Knight Frank recently held a United Kingdom hotels roundtable debate, an annual series chaired by CoStar News that reflects on the state of the market with leading figures in the sector.
The debate has been split into two parts with the first focused on how development can be made viable in an inflationary market, alternative uses to hotel conversions, what the main blocks to deal-making are, and how ESG requirements are affecting the market.
The debate, which took place at Knight Frank's London headquarters at 55 Baker Street, was attended by: Shaun Roy, head of hotels, Knight Frank; Karen Callahan, head of hotel valuations and advisory, UK, Knight Frank; Francesca Scott, executive support, hotels, Knight Frank; Paul Norman, Managing Editor, UK and Europe, CoStar News; Cristina Balekjian, director of hospitality research, CoStar; James Dunne, head of operational real estate, Abrdn; Tony O'Brien, Travelodge UK development director; Janice Mitten, business development director; HKS Architects; Anil Khanna, managing director, KE Hotels; Louise Wallace, head of corporate, M&A, specialising in hotels and leisure, CMS and Nick Kalamaras, head of hospitality and leisure, MetroBank.
Paul Norman: The first question is, how is the design of hotels adapting to ensure that inflationary construction costs result in a viable new hotel development? I will come to Janice first as this is right in your lane, I think.
Janice Mitten: Great, thanks Paul. I recently had the opportunity to tour the soon-to-open Park Hyatt in Nine Elms, and to my surprise, their stunning bathrooms were actually prefabricated pods. You’d never have known – they looked as luxurious as you’d expect from a high-end property. When people saw them, the reaction was, “Wow, this is something we could really be doing everywhere”.
So, yes, I believe prefabrication and modular construction can be applied across different areas, not just for bedrooms, but wherever it suits the project. It’s an approach worth considering for high-quality builds.
Louise Wallace: Where are they bringing the pods from?
JM: I can find out for you; I will check with the architect.
Shaun Roy: Yes, a lot of them are made in Poland, right? Lots of, you know, Eastern European countries, as far as I'm aware.
Tony O'Brien: Travelodge has used modular construction bathroom pods for years. We also opened a couple of hotels that were fully fabricated bedroom pods that were shipped over from China.
LW: Well, that's what I thought you were going to say. So that's why it surprised me when it was Eastern Europe.
TO: The Chinese pods were built using shipping container technology and were used to construct hotels that were built in Heathrow and Uxbridge. They could be installed very quickly. You have a room, corridor and room in one pod and they are craned into position, bolted and in place within 10 minutes.
Karen Callahan: It’s like Lego, isn’t it?
TO: It is like Lego. It's amazing. Or like Duplo. But the order time is quite long, and the construction costs were no cheaper, unless you were ordering in scale and volume, which we weren’t. And you've also got the shipping risk, which the developers were reluctant to take. So, they're the only two that we did.
We've looked at other UK modular construction as well, but, in the main, it doesn't really save you a lot of time or money. But if you've got something that's replicable for every new opening, like a bathroom pod, it certainly does.
PN: But do you have other areas that you are using at the moment and turning to in order to improve development viability?
TO: I think construction costs are important, but they're not the most important element of viability challenges at the moment. I think we've got the four horsemen of the apocalypse at the moment. We've got record high build costs. We’ve got – post-COVID– no forward funding to speak of, not just in the hotel sector, but in any sector. And it would be interesting just to get James's view on whether that's improving. Expensive development finance costs and then really soft investment yields. Put all that together and I think traditional development, where a developer requires third-party finance, is really hard to work in any sector at the moment. So, I think even if you hone down your build costs as best as you possibly can, that's not going to achieve viability.
James Dunne: My view on that is that when a hotel is built, it's almost always going to remain a hotel. But I think that's the same for a lot of other uses. I think it's a thing that's thrown at the hotel industry by the investment community as well, if it's a hotel, it can't be anything else. But, ultimately, if it's a supermarket, it doesn't really end up being anything else either. You know, the use classes tend to stay the same. And I think even as a new-build hotel, you don't often see them go to another use. It doesn't really happen very often.
KC: It's very rare that. Even if the value of the property would be higher as an alternative use, the costs of getting there and making the change, it makes it prohibitive.
Anil Khanna: What about the switch from offices to hotels, which seem to be quite common now? They want to reuse existing buildings.
