A potentially overlooked 1031 option: The hotel industry

As someone people come to for help with exchanges, boy is it getting difficult to find solutions that investors are happy with. After years of being able to find good multi-family or credit tenants in the 6-7%+ range, when you are now looking closer to 5, a lot of people lose interest. But, of course everyone wants to sell at these prices and still differ the taxes... In my searching for properties to satisfy the exchanges of my clients, I have come across an area that I personally hadn't spent much time focusing on. It is a sector that with the right management, you can potentially see cash flow of over 10% with additional upside, without cap rate compression or top line growth. If it sounds too good to be true, the catch is having the right operator. If you don't have the right partner in this area, it can be a quick turn in the wrong direction. However, with the right one, it has the potential for some great upside. The sector I'm speaking about is the hotel industry. Now that being said, with the cap rate compression we are seeing, more attention is turning to this sector. This is where you want to be very careful. The first thing to look at with these deals is what the proformas are based on. Anyone can show economic growth with an increase in top line, but if it goes the other way, look out below! What you need to look for is an operator that can increase the bottom line through cost cutting. When you buy a hotel, it is much more than a piece of commercial real estate, it is an operating business. This can either be a very good or very bad thing for how your investment turns out. If you are strictly a real estate operator, no matter how good you are at what you do, hotels are a whole different ball game. This is what has led to a lot of horror stories in the space. If your strategy is having a better crystal ball that tells you people will spend more so you can charge more, this seemingly high potential investment can easily turn into a nightmare. However, if you have serious seasoned hotel experience on your side, it can turn out a whole lot differently. With most property types, there isn't a lot of room for cost cutting, but when you have an operating business, there is plenty of room if you know what you're doing. A recent example is a 188-room Hilton Garden Inn identified by a seasoned hotel professional. Immediately they noted that the current rooms cost was 20% too high for this property. They were able to implement a strategy to reduce labor cost on low occupancy nights, which dropped the cost to 14%. This hotel's gross room revenue was $6 million and they picked up a 6% cost savings, day one. That added $360,000 to the bottom line and increased the value of the hotel by $3 million. The net cash flow also increased by 10% through this cost reduction. All of this of course, without an increase in market revenue. This is just one example of what an experienced management team can do. It is often small changes that are overlooked by an amateur hotel operator. However, if they can identify a hotel with a handful of little inefficiencies, they can add up to a substantial increase to the bottom line as well as cash flow. If you're considering the sale of a piece of property but don't know what you would exchange into if you get an accepted offer, this might be a sector to look into. However, if you do, make sure you find the right partner that knows the business well. Remember, it is a double edged sword, the experienced management teams implement cost savings that exist due to lack of experience of the prior owner. If you find the wrong partner, when you throw your hands up and sell, the experienced team that goes in and implements these changes will be buying from you. If you find the right team, you'll be the one buying from the frustrated previous owner. The most important thing to remember, if you decide to look to this area, is to make sure you do serious due diligence on the partner you are about to work with. They will make the difference in whether this is a horrible decision or a great one. Michael Packman is chief executive officer at PNI Capital Partners, Syosset, NY. Securities and investment advisory services offered through Financial West Group, member FINRA/SIPC. Financial West Group and PNI Capital Partners are unaffiliated entities.