Your SlideShare is downloading. ×
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20101
Capital Expenditure...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20102
Capital Expenditure...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20103
I would like to ack...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20104
This pilot study fo...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20105
1 INTRODUCTION 7
1....
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20106
TABLES:
Table 1 – M...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20107
1 INTRODUCTION
1.1 ...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20108
outlets. According ...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20109
interests of both o...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201010
interests of owner...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201011
1.2 Significance
A...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201012
1.3 The Purpose an...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201013
2 LITERATURE REVIE...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201014
2.1 Characteristic...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201015
temperature, resta...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201016
environment. Hassa...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201017
inefficiencies res...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201018
2.2 Research on Ca...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201019
found that almost ...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201020
2.3 Definition and...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201021
These empirical fi...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201022
In addition to the...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201023
Recognition Rule o...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201024
the definition of ...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201025
walls will enable ...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201026
2.4 Characteristic...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201027
The pictures below...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201028
Table 2 ‐ Composit...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201029
Figure 2 below ill...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201030
The results from I...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201031
 
Source: Phillips...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201032
revenue generating...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201033
It was already dis...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201034
Higley (2005) prov...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201035
Phillips (2003) lo...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201036
However, according...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201037
2.5 Provisions for...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201038
 
Based on a stead...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201039
Table 4 – Useful L...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201040
equipment so as to...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201041
The “ramp up” appr...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201042
roofs, elevators, ...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201043
need to replace/re...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201044
Table 5 ‐ USRC Hot...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201045
replacement reserv...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201046
2.6 Why Are CapEx ...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201047
2.7 CapEx planning...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201048
To be relevant, lo...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201049
The benefits of li...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201050
parties on general...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201051
Beals & Denton (20...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201052
accountant and def...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201053
• the past experie...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201054
It is clear that t...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201055
2.9 Role of Asset ...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201056
- The increasing v...
The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/201057
to negotiation whe...
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Cap Ex2005 Australia
Upcoming SlideShare
Loading in...5
×

Cap Ex2005 Australia

12,322

Published on

A pilot study focused on the issues relating to capital expenditure (CapEx) in the Australian hospitality industry.

Published in: Business, Travel
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total Views
12,322
On Slideshare
0
From Embeds
0
Number of Embeds
1
Actions
Shares
0
Downloads
38
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Transcript of "Cap Ex2005 Australia"

  1. 1. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20101 Capital Expenditures   In the Australian Hotel Industry    A Pilot Study      By Borivoj Vokrinek  Autumn 2005    Tourism and Hospitality Project  Bachelor of Business in Hotel Management  The Hotel School   School of Tourism and Hospitality Management      Southern Cross University Date: 10 November 2005
  2. 2. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20102 Capital Expenditures   In the Australian Hotel Industry    A Pilot Study      By Borivoj Vokrinek  Autumn 2005    Tourism and Hospitality Project  Bachelor of Business in Hotel Management  The Hotel School   School of Tourism and Hospitality Management      Southern Cross University ACKNOWLEDGEMENT
  3. 3. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20103 I would like to acknowledge all participants in this study and commend them on their willingness to share their knowledge and experience in this study. A special note of thanks goes to Rutger Smits, ISHC, MIMC; from HVS International – Sydney, for his encouragement and advice. Thanks to him I started this research and had a great opportunity to discuss the CapEx issues with the highly knowledgeable and experienced stakeholders involved in the Australian hotel industry. Also, thank you to all the staff at Sydney office for your support and understanding. I also want to thank Paul Weeks, GradDipEd, MEd-Trg & Dev; from The Hotel School Intercontinental, for enabling me to do this project and support along the way. Thank you. The Author Borivoj Vokrinek ABSTRACT
  4. 4. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20104 This pilot study focuses on the issues relating to Capital Expenditures (CapEx) in the Australian hospitality industry. High attention is paid to the thorough review of the relevant literature with the aim of developing a solid knowledge base for better understanding of the issues and further research. By utilizing in-dept interviews with a variety of stakeholders, an attempt is made to identify and explore problematic and/or important topics in an Australian context. The study finds that the subject of CapEx is a considerable and topical issue for the Australian hotel sector industry which would be beneficial to research further. The CapEx are a complex matter but it seems that major issues are related to the understanding of true CapEx needs and problems with achieving required returns on CapEx. No claims are made for the generalisability of findings, rather it is the intention to raise the discussion and encourage further research. TABLE OF CONTENTS
  5. 5. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20105 1 INTRODUCTION 7 1.1 BACKGROUND 7 1.2 SIGNIFICANCE 11 1.3 THE PURPOSE AND OBJECTIVES 12 2 LITERATURE REVIEW 13 2.1 CHARACTERISTICS OF HOSPITALITY INDUSTRY AND IMPORTANCE PHYSICAL ASSETS 14 2.2 RESEARCH ON CAPEX 18 2.3 DEFINITION AND UNDERSTANDING OF CAPEX 20 2.4 CHARACTERISTICS AND FACTORS INFLUENCING CAPEX 26 2.5 PROVISIONS FOR CAPEX 37 2.6 WHY ARE CAPEX UNDERESTIMATED? 46 2.7 CAPEX PLANNING 47 2.8 EXPECTED LIFE OF THE ASSETS 51 2.9 ROLE OF ASSET MANAGER 55 2.10 OWNER/OPERATOR RELATIONSHIP AND MANAGEMENT AGREEMENTS 57 2.11 NEW TRENDS IN HOTEL OWNERSHIP AND DEVELOPMENT 62 3 RESEARCH DESIGN AND METHODS 65 4 INTERVIEW FINDINGS AND DISCUSSION 71 4.1 MAIN ISSUES IN REGARDS TO CAPEX 72 4.2 FACTORS SHAPING CAPEX 84 4.3 REPLACEMENT RESERVES AND CAPEX 92 4.4 CAPEX PLANNING 97 5 CONCLUSION AND FURTHER RESEARCH 99 6 REFERENCES 102 7 APPENDICES 110 APPENDIX 1 - THE EXECUTIVE SUMMARY OF CAPEX 2000 111 APPENDIX 2 - PWC SURVEY: RESERVE FOR REPLACEMENT OF FIXED ASSETS 117 APPENDIX 3 - EXAMPLES OF CAPEX BUDGET TABLES 118 APPENDIX 4 – DEFINITION OF RESERVES AND FF&E 120 APPENDIX 5 - ‘ABOUT THE AUTHOR’ AND ‘HVS INTERNATIONAL, SYDNEY’ 126 APPENDIX 6 – THE INTERVIEW PLAN WITH BROAD TOPICS 129 LIST OF TABLES & FIGURES
