Hotel Lenders and Investors Should Watch Out for Shifting Allocations

After the devastating blow of Covid-19 lockdowns to the commercial real estate industry, the hospitality sector is rebounding. Hotel occupancies came in near pre-pandemic levels in the third quarter of 2022, according to Reis. Seasonally adjusted room rates rose 17.9% and RevPAR hit 26.6% year over year, while income returns hit the highest levels since 2019, according to SitusAMC Insights data. 

Still, the sector continues to face challenges – including labor shortages and rising wages, inflation in other essential costs, and the possibility of recession, which could weigh on future sustained hotel demand. The upshot is that lenders and investors need to keep a close eye on expenses. We spoke with Sandra Adam, Director of SitusAMC Financial Diligence and Forensic Analysis, about some troubling trends she is seeing in expense allocations in the sector that hotel investors and lenders need to know. 

Why should lenders and investors be concerned about expense allocations now? Why is it important to be aware of this risk in your hotel portfolio? 

Post-pandemic, we are seeing cases of management firms pushing expense allocations down to the property level. These costs are typically covered by the management fee itself and are disguised as operational expenses. While it’s not massive fraud, it’s a considerable risk that can add up to hundreds of thousands of dollars in costs that erode the profitability of a hotel portfolio. It’s not something that investors or lenders would typically think of because they are not deep in the weeds of day-to-day, property-level operations. 

What kind of costs are you seeing that are improperly allocated and where do they hide?  

I’m seeing categories such as legal fees, travel costs, meals and entertainment, IT-related contracts and non-operational expenses -- such as fees for consultants hired by the management company -- that are not property-specific. I’ve even seen management payroll misallocated. These costs are often hidden inside general and administrative expenses, miscellaneous items, sales and marketing, etc. 

Why does this happen? 

Sometimes it’s just unsophisticated accounting. In other cases, costs get shifted around for various purposes. An investor or owner may be trying to finance a portion of a portfolio, and costs will be allocated to their hotels outside of the portfolio to make those properties look better to lenders. It could be an ownership situation where the operating partner has complete control of the day to day, and the equity partner may not be receiving the distribution or share of the profits as they anticipated.  

What should lenders and investors do to avoid this risk? 

Before you lend or invest on a portfolio, it’s more important to establish a deeper level of understanding of what “reasonable” expenses your management agreement allows and the acceptable allocation methodology. This is crucial to understanding the true operating profit and ensuring the asset retains its value. 

What can lenders and investors do to verify what’s happening in their portfolios? 

Our Financial Diligence & Forensic Analysis practice provides in-depth, CPA-led financial diligence to proactively identify and mitigate risk in large, complex loans and portfolios. Our team works with participants across the debt and equity spectrum, to conduct comprehensive analysis. We scrutinize financials and identify deeply buried risk factors that could negatively impact loan value and business profitability. 

For more information, please contact Sandra Adam, Director, Financial Diligence & Forensic Analysis, at sandraadam@situsamc.com.