Why Hotel-to-Apartment Conversions Make Sense

Ted Jung of Parkview Financial on this new affordable option for residents.

Ted Jung

Now is the time to take advantage of favorable trends in both sectors.

The widespread conversion of underperforming hotels to apartments provides a creative solution to the U.S. endemic housing shortage and affordability crisis.

The U.S. has been operating in a low-interest environment for over a decade. Low interest rates have allowed for cheap financing and the compression of cap rates. As a result, housing, rentals and land values are at all-time highs despite going through the pandemic. The Fed and monetary policy has been nothing but accommodative during this time to stave off an immediate recession.

By doing so, however, the Fed balance sheet has added $5 trillion through emergency bond purchases and public debt has exceeded $30 trillion. This comes along with the backdrop of 7.5 percent inflation, which the Fed originally expected to be only “transitory” but now concedes is intransigent. The Fed is expected to combat the newly experienced inflation by aggressively raising rates.

While the market will take time to react, we are now at an inflection point, where borrowing costs are expected to rise significantly while property values and cap rates have not softened yet. Traditional buying opportunities are exceedingly difficult to find, but many developers have had success by repurposing hotels into multifamily properties.

During the Covid crisis, the tourism industry experienced a flight to quality. Tired and outdated hotels have been hit hardest by the lack of tourism, and many owners wanted to liquidate their worst-performing assets. This has created an opportunity for developers to quickly convert these projects into multifamily properties.

Unique Opportunity

One complaint against hotel conversions is that the units tend to be smaller than traditional multifamily. This can be a benefit, however, if properly utilized. In response to the affordability crises, government agencies are giving preference to projects with high affordability, on a per-door basis. Because the agencies do not measure affordability by square-foot, but by door, these hotel conversions are tailor-made for Section 8 or other affordability programs.

Hotel conversions should expect to be at the lower end of the rental market because developers can pencil a higher return due to the lower cost of renovating an existing structure compared to the high material and acquisition cost of ground-up construction– not to mention the faster timeline in getting units to market for hotel conversions.

Hotels that are currently operating poorly or that have been closed are finding it difficult to get traditional lenders to finance them. Instead, developers tend to use private debt or bridge loans to acquire and renovate the units. Once there is significant lease-up activity, CMBS and more traditional financing is easily available.

While converting hotels is not a traditional development play, it does provide an opportunity for innovative developers. Many hoteliers are looking to get out of bad transactions, and the market has nearly unlimited demand for quality rentals that fit within a market’s affordability ratios. For the intrepid developer, this is a great opportunity in the market today.

Ted Jung is chief credit officer, Parkview Financial.

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