  6. 6. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20106 TABLES: Table 1 – Major Expenditure Threshold to Warrant a Formalized Cost/Benefit Study 19 Table 2 - Composition of CapEx in % 28 Table 3 - Conditions influencing capital expenditures: 36 Table 4 – Useful Lives of FF&E components 39 Table 5 - USRC Hotel Investment Survey, Reserve for Replacement (US Investors) 44 Table 6 - Suggested Useful Economic Lives of Categories Tangible Fixed Assets 52 Table 7 - Effective Life of Depreciating Assets in the Accommodation Sector 53 Table 8 – Interests of Hotel Owners and Operators 58 Table 9 – List of Categories of Interviewed Stakeholders (in chronological order) 68 Table 10 – Job Titles, Associations/Membership and Expertise of Interviewees (in alphabetical order) 69 Table 11 – CapEx Categories used by interviewees 74 Table 12 – CapEx as percentage of revenues; individual averages over 10 year (6 properties, Australia) 85 Table 13 – Summary of Factors influencing CapEx spending based on the literature review 85 Table 14 – Factors shaping CapEx spending as identified by the interviewees 87 Table 15 – Performance of Hotels in Major City Markets, YTD May 2004/2005 90 Table 16 – Summary of provisions for CapEx as used by the respondents 97 FIGURES: Figure 1 - Average CapEx by Year as a Ration to Total Revenue 27 Figure 2 - CapEx Spend over Time, as a % of Total Revenue 29 Figure 3 - Maintenance and Development CapEx – Disparity among hotels 31 Figure 4 - Accor: Manage Free Cash Flow by Reducing Renovation CapEx 35 Figure 5 - Cumulative Surplus or (deficit) of Capital Reserve vs. Actual Spending 38 Figure 6 - FF&E Reserve as a %age of Gross Revenue – Asia Pacific 40 Figure 7 - Combined CapEx spending as a % of gross revenues; 6 hotels over 10 years (Australia) 77 Figure 8 - Graph of CapEx as % of total revenues, 6 properties over 10 years Australia 84 Figure 9 - Accommodation, Cafes and Restaurants; CapEx Actual Expenditure in Current Prices 1996 – 2005 ($ Millions) 86 Figure 10 - Comparison of Hotel Revenues at International Markets; RevPAR 2004/2005 89
  7. 7. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20107 1 INTRODUCTION 1.1 Background During the life of operations, almost any business must realise capital expenditures (CapEx) to maintain competitiveness. This is especially true for the hospitality industry where the capital expenditures have a significant impact not only on the hotel competitiveness but also on the real-estate value of the property. The following paragraphs provide a brief introduction to the issues of capital expenditures in the hospitality industry. According to the Appraisal Institute (Dictionary of Real Estate Appraisal, Third Edition) “Capital expenditure is defined as the investment of cash or the creation of liability to acquire or improve an asset, e.g. land, building, building additions, site improvements, machinery, and equipment; as distinguished from cash outflows for expense items that are normally considered part of the current period’s operation” (Mellen, Nylen & Pastorino, 2000). McGuigan and Kretlov (2003, p.272) highlight the long-term, positive impact of capital expenditures on a business and define them as “a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year”. Unfortunately, decisions regarding CapEx are very complex due to their high dollar values and cyclical, ambiguous and irreversible nature. For example, the study CapEx2000 found that a full-service hotel in the US spends on average 6.1% of total revenues on capital expenditures and that the major targets of those expenditures are ‘Rooms & Corridors’ followed by the ‘Food & Beverage’ Definition Characteristics of CapEx
  8. 8. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20108 outlets. According to Denton (1998), capital expenditures vary significantly from year to year but in general, the expenditures are low during the early years of the hotel life cycle with the first increase after 4-5 years for soft refurbishments. However, the most significant CapEx requirements that hotels usually face is after 7-12 years (of operations) when the general refurbishment of the property must be realised (Denton, 1998). Despite this predictable pattern, Beals & Denton (2004) warn that additional unexpected expenses, such as break downs of equipment, may frequently occur. Furthermore, Moyer, McGuingan & Kretlow (2003) highlight the irreversible nature of CapEx. For example, once an hotelier decides to transform a banquet area into a ‘Health & Spa’ centre with swimming pool, it is very costly and difficult to return it to its former state. Hence, it is clear that effective management of CapEx is necessary to cope with this complexity and to ensure that sufficient funds are available to maintain competitiveness of a hotel while utilising the owner’s capital in the most optimal way. The most common provisions for CapEx are the reserves for replacement and the practice of plans/budgets for CapEx. Many organisations employ an asset manager/consultant whose key responsibility is CapEx management. In general, reserves serve to accumulate funds for future capital expenditures, usually put aside as a percentage of total revenue (Beals & Denton, 2004). According to the ‘Global Hotel Management Agreement Trends’ study (Haast, Dickson, Braham, 2005) almost every hotel management contract specifies an FF&E Reserve (reserve for replacement of fixtures, furniture and equipment) having the fee set as a percentage of revenues. However, Denton (1998) argues that a reserve as a percentage of revenues might lead to an inefficient use of the capital and unnecessary spending, and therefore he recommends to ground reserves on expenditure schedules, plans and budgets. Such activities are usually the responsibilities of an asset manager. The role of the Asset Manager is especially important in the situation where the management and the ownership of a hotel are separated (Beals & Denton, 2004). In these cases, asset managers must balance Provisions for CapEx
  9. 9. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/20109 interests of both owners and operators; however the primary responsibility is to the owner (Beals & Denton, 2004). According to Denton (1998), there is a growing trend towards a management and ownership separation in the hospitality industry with investors who are less knowledgeable about the specifics of hotels’ operations. This is especially true for investors who are institutionalised or fragmented (Denton, 1998). For example, there are a growing number of strata management hotels and resorts in Australia where each unit is owned by an individual investor (in NIF study, No Author, 2003). These investors are often ‘mums & dads’ who do not have any experience with a hotel’s operation. However, also institutionalised investors lack understanding (Anon., 2003). According to the NIF study, the hotel investment is frequently just small part of large investment portfolio in funds that are not particularly focused on the hospitality sector, such as superannuation funds (No Author, 2003). Thus, the ultimate owner is very distant from the day-to-day operations. However, the separation and remoteness of the owners from the operations combined with lack of understanding might raise problems with CapEx. Many authors argue that there is a clash of interests between owners and operators in regard to CapEx. According to Higley (2005), operators may tend to spend on capital expenditures more than is necessary because CapEx are fully paid from the owners’ funds. Highley (2005) argues, that due to a management fee structure which is predominantly based on revenues and operating profit, operators have no incentives to be responsible with spending on CapEx. On the other hand, the investors/owners’ interest is to maximise return on investments, hence they may prefer to invest funds into other projects with higher returns. Especially those owners who have short-term investment horizons might be reluctant to provide funds for CapEx. For example, some investors interviewed in the NIF study suggest that “the ultimate investment term for hotels should be 3-5 years so that investor avoids making any capital expenditure” (No Author, 2003, p.54). Beals & Denton (2004) inform that operators may be frustrated since some owners fail to provide funding for necessary renovations. Hence, the different Issues with CapEx
  10. 10. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201010 interests of owners and operators make management of CapEx difficult and may lead to frustration on both sides; the owners might feel that the operators do not manage property in their best interests and the operators might be frustrated due to the lack of resources and the low standard of the property. This problem is accelerated by the vague definitions of the CapEx. It is surprising that despite the significance of CapEx, there is a lack of uniform standards for defining what is and is not a capital expenditure (Beals & Denton, 2004). This creates room for further disagreements between owners and operators/managers. According to Denton (1998) operators tend to capitalise expenditures as much as possible since this way it does not reduce their fees that are usually based on operating profits and revenues. On the other hand, owners prefer to recognise expenditures as a ‘revenue expense’ since it reduces the tax obligation and fees paid to the operators. Hence, it is not surprising that CapEx are subject to many discussions and studies. However, the majority of the literature is from the USA and there is a little that can be found in Australia. It is the intend of this study, to establish an initial platform for further research of CapEx in the Australian hotel market.