KC: There are definitely opportunities there. There have been a number of notable office sales for conversion to hotel use over the last year or so. However, I think that the number of offices that are suitable for conversion to hotel use is actually much lower than people think, and we do, from our colleagues in the office teams, get quite a steady flow of “well, what can we do with this office that is now obsolete?” And everybody thinks, well, let's make it a hotel. But the ones that truly have the potential is quite small.
SR: It’s high conversion costs. It really only works in high-value areas. So, we've seen a couple of them come done in the City, a few done in central London to Westminster. But Westminster [Council is] getting a little less enthusiastic about conversion to hotels.
AK: It doesn't really work out of London, does it?
TO: I'm going to disagree, actually, because I think there are a lot of office buildings, especially the traditional office buildings of, 60s 70s and 80s construction, which are simple rectangular blocks, with columns that are slightly offset from the centre. Typical brick and concrete construction that you got during that period of time. They convert very readily to branded budget hotels. Probably not, you know, mid-scale and full service, but certainly for the budget sector they do. And I think there's quite a lot of that stock around.
We're doing one at the moment on the High Street in Stratford; 151 rooms. It was an office that they did a full office refurb on three years ago. Couldn't let it. We approached them. It's owned by an office developer. A high-net-worth individual, who’s done a lot of development over the years. A lot of office and residential. We approached him and, initially, he wasn't really that keen. But we cashflowed it and showed him the benefits of Travelodge taking a 30-year lease of the whole office, with no breaks, versus short-term lets of part, and the numbers just made sense. So, in the end, we ended up doing that deal. And I think there's a lot more offices like that. Now, on the build cost, they can be relatively expensive, but also can be a lot cheaper than new build. So, new build at the moment for us is probably £90,000-£95,000 per room, for a full turnkey. Whereas on a conversion, if it converts readily, you probably do it for around £70,000.
SR: Just on my personal feel, it just means that the office owner must have the right base cost of what their offices are. And that we're not in that market.
NK: Just on the alternative use of the hotels, because I actually head up the healthcare team at Metro Bank. We've actually seen quite a few care home operators target the hotel sector, and we've seen a number of conversions that have taken place in the regions, so that they see actively as an opportunity, less cost than to come from ground up.
AK: Probably converts easier, doesn’t it?
SR: Yes, as I said, we've done one other conversion in January or February. We sold a hotel site for a data centre conversion.
LW: Data centre?
SR: Yes, it was an operational hotel.
TO: And did they knock it down?
SR: They will be, yeah. It just happens to have the sweet spot of connectivity. Not on a flat plane. It's an unusual case, but it wasn't going to be a hotel. It was either going to be logistics or it was going to be something else.
PN: That's a great story. I thought everything could become a distribution hub or a life sciences development?
KC: I think it also depends on room sizes and how you configure them. If you look at some of the conversions of offices to hotels that the Zedwell brand has achieved, the use of windowless rooms has enabled them to efficiently utilise the floor plates. You can also drive this efficiency in the hostel market, with large dorm rooms enabling you to go deeper into the building before the lack of windows starts to become an issue in that depth of floor plan.
JM: There’s also a new brand, which some of you may have seen during the [International Hospitality Investment Forum]? The MM:NT Berlin lab was a kind of mini-hotel laboratory which allowed guests to stay for free in six converted hotel rooms in exchange for feedback on the prototype. Some of their rooms were windowless but totally didn’t feel that way; they felt light and airy and would be a great choice for converted buildings with deep floor plates.
SR: I have to say I’ve sold lots of hotels with windowless rooms, done show-rounds and people get there and say “cool, can we see some of the windowless rooms?”. And you're like, “you've actually had a look around them”. They just don't know. I don’t think it’s an issue, I have to say. In the right locations, it's just not an issue.
TO: I think, from the sustainability perspective, just reusing existing buildings has got to be the right thing, doesn’t it?
PN: And then just to ask some of the other hotel developer investors this question around design. I mean, are there other areas here where you're looking at the design of hotels, changes to improve the construction cost of it?
AK: I think what we're seeing on the fit-out side is being smart with how you reuse existing furniture and try and reuse things more than we historically have. You know, before you would go in and redo an entire room, whereas now you try to pick and choose elements to focus on. And we tend to work with the brands to end up with a new-looking room. But not everything is brand new, which we've never done before.
LW: And they’re being flexible?
AK: There’s more flexibility. It depends on the condition of the goods. But the price of case goods [furniture that provides storage such as wardrobes and cabinets] has gone up so much, you have to be a bit more flexible with what's done.
