual guests is low. Bad debts are also low because, typically, room rent is collected in advance. Rents in extended­ stay facilities, particularly in the economy segment, are often paid in cash or by check, thereby reducing credit card charges. Most extended-stay rooms are booked by individuals or a relatively small business guest's secre­ tary. Consequently, commissions to travel agents and other third-party reservationists are relatively small. Be­ cause the mid-priced property has a higher rate of check-in and check-out and a somewhat higher level of service than the economy facility, it requires more administrative and general expenditure. However, total 53 Berg & Skinner/ Extended-Stay Lodging expense in the department is still lower than in a com­ parably sized hotel. Exhibit 1 includes no expenses for property oversight and assumes that ownership handles this responsibility. o Marketing and sales costs. Economy-priced extended­ stay properties incur relatively low marketing and sales expenses. Marketing usually consists of ( 1) sales calls by the general manager, (2) a clearly visible sign advertis­ ing the product and room rates, and (3) advertisements in telephone directories. Mid-priced extended-stay fa­ cilities require more concerted direct sales efforts. In ad­ dition, as the transient component of demand for these facilities increases, they require more signage and more marketing. In Exhibit 1, the economy-priced extended­ stay facility has annual marketing and sales expenses of $33 OOO, compared to $88 OOO for the mid priced prop­ erty. A typical limited-service hotel is likely to incur mar­ keting and sales expenses of 5% to 6% of total revenues, only slightly more than the expenses shown in Exhibit 1 for the mid-priced facility. o Franchise fees. The economy-priced product in Exhibit 1 pays no franchise fee. To date, facilities of this type have been reasonably well received without national branding. During the course of time, national branding is likely to become more important. The Exhibit 1 pro forma for the mid-priced facility pays a franchise fee equal to 4% of room revenues. The closer a facility is to a hotel product, the more likely it is to be franchised in order to obtain desired room rates. o Property operations and maintenance expenses. Main­ tenance for the economy property is shown at about $500 per available room per year compared to more than $900 for the mid-priced property, including staffing. Both figures are within the range of limited-service ho­ tels. The variation is caused by the size and complexity of the guest room and equipment. During the course of time, maintenance on extended-stay properties would 54 1997 Acta Structilia Vol 4 No 1 tend to be increased by the costs of in-room kitchen maintenance. Wear patterns for the rooms can be ex­ tended to be slightly different than in a hotel because of the extended-stay nature of the guest. a Energy expenses. Energy expense for the economy property is shown at $706 per available room compared to $934 per available room per year for the mid-priced property. Both are conservative figures and reflect rea­ sonable energy-efficient design and new heating and cooling units. Energy expense per room can be ex­ pected to be higher than for a traditional limited­ service hotel because of the in-room kitchens. a Fixed costs. Exhibit 1 bases property tax expenditures on an assumed development cost of $30 OOO per room for the lower-priced property and $50 OOO per room cost for the higher-priced property. Insurance is based on gen­ eral insurance levels for hotels, and varies widely. The re­ placement reserves reflect detailed analysis of the CapEx requirements for limited-service hotels. Because of the kitchens in these facilities, replacement reserves may need to be relatively higher than in hotels. Financial results The Exhibit 1 assumptions produce a gross operating profit for the economy-priced facility amounting to 64% of total revenue, compared to 59% for the mid-priced product. These profit margins are higher than those typically found in hotels. The key items of the difference are the lower la­ bour costs, reduced or absent franchise and manage­ ment fees, reduced cost of supplies, and lower adminis­ trative costs. Exhibit 2 compares typical departmental and undistributed operating expenses per room of econ­ omy- and mid-priced extended-stay properties and of a limited-service hotel. Return rates The before-tax internal rate of return on an unleveraged irwestment in the economy-priced property is 22%. Returns 55 1997 Acta Structilia Vol 4 No 1 3 & 4 assume that revenues and expenses increase by 3% annually to reflect inflation. EXHIBIT 3 REVENUE, EXPENSE, AND CASH FLOW STATEMENT: ECONOMY-PRICED EXTENDED-STAY HOTEL 1 Year -0 1 2 3 4 5 6 7 Gross so $1 331 700 $1 371 744 $1 412 896 $1 455 283 $1 498941 $1543 910 $1 500227 revenues a Total oper- ating ex- so $639 951 $659 150 $678 924 $699292' $720271 $741 879 $764135 pensesa Net Operat- ing Income so $691839 $712 594 $733 972 $755 991 $778 671 $802 031 $826092 Debt ser- so $303 658 $303 658 $303 658 $303 658 $303 658 $303 658 $303 658 vice Cash flow Unlever- $(37!iIDXJ) $691 839 $712 594 $733 972 $755 991 $778 671 $802 031 $5!)84519' aged Leveraged $(937 500) $388181 $408997 $430314 $452 334 $475 013 $498373 $3358640 Reversion calculations Sales prices' $5 317 966 Sales costs $159539 Net proceeds $5158 427 Debt payment $2 322 221 Before tax cash flow $2 836206 a Increases 3'!