  11. 11. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201011 1.2 Significance Australia is competing with other countries on the international tourism market and Australian hotels must be in good condition to satisfy the high requirements of international and domestic travellers. Furthermore, investments in the Australian hospitality industry are necessary to maintain long-term competitiveness and stimulate further development. It is clear that the issues involved with CapEx influence both, number of investments into the industry and the satisfaction of the hotel guests. The Australian accommodation industry generated more than 8.2 billion of total revenues in 2001 (ABS, 2002). This combined with the already discussed finding of the US study ‘CapEx2000’ that a full-service hotel in USA spends in average 6.1% of total revenues on capital expenditures, allows to calculate that the broad dollar value of the CapEx issue in Australia is approximately half a billion dollars a year. Even though this is a very rough and simplified estimate, it helps to realise the significance of the subject for the Australian hotel sector. Hence, it is clear that it is important to strive for a good understanding of the CapEx and that a study exploring this issue in an Australian context might be valuable for all stakeholders; investors, owners, lenders, operators, customers and consequently, for the whole society.
  12. 12. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201012 1.3 The Purpose and Objectives Using a pilot study sample, this study analyse provisions for Capital Expenditures in the Australian hotel industry. The objectives of this research are:  To explore current practices and problems related to the provisions for Capital Expenditures in Australia  To examine views of the different stakeholders – owners, operators and asset managers o Is there any disagreement among the stakeholders regarding CapEx? o Are the provisions for CapEx able to ensure that sufficient funds are available to maintain hotels’ standards and competitiveness? o Is the owner’s capital used in the most optimal way?  To increase knowledge regarding the Capital Expenditures in the Australian hospitality industry and establish a base for further quantitative research Purpose Objectives
  13. 13. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201013 2 LITERATURE REVIEW The literature review section is a critical part of this pilot study. There are two reasons; First, it is necessary to analyse related literature to get sufficient knowledge about possible issues, hence to ensure the quality of the primary data collection; the interviews. In other words, the review of current literature revolving around the CapEx helped to raise appropriate questions as well as it enhanced understanding of participants answers during the interviews. Second, the body of the literature review partially fulfils the purpose of this pilot study; to explore current practices and problems related to CapEx, to examine the view of stakeholders and to establish a base for further research. The review starts with the nature of hospitality industry and the importance of physical assets for this type of business. Then the paper focuses on CapEx, its characteristics, definitions and on suggested provisions for management of these expenditures, such as ‘Replacement Reserve”. Finally, the literature evolving around owner/operator relationship and CapEx is examined including a brief introduction to new trends in the ownership structure, such as strata titled hotels.
  14. 14. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201014 2.1 Characteristics of Hospitality Industry and importance physical assets There are no doubts that the hospitality industry is a service industry. However, it seems that the majority of the literature emphasises ‘intangible’, human part of the service (for example: Ingram, 1995; Brotherton, 1999; Skapinker (2003), Hartline, Woolridge & Jones, 2003). Hence it needs to be reminded that the overall service delivery is dependant not only on soft assets such as people but also on hard physical assets (No Author, 2005). In effect, according to the World Travel and Tourism Organization (WTTO) all tourism industries depend on physical assets such as buildings and infrastructure (WTTO, 1999). This is particularly true for the hospitality industry. Losekoot, Wezel & Wood (2001) point out the uniqueness of hotel industry given by its capital intensive nature and strong interface between facility management and provision of commercial hospitality. According to the authors, the satisfaction of customers is strongly affected by physical features of a hotel facility. Losekoot et al (2001) argue that in terms of customer’s satisfaction, hotel managers underemphasize the importance of “hard’ facility related factors (i.e. condition of physical assets) in favour to almost exclusive focus on “soft” interpersonal factors such as personal service (2001). The authors agree that customer service is an essential element of hospitality; however, they argue that “no amount of front-line worker concern for the welfare and experience of the customer can compensate for flawed product” (Losekoot et al, 2001:298). Losekoot et al (2001) conducted a research that provides evidence about growing guests’ emphasis on the quality of the product rather than the quality of service. The research analysed customer complaints in two hotels and found that every third or fourth guest complaint is related to facility factors such as room Physical Assets and Customer Satisfaction
  15. 15. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201015 temperature, restaurant capacity, room amenities, décor and carpets. Similarly, according to LRA Worldwide (a global provider of specialized brand assurance, brand performance and quality assurance consulting services), the physical attributes are important factors influencing customer satisfaction in hotels. For example, the LRA Satisfaction Survey highlights that “satisfaction with the guestroom is, by far, the most important element in determining a guest’s overall satisfaction with a particular hotel or hotel brand” (LRA Worldwide, 1999:3). This is confirmed by Hassanien & Baum (2002) who note that a study conducted by Dube et al (2000) found physical aspects and room design to be the third and fourth determinants in the customers’ purchase decisions, after hotels location and brand name but, interestingly, before service attributes. Libert & Cline (1996) believe that hospitality enterprises require two types of infrastructure to do business and fully meet customer needs - real estate and technology. According to Johnstone & Duni (in Pagliari, 1995), hotels differ from other real estate. In contrast to other property types, hotels combine the real estate leasing component with other business activities such as running restaurants, equipment rentals and business services (Johnstone & Duni in Pagliari, 1995). Thus, hotels are true operating businesses. This consequently increases requirements on capital. For example, Johnstone & Duni in Pagliari (1995:490) emphasize that; “The excessive wear and tear on hotel real estate due to the public nature of the facilities requires annual expenditures for property renovation and improvements that other real estate types do not require”. Ransley & Ingram (2000) also stress that hospitality properties are capital-intensive assets, and argue that those high- value assets require concentrated management in order to generate adequate returns on the capital employed (Ransley & Ingram, 2000). Hassanien & Baum (2002) point out that hospitality industry is characterized by a “dogmatic need for repositioning”. The authors believe that the repositioning is inevitable within the life of any hotel due to continuous changes in the Need for renovation Hotels as a capital intensive Real Estate
  16. 16. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201016 environment. Hassanien & Baum (2002) inform that repositioning is usually a costly process and almost always inseparable from renovation of physical assets. Interestingly, Hassanien & Baum understand renovation as “the process of retaining or improving the hotel image by modifying the tangible product, due to a variety of reasons, through any changes in the hotel layout (e.g. property structure-new extension) and/or any addition or replacement of materials and Furniture, Fixtures & Equipment” (2002:148). Thus, according to the authors, renovation includes not only repair and replacement activities within the existing building but also new product developments such as room extensions or building of new conference facilities attached to the hotel. This basically covers all possible areas that require CapEx. Also McDaniel (2003) emphasises that hotels are capital intensive businesses due to inevitable replacement cycle. The author points out the conflict between brand standards and financial return objectives given by the growing brand standard requirements that are pushed by the competitive pressures created by oversupply and diminished demand (McDaniel, 2003). Ransley & Ingram (2000) refer to the integrated nature of hospitality products. According to authors, hospitality industry is similar to car industry which is facing ultimate conflict between design and production costs. Similarly, in the hospitality industry “there are properties that are difficult to manage or operate, but sumptuous in style“(Ransley & Ingram, 2000:239). Thus, Ransley & Ingram highlight that specialist and stakeholders involved in development and management of hospitality products need to understand its integrated nature. In other words, all major actors have to learn how to work “in unison and with mutual understanding of their individual disciplines/roles” otherwise there will be inefficiencies in capital development expenditures and consequently lower operational profitability of the facilities in hospitality industry (Ransley & Ingram, 2000:239). In addition, Ransley & Ingram believe that these working Integrated Nature of hospitality products