LW: Because the contractual terms you'll see in the agreements are really quite fixed as to when you're meant to replace them, particularly on a franchise. There are more waivers, I believe.
AK: I think there's a bit more common sense coming through from the brands because they know that, especially since COVID, that a lot of hotels struggled to cover their costs and need time to rebuild their base. And I think simplifying design has been a constant thing that we're looking at. We're doing a project in Oxford at the moment and going through the design stages of it to work with the contractor to really try and keep costs as tight as possible. But it is a big problem.
NK: Well, you're seeing that flexibility with the big brands, aren't you?
AK: Well, they’re all launching these sub-brands, aren’t they, to cater for flexibility.
LW: It's not the same very strict standards, eg, bedspreads, and it needs to be changed all the time.
JM: And actually, to add to an earlier comment about reuse, for example, many interior design schedules now include an additional column specifically for cradle-to-cradle considerations. For each piece of furniture or material, we evaluate what can be done with it at the end of its useful life – whether it can be reused, recycled, or safely returned to the environment.
TO: So, on a related subject – but I’m not really sure what the answer is – we're developing in Spain as well as the UK. And the construction costs in Spain are considerably cheaper than in the UK. Now, why that is, I don't know. That's an interesting thing for you guys to investigate.
NK: To be fair, they've got quite a bit of manufacturing or a lot of it's done onshore rather than importing a lot of the products in. I'm not too sure to what extent that might play a part.
JD: But is it design standards as well? I mean, you know, with all the ESG credentials that we have to have in the UK, is that similar or not?
TO: Again, I don’t know.
SR: You’ve raised an issue.
PN: If someone can advise you they’re on to a good one on that aren’t they.
TO: I deal with the UK rather than Spain, but it's a really noticeable difference for the first time. It's probably more viable to develop in Spain at the moment than the UK.
PN: And is the UK specifically really expensive anyway compared with all other countries? Does it stand out?
JD: I think you have to remember that you’re starting on a small island, aren't you? So, your land costs are going to be higher. I don't know if you see that prices really readjust. Whether it be existing buildings like offices, or just bare brownfield or greenfield land, it's just still too expensive.
NK: To what extent are we seeing…or are we seeing any involvement of local authorities with developments? Has anyone seen that?
AK: There’s quite a few around the country, I know Hilton have done quite a few projects where the council have got involved. I know there’s a Moxy in Slough where the council got involved. They’re all getting into trouble, these councils.
JD: It’s involvement in different ways, isn’t it. In Slough they got directly involved. Where local authorities should be getting involved is in providing the land for development, improving planning or considering grants. I think a lot of councils and other bodies like the combined authorities are being more proactive. Using their covenant to provide security as an example as I know you have done, Tony, a few times.
SR: A lot on the residential side.
JD: A lot on the residential side. But I think there’s a bit more of an awareness that a hotel can actually drive regeneration in an area as well. It can be the start of it, the start is you need somewhere for people to stay, although I think there’s probably too much of an aspiration to have quite a high level of service in those hotels though.
PN: Taking a hotel deal from an offer being accepted to a deal closing has become a lengthy process. What are the main obstacles and what initiatives can vendors employ to ensure deals make it over the line with minimal delays?
SR: Easy answer. Definitely the answer to this is fire regulations.
TO: I thought you were going to say employ a good agent.
SR: Totally understandable, obviously it's all in the press at the moment, the Grenfell Inquiry, etc, that has highlighted a lot of the issues. But vendors need to be prepared. If they want to sell the building, this has to be workstream number one, not, “oh I think it's fine, I'm sure we'll come up with the answers in due course”. It's not a matter-of-fact in degree, it is very binary, you either have the information or you don't.
If you want to sell it to anyone that is an institution or is going to debt finance, which is what, 95% of the market, you need these answers. And they might not be the best answers, but you need facts. That's all people want. If you've got the information, they can then come up with a plan or take a view or have an improvement plan or whatever it is, but if you don't have any facts, you will not be able to sell your property, full stop. Fair comment?
JD: Yeah. It's probably one of the first questions we ask now. When we have something introduced or we're looking at an opportunity, “yes that's the right location, yes it's the right kind of lot size, the right hotel, but what can you tell me about the [due diligence] they've done on the health and safety and fire safety side?” Because if you don't have that information, you're just going down a rabbit hole.
SR: And it's not transactable.