(. amually b Includes cash flow from reversion c Based on year 8 no.1 of $850 875 capitalized at 16'!(. EXHIBIT 4 nnvew REVENUE, EXPENSE, AND CASH FLOW STATEMENT: MODERATELY-PRICED EXTENDED-STAY HOTEL 1 Year -0 1 2 3 4 5 6 7 Gross so $2006199 $2192384 $2258155 $2325900 $2395677 $2 467 547 $2541573 revenue• Total oper- ating ex- penses' so $1125962 $1153236 $1187833 $1223458 $1260172 $1297977 $1336917 Net _operat- so $880237 $1039148 $1070322 $1102432 $1135505 $1169570 $1204657" lfl0111Come Debt ser- so $506096 $506096 $506096 $506096 $506096 $506096 $506096 vice Cash flow 57 Berg & Skinner/ Extended-Stay Lodging REVENUE, EXPENSE, AND CASH FLOW STATEMENT: MODERATELY-PRICED EXTENDED-STAY HOTEL 1 Unlever- I $(62500:xl) $880237 1 $10391481 $10703221 $11024321 $11355051 $1169570 I $8726986" aged Leveraged I $(1562500) $374 141 I $533 052 I $564 226 I $596 336 I $629 409 I $663474 I· $4350521 Reversion calculation Sales prices' $7 754 979 Sales costs $232 649 Ne1 proceeds $3 870 369 Debt paymen1 $2 322 221 Before tax cash flow $3 651 900 a Increases 3% annually b Includes cash flow from reversion c Based on year 8 no.1 of $1 240 575 capitalized at 16% Before-tax internal rates of return for a typical limited­ service hotel that costs $45 OOO per room to develop and that operates at a stabilized occupancy of 75% at an aver­ age room rate of $55, are about 15% on an unleveraged basis_ Under the same financing assumptions applied to the extended-stay properties, leveraged returns on equity for typical limited-service hotels would be about 30%. The pri­ mary reason for relatively high rates of return on extended­ stay properties are the low operating expenses possible in extended-stay facilities when compared to the transient "short-term" hotels. Revenue statistics and rates of return are compared in Exhibit 5. EXHIBIT 5 RETURN ON INVESTMENT COMPARISON FOR HYPOTHETICAL HOTEL PROPERTIES 1 Lodging product Economy-price Mid-price Typical limited- Extended-stay Extended-stay Service hotel Development cost per room $30 OOO $50 OOO $45 OOO Gross revenue $1 331 790 $2 192 384 $1 882 OOO Gross operating prof� (net operating in- 64% 59% 4210 50% come as% of total revenue) Pre-tax cash flow $386 181 $533 052 164000 58 1997 Acta Structilia Vol 4 No 1 RETURN ON INVESTMENT COMPARISON FOR HYPOTHETICAL HOTEL PROPERTIES 1 Lodging product Economy-price Extended-stay Mid-price Extended-stay Typical limned- service hotel Before tax internal rate of return on equity Leveraged 51% 39% 30% Unleveraged 22% 19% 17% Conclusion Given the present level of investment in extended-stay lodging product, this type of facility is expected to be a force in the real estate market. As this product type has evolved, it has moved away from the apartment model and closer to the hotel model. However, for long-term vi­ ability, extended-stay lodging must find its own niche. That niche could be considered a subset of the hotel industry or an independent real estate product, but extended­ stay properties cannot be highly profitable if they are op­ erated as hotels. The basic concept of the extended-stay product is that a guest staying several weeks to several months gets the highest value for his or her lodging dollar by staying in a fur­ nished efficiency unit that has all utilities, including tele­ phone. Guests in these facilities consider kitchens to be important, but they will do without expensive personnel­ based services. The product must be carefully tailored for people who need lodging for periods of one week to sev­ eral months. Extended-stay properties can afford to offer tremendous price-value to their guests as long as their service level re­ mains low. According to Smith Travel Research's Host Re­ port, total payroll and related expenses at limited-service hotels average 26% of total revenues. A limited-service ho­ tel like the one profiled in this article would normally employ about 20 full- and part-time personnel. Staffing for an extended-stay hotel of the same size is in the range of 10 to 14 individuals so that total payroll expenses are reduced to 59 Berg & Skinner/ Extended-Stay Lodging approximately 15% of total revenues. The savings in payroll, coupled with reduced costs of operating supplies, enable extended-stay hotels to provide excellent value to extended-stay guests. Consumers want extended-stay facilities for many reasons. These include corporate training assignments, equipment installations, relocations, short-term assignments, trips to handle family matters, etc. Until recently, no existing prod­ uct type was well-suited for this purpose. It is difficult if not impossible to rent an apartment for a few weeks or only a few months. If they can be found, such apartments are unfurnished or poorly furnished, and often they do not have utilities and telephone service in place. Hotels, on the other hand, are well-suited for stays of one to five nights, but lack convenient kitchen facilities for longer stays. They are also expensive. The underserved market and the possibility of strong poten­ tial returns from extended-stay lodging is expected to result in a national roll-out of these facilities. 1 Source: The Highland Group 2 Smith Travel Research, Host Report ( 1996) 3 Source: Smith Travel Research Host Report ( 1995) 60