  17. 17. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201017 inefficiencies restrain innovation and the ability of industry to react to the changing needs of markets within national and international contexts. Consequently, as Ransley & Ingram (2000) argue, this situation causes lower attractiveness of the industry for institutional investment and, is not consistent with environment that would create opportunities for future growth. According to Ransley & Ingram (2000), there are three main trends in hospitality industry that are related to physical assets. These are:  Traditional ‘owner = operator’ framework is superseded by a structure in which the ownership of the asset is vested in one entity and while the day-to- day management of the hospitality business is carried out by a third party  The hospitality properties are becoming larger and more complex structures requiring greater amounts of capital and being much more substantial businesses requiring integration of property operations.  Increasing emphasis on financial aspects of hospitality operations. Entry of large financial institutions into hospitality ownership partially initiated shift of focus to financial returns away from traditional hospitality as the measure of success Hospitality trends and physical assets
  18. 18. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201018 2.2 Research on CapEx According to Berg & Skinner (1995) CapEx is vital for organizations in hospitality industry. The authors remind that failure to adequately plan for CapEx was one of the major reasons for many bankruptcies and operating losses the hotel industry experienced in the early 1990s in USA. Perhaps this is the reason why most of the research regarding CapEx has been conducted in the USA. Although the majority of this research has been focusing on CapEx appraisal techniques there is also a limited number of studies that has been focusing on definition/understanding of CapEx or actual CapEx spending. There are numerous studies focusing on capital budgeting in hospitality (i.e. (Eyster & Geller, 1981; Berg & French, 1995). However, despite the fact that it is important to understand investment assessment techniques, it would be above the scope of this paper to discuss them here. Fortunately, these techniques are well covered in most financial analysis books. In general, it can be simplified that all these techniques involve some form of comparison of required investment to expected cash flow within specified time. Ransley & Ingram (2000) inform that all the traditional techniques for investment appraisal are used in hospitality industry with NPV (Net Present Value) and IRR (Internal Rate of Return) as the most popular methods. However, the authors point out that the sophistication of analyses varies according to the type of the expenditure; refurbishment is usually assessed locally and without formal analysis whereas expenditures in the development, that usually require a significant amounts of investments, are usually subject of feasibility studies and evaluated by several investment appraisal techniques. DeFranco & Schmidgall (2003) recently conducted more comprehensive research among 600 hotel professionals and once again reviewed the utilization of traditional capital budgeting criteria, such as Payback, NPV and IRR. The study Assessment of CapEx
  19. 19. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201019 found that almost 75% of respondents agreed that they had undertaken a formalized cost/benefit study prior to acquiring property and equipment. However, 46% of them admitted that this was done only for "major" acquisitions. The table below provides more details about what respondents considered as a major project: Table 1 – Major Expenditure Threshold to Warrant a Formalized Cost/Benefit Study  Expenditure Levels Frequency (%) over $1,000 12.6 over $10,000 37.8 over $50,000 21.9 over $100,000 10.1 over $250,000 0.8 over $500,000 2.5 Other 14.3 Source: Capital Budgeting and its uses in the Lodging Industry DeFranco & Schmidgall (2003) Interestingly, the study found that in the case of small hotel operations, the majority of managers/owners do not conduct formalized studies. In addition, DeFranco & Schmidgall (2003) identified 6 main categories of CapEx as identified by hotel managers:  Replacements to improve revenues;  replacements to reduce costs;  replacements for maintenance;  expansion of existing concepts;  expansion into new concepts and  safety and environmental projects. As can be seen, the range of cash outflows that may be considered as CapEx is relatively wide. This brings to the light the discussion regarding the unclear definition of CapEx.
  20. 20. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201020 2.3 Definition and understanding of CapEx In regards to understanding of CapEx, the main issue is what item should be expensed and what should be capitalized. For example, Schimdgall & Damito (1997) found that about 62% of hoteliers are often or sometimes unsure about whether expense or capitalize an item and, that more than 72% of respondents would appreciate better guidance. In their next study, Schimdgall et al (1998) focused on criteria used by hoteliers for decision making regarding capitalization of expenses and find that the most frequently used criteria are as follows: A. In case of Equipment Purchase – the item is commonly capitalized when expenditure exceeds defined dollar amount or/and when expenditure is part of hotel renovation. B. In case of Repair & Renovation – the expense is commonly capitalized when improvement prolongs the useful life of the property or/and when the improvements are over a certain dollar value However, the study also finds that there are several “grey” areas that are difficult to classify (Schimdgall et al, 1998). For example, 49% of the respondents believed that parking lots should be capitalized only when repaving consists minimum of 2.5 inches of bituminous asphalt whereas the rest of respondents either disagreed (31%) or was uncertain. Large disagreement was also in regards to pool motors; only 52% of the respondents believed that this expense should be capitalized. Other grey areas identified in the study were as follows:  Reupholstering (59% of respondents would expense and 41% capitalize)  Repairs and major overhauls of existing equipment (55% of respondents would expense and 45% capitalize)  Boiler re-tubing (54% of respondents would expense and 46% capitalize) (Schimdgall et al, 1998:30)
  21. 21. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201021 These empirical findings indicate that the definition of CapEx is unclear. The following section will thus examine the clarity of CapEx definitions in well recognized standards and accounting guides. Uniform System of Accounts for the Lodging Industry (USALI, 1996) is the accounting standard specifically developed for hospitality industry. However, CapEx is not explicitly discussed in this standard since it is not an item of the balance sheet. Despite that USALI comprise a CapEx related provision in the ‘Section 4 (Statement of Cash Flow; Cash Flows form Investing Activities)’ and also in the section “Expense Dictionary” (USALI, 1996). According to the Section 4, Capital Expenditures, as a cash flow item, “represent payments to purchase property, buildings, equipment, and other productive assets. These payments include interests payments capitalized as part of the cost of those assets (USALI, 1996:26)” This section of USALI also suggests to disclosure separately the portion of the capital expenditures that is required to maintain operating capacity from the portion that results in an increase in the revenue generating capacity of the property. This should help to determine whether there is/was adequate investment in the maintenance of operating property or not (USALI, 1996). Logically, it will also help to determine what portion of CapEx was actually invested into new capacities and products. This is an interesting advice since it helps to define two major types of CapEx: A. Capital Expenditures that are required to maintain operating (existing) capacity of the property B. Capital Expenditures that represent an increase in revenue-generating capacity of the property It is worth noting that Phillips (2003) builds on this definition and research spending on “Maintenance CapEx” and “Development CapEx” among hotel chains in the UK. The Phillips’ findings will be discussed later in this paper. USALI - Uniform System of Accounts for the Lodging Industry