AK: What sort of things are you looking for when you're looking at the site?
JD: Well, it's the information that can give you the confidence that that hotel is safe, and safe going forwards.
AK: It's quite tricky though, with some of these older buildings that have been converted to a hotel, to prove a wall's thickness and fire safety, it’s really difficult.
SR: And that’s the problem.
AK: So, you're ending up having to do lots of work.
SR: Yep.
JD: But you either have to do that work before you try and sell it or you end up having to do more work afterwards. Because if as an investor, as a buyer, if I'm presented with a package which says we've been through all of this and this is what we know, this is what we don't know, this is what we can bring, this is what we can't bring, you've got a really good starting point.
If we're going into a transaction and we know nothing, all of a sudden you're just peeling layer after layer after layer of the onion and getting into more and more detail. And it takes longer, it's more expensive and it'll probably lead to the transaction not happening. So, the more information and DD you can give upfront, the better.
SR: I've done deals where we're halfway through it, “can you prove that the insulation or the fire breaks have been installed?” “Of course they have, here's the as-built plans.” “Well, can you prove it?” “Well, I can't prove it but here's the as-built plans.” Go in there, do some drilling, actually it turns out that it's not. So, all you need is evidence of what you're saying. So, if you can prove that there are fire barriers installed and here you go, here's pictorial evidence, here's photographic evidence that this has been done, that's all you need.
TO: Because sadly as a property industry, we've been very poor.
JD: Terrible.
TO: And we're all part of the industry and it's happened for many, many years and shortcuts have been taken across the board.
AK: Some of it is contractors though. As you've mentioned there, you've done the drawings and the contractor hasn't done it, no one's checked it through the process of it being there.
SR: But you know what, the vast majority of time the information is there but it's hidden under layers and layers and layers and layers, not deliberately, just because when it was built it was not an important thing. Do you have photographic evidence of the fire barriers being installed? That just wasn't an interesting question five, seven years ago. So no one ever thought “oh I'm going to make sure I save that in my files because I'll need that when I want to sell the building”. Now that is absolutely almost the most important thing, you ask your contractor and the contractor asks the [sub-contractors].
AK: Of course, that’s the problem.
LW: You ask for it right at the start, even the lawyers you're seeing, we're the last people that normally ask the technical questions. It's the first question, what's the cladding issues on that, have you checked it?
PN: On a related question then, how are ESG credentials impacting investor decisions, is that right at the start, is there any evidence of it touching yield premiums? We'll maybe go to James on that first.
JD: Yeah I mean it's right up there in terms of when we're assessing opportunities, we make long-term plans to look at the future viability from an ESG point of view of those assets, so it's not just “is it ticking boxes today”, it is as much “is it going to tick the boxes in 10 years time?” Does that translate into a yield premium?
I don't think you can sit here and say building A and building B, that one's 25 basis points better than that one, but it absolutely filters through into your liquidity and into pushing that price into where it will be and if building A is okay from the ESG point of view and building B is excellent, then we're all going to gravitate towards B and B is going to sell and B is going to probably command that stronger pricing.
So is it quantifiable to say 25-50 basis points? No. Is it quantifiable in terms of liquidity and stronger pricing and demand? Absolutely. And it will only continue.
SR: Do you think that means that, going back to Tony's point about fundings, do you think that will mean that fundings will become more attractive? A, because you know exactly what's going into your building and also you can dictate that it is ESG excellent, not “we could have a performance improvement plan?”
JD: Yeah absolutely and I think coming back to your earlier question, you will see the funding market come back for those sort of reasons. You know you're going to have a safe building, you know exactly what's going into it because people are taking those photos and keeping them safe. You will have a future-proof building in terms of ESG and I think we've got a better understanding of what that means, as well, in terms of what accreditations need to be there, what levels need to be met as well.
So, yeah, I think it's a really important thing. And I think, hopefully we're also coming to… or we're either at or at the bottom of where we are in terms of the market and that was always a concern in funding.
If you're funding in a declining market, where is your value going to end up in two years', three years’ time when the development completes? Particularly when a number of things were funded three, four years ago, and you are now paying over the development profit cheques when it's going into the valuation books at 50, 100 basis points less than you funded it and that's quite a nasty thing to have to do, so people are burnt from that. But I do think that funding market will come back during the course of next year.
SR: There we go Tony, funding premium is coming back, that’s what I heard.
This roundtable has been edited for clarity and length.
The second part of the roundtable is here.