Hotel and motel conversion into housing
by Zain Jaffer
The amount of debt in the commercial real estate sector, particularly in the Class B and C office spaces that are becoming problematic given the low occupancy and higher for longer interest rates, is staggering. While many of these properties may end up foreclosed if these cannot be refinanced satisfactorily, many can still find salvation if these are converted into properties that have demand. Occupancy is low because of Work from Home trends, exacerbated by street crime, homelessness, and drugs in some downtown areas in San Francisco, New York, Los Angeles, and other large US cities.
For companies with deep pockets, even if they decide to terminate their leases, the payments continue until the lease ends. Unless they want to pay additional to break the lease prematurely, especially if they terminate for their own reasons. That still creates big problems if there are no takers after the payments end.
Lay observers who are outside the real estate industry need to know that the banks who make these loans normally have covenants with their borrower real estate developers. I’m sure many of us are familiar with metrics like Loan to Value (LTV) and Debt Service Coverage Ratio (DSCR). The LTV ratio is simply the loan amount divided by the property value. If the LTV is low, the loan has a higher chance of getting approved, versus having an LTV that is at 90% or higher, which means that most of the property value is in debt. With a DSCR metric, if the revenue (e.g. leases/rent income) from a property under loan falls below a certain ratio, the banks step in and ask the borrower to add equity, make up for the missing amounts, refinance, or risk a foreclosure in extreme cases.
On the residential housing end, the sudden spike of high interest rates likewise prevents more people from buying and even selling houses to prevent signing up for higher mortgage rates on a new house. Because they can’t buy the house they want, people end up renting more and longer. Less people are also selling for the same reason, because when they sign up to buy a replacement house on a new mortgage, they end up paying higher rates too. Hence the residential real estate market is almost frozen in many markets.
Putting two and two together, the trend to try to convert some offices to residential units is rising. However, it is not always easy to do that especially for very large offices. Sometimes the best option is to simply demolish the older building (if there are no historical restrictions) to make way for a new building especially for older non ESG compliant Class B and C buildings with no historical landmark restrictions.
Aside from zoning restrictions preventing the conversion of offices to housing, there are also technical considerations. Offices often have large floor areas which would make each residential unit have a large footprint only ideal for rich buyers, since the middle area has no access to the windows and natural lighting. Otherwise if the units are smaller, the building will have a large common area per floor.
In addition, offices often only have two to three toilets (M/F/PWD) with no bathrooms per floor, so each residential unit will require its own kitchen, plumbing, sanitary and HVAC connections.
Enter the hotels. Because of lower tourism and business travel numbers, the occupancy rates for some hotels that are no longer competitive tend to create ideal valuations where they can consider either converting or selling their property to be converted into residential properties.
If their hotel cap rate (the annual revenue from a property relative to its price) is falling below what they need to properly service their loan/debt then the owners (or property buyers) may be open to this.
Not only that. Since some hotels (or motels) already have provisions for kitchen, toilet/bathroom, and individual air conditioning, the conversion cost can be less than building a new residential multifamily property from scratch.
It does not always make sense, but if the cost of converting a hotel is lower than tearing it down and building a new residential property, and the financial ratios and demand show that it makes sense, then it could be a good direction to undertake.