  22. 22. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201022 In addition to the provision in the Section 4, the Expense Dictionary section of USALI (1996) indirectly defines CapEx by denoting that not all property expenditures should be recorded as an expense. It states that; “an expenditure made to purchase an item with a useful life of more than one year will typically be capitalised. That is, the amount will be included as an asset on the balance sheet and expensed through depreciation or amortization over the item’s useful life (USALI, 1996:205)”. However, two main exceptions are identified to this general rule: 1) Minor expenditure – “Immaterial expenditures, where the benefit of capitalising the item may not outweigh the cost of setting up and maintaining the depreciation records”. This expenditure might be expensed. However, the USALI do not provide concrete dollar amount that would determine when the expenditure can be expensed. It is a question of judgement but once the amount is defined, it should be followed consistently as a part of the property or company policy (USALI, 1996). 2) Repair expenditure – “Expenditure that only restores the value or expected life of the asset to its condition prior to the repair.” - In other words, any expenditure that extends the life of the asset or increases value of the asset should be capitalised (USALI, 1996). The second exception seems to open the door to discussions about which expense restores the condition of an asset and which extends its life or increases its value. The section provides some guidance about expenditures that are usually expensed, such as interest costs or software development costs; however, if those expenditures occur as a part of the acquisition of the asset, it should be included in the total amount that is capitalised (USALI, 1996). According to new Australian Accounting Standards (Kemp & Knapp, 2005), that are aligned with International Accounting Standards, a hotel is considered as Property, Plant and Equipment. Hence, the main section of AASB relevant CapEx in hotels is AASB 116; ‘Property, Plant and Equipment’. According to the AASB – Australian Accounting Standards
  23. 23. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201023 Recognition Rule of this standard (Kemp & Knapp, 2005:522) “the cost of an item of property, plant and equipment shall be recognised as an asset if, and only if: (a) it is probable that future economic benefits associated with the item will flow to the entity; and (b) the cost of the item can be measured reliably” The standard is quite specific but for the purpose of this paper the important is that under this recognition principle the cost of an item of property, plant or equipment includes not only initial costs but also “cost incurred subsequently to add to, replace part of or service it (Kemp & Knapp, 2005:522, paragraph 10)”. In regards to initial costs incurred in acquisition of the asset, the standard highlights that even though some initial expenditures to acquire property, plant or equipment do not lead directly to a growth of the future economic benefits, the item should be recognised as an asset (thus expenditure should be capitalised) if the item is necessary for the entity to obtain the future economic benefits form the other assets (Kemp & Knapp, 2005). In other words, if the expenditures enable the entity to derive future economic benefits from other assets in excess of what could be derived had the item not been acquired, it should be capitalised (Kemp & Knapp, 2005). The standard gives as an example of the expenditures necessary to comply with safety regulations or environmental requirements. However, for the purpose of this paper the most relevant are the paragraphs related to subsequent costs. According to the standard, the entity should not capitalise the costs of the day-to-day servicing of the property, plant or equipment (Kemp & Knapp, 2005). These costs should be recognised in profit and loss as they incur. The standard defines the cost of the day-to-day servicing as the expenditures with the purpose of repairs and maintenance of the item of property, plant and equipment which are primarily the costs of labour and consumables but it also might include costs of small parts (Kemp & Knapp, 2005:522:12). Unfortunately,
  24. 24. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201024 the definition of what is meant by ‘small part’ is not provided. However, the standard provides specific guidance how to capitalise replacement of parts of items of property, plant and equipment or replacement of whole items that are necessary on regular or irregular basis, given to the nature of some assets. As an example of such a ‘replacing part’ expenditure that should be capitalised, the standard gives the seats in an aircraft or interior walls of the buildings. Noteworthy, the standard does not specifically require the replacing part or the whole new item to increase the inflow of future economic benefits derived from the item, to be eligible for capitalization. Hence, someone may interpret the standard that it is sufficient if it is probable that future economic benefits associated with the item which is replaced or part of which is replaced ‘will flow’ to the entity and the costs are measurable. (Notice the difference between ‘increase of economic benefits’ as commonly used criterion in regards to capitalization and ‘will flow’ as applied in the recognition principle of the AASB standard). In this case, the cost of replacing parts would be capitalised, added to carrying amount of the asset. However, very important is that the carrying amount of the parts of the item or items that are replaced should be, according to the AASB standard derecognised (Kemp & Knapp, 2005). The gain or losses arising from the derecognition of an item of property, plant and equipment should be included in profit or loss when the item is derecognised and “regardless of whether the replaced part had been depreciated separately” (2005:523). The standard provides detailed guidance of how to determine the carrying amount of replaced items or replaced parts of the items. Hence, the standard can be understood that if the hotel management decides to replace the walls in the building, the costs should be capitalised, even though it does not increase the expected life of the building or the increase economic benefits generated from the building. It is sufficient that the replacement of the
  25. 25. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201025 walls will enable the hotel (building) to maintain its economic-benefit generating capacity. The logic behind this is that, when the expected life of the whole building was initially determined, it was assumed that some parts, such as walls, will need to be replaced on some standard/regular basis. The Chartered Institute of Management Accountants (CIMA 1996) defines capital expenditure as ‘the cost of acquiring, producing or enhancing fixed asset’ (Ransley & Ingram, 2000:75). A fixed asset is “any asset, tangible or intangible, acquired for the retention by entity for the purpose of providing a service to the business, and not held for release in the normal course of trading” (Ransley & Ingram, 2000:75). Expressed more simply capital spent is “the expenditure relating to the purchase and enhancement of long term fixed assets such as land, buildings, furnishing, equipment, motor vehicles and machinery“ (Ransley & Ingram, 2000:75). According to CIMA, ‘spend on fixed asset’ is easily recognised as a capital expenditure due to its well determined characteristics which are:  the expenditure is usually substantial in nature  the precise benefits arising from the use of the expenditure may be difficult to determine and will be based on estimate but,  these benefits may be spread over more than one year  the expenditure will be related to furthering the objectives of the business (Ransley & Ingram, 2000:75) However, Ransley & Ingram (2000:75) also admits that some spends might be difficult to classify as capital expenditure. Whether it is an issue in Australia or not, will be determined through the interviews with industry stakeholders which will be the next step after this literature review. Based on their JLLH study (2005) Jones Lang LaSalle Hotels define CapEx as expenditures that “relates to structural changes of the property, major remodelling, replacement of existing assets etc. in order to maintain the hotel and/or improve the profitability of extend the live of the asset” (JLLH study, 2005:18). Interestingly, also this definition does not consider only expenditures that increase economic benefits or extend economic life of the asset as CapEx. CIMA - The Chartered Institute of Management Accountants Jones Lang LaSalle Hotels
  26. 26. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201026 2.4 Characteristics and factors influencing CapEx It is clear that characteristics of CapEx and factors that influence CapEx are mutually interconnected. In other words, CapEx in hospitality have specific characteristics due to factors specific to this industry. Some of these CapEx characteristics and factors were already identified in the background section to this paper. These are:  Decisions regarding CapEx are very complex due to their high dollar values and cyclical, ambiguous and irreversible nature (McGuingan & Kretlow, 2003)  Capital expenditures vary significantly from year to year but in general, the expenditures are low during the early years of the hotel life cycle and the first increase usually occurs after 4-5 years, for soft refurbishments. However, hotels usually face the most significant CapEx requirements after 7-12 years of operations, when the general refurbishment of the property must be realised (Denton, 1998). One of the most comprehensive studies regarding CapEx in hospitality industry that gives very good picture about characteristics of CapEx as well as it helps to identify some of the main factors that influence capital spending in hotels, has been the research conducted and published by ISHC on a regular basis. The last study was published in 2000 (the executive summary can be found in Appendix 1.). This study analyses historical data of 350 hotels across the USA as well as estimates future spending based on expert analysis of expected costs and useful lives of items. The study finds that CapEx vary significantly within the life cycle of the hotel, depend on the ultimate age of the property and differ by hotel type. In addition, the study also found some correlation between ownership type and CapEx.
  27. 27. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201027 The pictures below clearly illustrates that the magnitude of CapEx varies significantly within the life cycle of a hotel.   Source: ISHC study CapEx2000, Mellen et al. (2000) Figure 1 – Average CapEx by Year as a Ration to Total Revenue  According to Berg & Skinner (1995) CapEx are below 3% of revenues only during the first 5 years of the property life and than the expenditures go up and usually do not fall below 3% again. In other words, a new hotel has limited or no needs for CapEx, while ageing properties will usually demand more attention. The graph provided above illustrates that initial increase in CapEx requirements should be expected in the sixth or seventh year of a hotel’s life due to the need for replacement of soft goods. However, the first real CapEx escalation will likely occur around year 9 to 11 when rooms and corridors will need renovation (Mellen et al., 2000). As for the following years, according to Berg & Skinner (1995), CapEx regularly increase every 7th to 9th year as an average hotel must undergo major renovations within this interval, to maintain competitiveness. The table below provides a broad picture of the typical composition of CapEx (based on ISHC study). Life cycle of the property
  28. 28. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201028 Table 2 ‐ Composition of CapEx in %  Component Full-Service Hotel Limited-Service Hotel Room & Corridors 33% 29% Building 14% 24% Other Public Space 16% 13% Food & Beverage 11% 10% Technology 8% 8% ADA / Life Safety 3% 5% Other 15% 11% Source: ISHC study CapEx2000, Mellen et al. (2000) Interestingly, the data from ISHC study indicate that over time, as properties age, the CapEx tend to vary more significantly among individual properties. This is clearly reflected in the Figure 1, where the maximum and minimum of CapEx spending as a percentage of revenues widens within the years (Mellen et al., 2000). This suggests that in case of an older property CapEx estimates might be more difficult. However, Berg & Skinner (1995) point out that in comparison to modern properties, older properties were found to require generally more CapEx per room as well as a percentage of revenue. Ultimate age of the property
  29. 29. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201029 Figure 2 below illustrates the difference in average CapEx in Full-Service hotels and Limited-Service hotels.   Source: ISHC study CapEx2000, Mellen et al. (2000) Figure 2 CapEx Spend over Time, as a % of Total Revenue  It is clear that CapEx vary by hotel type quite significantly. For example; when combining last two ISHC studies, CapEx2000 and CapEx1995, it can be found that limited-service hotels spend in average on CapEx somewhere about 3.7% of gross revenues over 25 years whereas full-service properties required 6.9% over the same period of time (Mellen el al. 2000). Hotel Type
  30. 30. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201030 The results from ISHC study CapEx2000 suggests that the spending for hotels owned by public hotel companies will exceed that spend on hotel owned privately. In particular, private-held hotels spend 52% less on CapEx (in average) than hotels owned by public companies. There are two issues that need to be kept in mind in regards to ISHC study. First, the authors warn about applying the averages for estimating CapEx for individual hotels, since CapEx in each facility may also vary based on hotel’s specific circumstances such as:  Construction  occupancy;  competition;  geographical location;  brand;  difference in local costs factors and  other factors High variance of CapEx within properties in time is confirmed by Phillips (2003) who researched Maintenance and Development CapEx among UK hotel chains. Figure 3 below shows evident disparity in the maximum and minimum levels of both Maintenance and Development CapEx spending as a percentage of hotel turnovers within the surveyed hotel chains. For example, during 2002, one hotel chain spent more than 20% of its turnover on CapEx, while the least amount spent by other hotel chain was 3.1% (Phillips, 2003). Interestingly, Phillips also point out that the 4% rule of thumb measure for ‘Maintenance CapEx’ does not reflect current hotel chains practice, since the CapEx were almost always above 4% (Phillips, 2003). Even higher disparity in CapEx was observed in regards to Development where one hotel chain spent 51% of hotel turnover in 2000 whereas other hotel chain invested only 1% of turnover towards development of new revenue generating capacities. Ownership Structure Other Factors
  31. 31. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201031   Source: Phillips, (2003) Figure 3 ‐ Maintenance and Development CapEx – Disparity among hotels  If we ignore the conflict of ‘Maintenance CapEx’ with the accounting definitions of CapEx, the differentiation between spending on two types of CapEx, Maintenance and Development, leads to a second issue that needs to be kept in mind when assessing results of ISHC study CapEx 2000. It is that the study investigated ‘all capital improvement costs’ of owning hotels over an asset’s life span. In other words, ISHC CapEx includes not only cost to replace ‘short lived items’ or ‘furniture, fixture and equipment’ but also:  Updating design and décor;  curing functional and economic obsolescence, thereby extending both the physical and economical life of the asset;  complying with franchisor’s brand requirements;  technological improvements;  product change to meet market demands;  adhering to government regulatory requirements; and  replacing all short and long-lived building components due to wear and tear Source: ISHC study CapEx2000, Mellen et al. (2000) Clearly, the list above includes CapEx that are not only necessary to maintain current generating capacity of the facility, such as replacing components due to wear and tear, but it may also includes CapEx that may result in increased
  32. 32. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201032 revenue generating capacity of the lodging property, such as ‘product change’ or ‘technological improvements’. The two lists above can be also seen as the lists of factors that may drive CapEx spending. Other authors confirm some of these factors. For example, Losekoot et al (2001) believe that CapEx are predominantly driven by the enhancements in the guest technologies, such as integral bathrooms, communication and entertainment technologies, mini-bars, trousers press and so on. Watkins (1996) adds that hoteliers should engage in CapEx such as refurbishment not only to replace outdated items but also for strategic purposes. The author understands renovation as replacement and refurbishment of existing items/facilities but also as the development of new facilities within the existing hotel. In particular, Watkins (1996) stresses 4 frequent reasons to renovate:  To prepare for special events (i.e. Olympic Games)  To increase profitability (i.e. new bar)  To attract convention business (i.e. development of conference facilities)  To satisfy repeat business According to the University of Sydney (Planning Research Centre, 2005), the hotel construction and development (including refurbishment activities) are, in Australian context, pushed primarily by the events. This confirms one of Watkins’ arguments. However, the most interesting point raised by this author is in regards to renovation for satisfaction of repeat business. Watkins (1996) argues that there is more pressure to renovate more often if the hotel relies/focuses on repeat business. Hence, the segmentation strategy can actually influence CapEx spending. This brings to light possible interrelations between CapEx and the customers’ satisfaction.
  33. 33. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201033 It was already discussed that for many customers the physical appearance and functional aspects of the accommodation facilities is important. Gunter (2005) adds that customers require unique experience not only from a service delivery perspective, but also from an aesthetic perspective, especially in terms of luxury and upper-upscale hotels. According to the author, the customers require bigger rooms and bigger bathrooms with highly designed elements. Also according to Angela Denney, director in the hospitality and restaurant studio at FRCH Design, "People are a lot more educated about design and [furniture, fixtures and equipment]” and “People are exposed to a lot more ideas, so people tend to expect more out of guestrooms now" (in Gunter, 2005:60). Growing popularity of design and boutique hotels supports this argument. However, the question is whether the customers are ready to pay for ‘It’. Unfortunately, the author of this paper did not find any quantitative study that attempted to quantify the link between CapEx and customers’ satisfaction. Furthermore, no quantitative study was found that would link CapEx and profits, either through increased revenues or reduced costs. In effect, Phillips (2003) finds that even hotel financial executives have, in many cases, difficulties to perform post investment appraisal of CapEx since the returns could be affected by too many factors beyond the control of management and it is difficult to link cause and effect. Especially in the case of replacement and multiphase CapEx projects, managers see disaggregation of investment and returns very difficult. According to authors, CapEx are frequently seen as an ‘enabler’ rather than the ‘driver’ of business (Phillips, 2003). Despite lack of research it is clear that not always are customers willing to pay extra money for improvements. For example, internet access in rooms is now-a-days more and more expected as a fee-free standard. This might accelerate concerns among hotels owners in regards to the effectiveness of CapEx spending.
  34. 34. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201034 Higley (2005) provides insights from the recent annual meeting of the presidents of American hotel owning companies and according to his reportage, the main factors that owners consider when approving Cap-Ex is, not surprisingly, the return on investment (ROI). In particular, the owners prefer the Cap-Ex which will enable the hotel to raise the average daily rates (Higley, 2005). In effect, the hotel owners admit that the price increases became more product-driven and less market driven (Higley, 2005). ‘Product-driven’ means that rates are actually raised up to cover for high Cap-Ex in contrast to ‘market-driven’ increases where the price changes are based on demand (Higley, 2005). In addition, according Chipkin (2005) CapEx might be affected by ownership structure, in particular the demands of operators. However, the author informs that many operators understand owners’ concerns about investment returns. According to the author, some operators consider owner’s willingness to pay when introducing initiatives that will require CapEx, such as up-grading the brand standards. Chipkin (2005) gives following resent examples:  Intercontinental Hotels Group's Holiday Inn brand have opted for a new hotel prototype that is designed to be less expensive to build and maintain  Even though Hilton Hotels brand standard require a new television that costs twice as much as the previous one, the new standard does not require the armoire to even out the final costs. In addition, the standard requires new type of beds but the increase of this CapEx will be balanced by reduction of expenditures in other areas such as elimination of the need for two phones and two phone lines and reduced dining room costs.  Choice Hotels pursue approach "franchisee-first" and claim to propose to the owners only those changes that will increase revenues.  Starwood hotels & Resorts Worldwide's Sheraton tests positive revenue impact of new CapEx initiatives, such as Sweet Sleeper (bed), in own properties first before introducing it to franchisees Source: ‘Brands consider costs, consumers when reimaging’ Chipkin (2005) Ownership Structure
  35. 35. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201035 Phillips (2003) looks at CapEx from operators/management point of view and finds that managers see the best time to realise CapEx in the bottom of the economic cycle as hotel companies have a stronger negotiating position with all parties involved in the hotel development process. However, Phillips warns that when there is a slowdown in earnings growth, owners will become less willing to spend. Phillips advises that management have to find a balance in income distribution (owners/shareholders vs. CapEx) since failure to ascertain the appropriate balance in distribution could affect the share price (2003). Phillips gives Accor as a good example of how to achieve desired free cash flow from operations by decreasing renovation CapEx (2003).   Source: Accor 2002 Full-Year Results: Presentation to Financial Analysts, http://www.accor.com/gb/upload/pdf/gb_Resultats_2002_web_gb.pdf Figure 4 – Accor: Manage Free Cash Flow by Reducing Renovation CapEx  The picture clearly illustrates that Accor, in market down-turns, is ready to scarify some of renovation CapEx in order to maintain steady Cash Flow. However, Crandell warns that this might lead to the acceleration of CapEx requirements in the future. However, it needs to be stated that Accor seems to take this in consideration by setting the minimum for Maintenance CapEx spending at 4%. In addition (Phillips, 2003) finds that incremental CapEx spending might be less respectful of customers’ convenience than “big bang approach”.
  36. 36. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201036 However, according to the Lodging Industry Investment Council (LIIC, 2005) expensive Product Improvement Plans (PIPs) are still a threat to investment yields, since hotel brands are expected to be very strict with lodging owners in terms of requiring huge expenditures to maintain ever increasingly stringent product standards. Also Crandell (2002) discusses the influence of operators and franchisors on CapEx in hotels. However, the author adds that lenders should also be considered. According to Crandell “lenders, who control the ‘purse strings’, want to clearly understand capital expenditure plans and, as a result, may require that certain projects be done, even if they aren’t necessary at the time” (2002:1). Lawson (1995) also provides brief overview of macroeconomic factors that can have impact on CapEx in hotels. These are as follows:  Table 3 ‐ Conditions influencing capital expenditures:  Changes Conditions Economic Low rates of interests charges on loans and the availability of capital for investment Business Progressive increase in hotel prices and property values compared with other sector (price and cost indicies) Demand Expansion of demand arising from growth in tourism or/and investment in the attractions of the area Incentives Government-regulated incentives for new investment and conversion/refurbishment schemes Source: Lawson (1995:p 34) Now, it is clear that CapEx may involve and be affected by many factors and all stakeholders such as owners/investors, customers, authorities and operators. Hence the effective provisions for management of CapEx are important. The following section will review the literature in regards to provisions applied to manage CapEx in hotels. Macro- economic Factors
  37. 37. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201037 2.5 Provisions for CapEx There are two main tools that are employed to manage CapEx; FF&E reserve and CapEx plans/budgets. However, to manage these tools effectively the literature suggests employing an Asset manager whose main responsibility is management of CapEx on behalf of the owner (Beals & Denton, 2003). Johnstone & Duni (in Pagliari, 1995) believe that establishing a reserve for replacement that is funded from cash flow on an ongoing basis is the best way to ensure a sufficient renovation capital that is critical for the long-term success of hotel properties. The authors suggest putting funds aside in low risk insured account on regular basis so that resources are available for the major renovations that will occur every 5-7 years (Johnstone & Duni in Pagliari, 1995). However, Denton (1998) argues that reserve for replacement is, in effect, a “rudimentary step” in management of CapEx due to following reasons;  It does not provide sufficient funds for capital projects anyway  It leads to inefficient use of capital Denton explains that since the CapEx are not correlated to revenues the reserve for replacement can be over funded for long period of time; usually the initial period in hotel life cycle (see the picture below) whilst significant amounts of funds may be lacking when major renovation need to be undertaken (1998). Denton particularly warns against using constant percentage of revenues as a determinant for contributions to the replacement reserve. As can be seen from Denton’s example of CapEx in full-service hotel with 200 rooms (Figure 5 below), the reserve funded by steady contribution of 4% from gross revenues almost never fit with the actual CapEx requirements. RESERVES FOR REPLACEMENT
  38. 38. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201038   Based on a steady contribution to the reserve based on a arbitrary percentage of hotel revenue. Source: Managing Capital Expenditure (Denton, 1998) Figure 5 ‐ Cumulative Surplus or (deficit) of Capital Reserve vs. Actual Spending  Denton (1998) reminds that major CapEx occur within 10-12 years hence relatively high amounts of money can be tied up on the reserve account without efficient use for this period of time. As a consequence of such inefficiency, investors suffer high opportunity costs since the funds could be generating much higher returns elsewhere and, the hotel is not properly maintained in later years due to shortages of funds in the reserve. On the other hand, Rushmore (2002) warns that even though FF&E assets have an average useful life of 8-10 years, there are many items with much shorter life. Thus, the contribution to the FF&E reserve should start with the first year of operations (Rushmore, 2002). To support his arguments, Rushmore (2002) provides following table of typical useful lives of various FF&E components.
  39. 39. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201039 Table 4 – Useful Lives of FF&E components  Source: Hotel Investment Handbook, Ch.20, Rushmore (2002:63) As can be seen, a new hotel may need funds from the FF&E reserve already in the second year as some items should be replaced within this time frame (Rushmore, 2002). The issue of useful lives of items will be discussed further in the next section of this literature review. Despite many pitfalls and discussion in regards to replacement reserve, it is widely used across the industry. There are two reasons for it: requirements of operators and lenders. It is clear that operators need to undertake replacements and renovations to maintain competitiveness of the managed hotel. However, in most cases, it is up to owners to provide necessary funds (Denton, 1998). To ensure that some level of funds will be available, operators usually require in management agreements with owners to establishment a replacement reserve, since worn-out facility negatively affects profitability as well as the image and reputation of the operator (Rushmore, 2002). Most of management agreements usually define an FF&E reserve. FF&E reserve can be specified as reserve “solely for capital improvements and replacements of and additions to furniture, fixtures, and
  40. 40. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201040 equipment so as to maintain the hotel in first-class condition“(Rushmore, 2002:73). According to recent John LaSalle Hotels study (Haast et al. 2005) FF&E reserve was found to be the standard provision in management agreements across all major markets; USA, Europe and Asia Pacific which includes Australia. It was also found that some agreements allow for an escalating structure of reserve that ramps up to the stabilised percentage; from small or nil percentage in the initial years to a fixed percentage (stabilised fee) going forward from year three or five onwards. Interestingly, agreements in the Asia Pacific were found to specify a stabilised fee of about 3.1% of gross revenues which is about 20% less than typical agreements in Europe (3.9%) and more than 29% less than in USA where owners are required to put aside in average 4.4% of gross revenues.   Source: Jones Lang LaSalle Hotels; Baker & McKenzie (2005) Figure 6 FF&E Reserve as a %age of Gross Revenue – Asia Pacific 
  41. 41. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201041 The “ramp up” approach to replacement reserve discussed above is designed to respect lower CapEx requirements in the early years of hotel life and the owners/investors concerns about inefficiently tied up money on the reserve accounts. In addition, Denton (1998) advices those owners/investors that have multiple properties under management by the same operator to apply the portfolio approach to replacement reserves. The author suggests concentrating contributions from all hotels to single fund/reserve and applying these common funds for replacements across whole portfolio of properties, thus dispersing the volatility of the capital outlays, assuming the properties are in different stages of the lifecycle (Denton, 1998). This is in line with suggestions of the Property Council of Australia that recommends the investors to solve issues with fluctuations in CapEx funding requirements by building a well-balanced portfolio of properties with different timing for CapEx and using cumulated funds “wherever and whenever most necessary” (JLLH, 2003:67) However, the JLLH Management Agreement study (Haast et al., 2005) found that there is another trend in regards to the FF&E reserve. The FF&E reserve is becoming an accounting entry in the owners’ books rather than an actual cash fund, particularly in Australia. This is an interesting finding since it contradicts the ultimate purpose of the reserve; to ensure funds. However, the study also found that most agreements impose a legal obligation upon owners to provide sufficient fund for CapEx to maintain hotel at its specified standard, particularly in relation to 5-star hotels (Haast et al. 2005). It needs to be understood that this obligation is related not only to regular replacement of FF&E but it covers other hotel assets. This brings to light definitions of Replacement Reserve. According to literature it seems that there is confusion between Replacement Reserve and FF&E reserve. These two terms are used interchangeably however; it seems that these terms are not understood and/or used in a same way by all stakeholders. Beals & Denton (2003) emphasize that FF&E reserve should not be understood as a fund for replacement of major building components, such as Portfolio Approach to Reserves Reserve as accounting entry Confusion with Reserves
  42. 42. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201042 roofs, elevators, and chillers. Despite this, Phillips (2003) found that many hotel general managers frequently use the FF&E reserve to fund the replacement of major building components, instead of keeping funds strictly for periodic replacement of FF&E. According to the Dictionary of Real Estate Appraisal, Reserve for Replacement is defined as “The funds put aside for the periodic replacement of furniture, fixtures and equipment [FF&E]” (US Appraisal Institute). However, according to the PricewaterhouseCoopers LLP Investors Survey (Korpacz, 1999) Reserve for Replacement is understood as “a dollar amount allocated for periodic replacement of building components during a property’s economic life”. In Addition, the PWC dictionary specifies ‘Reserve for Replacement of Fixed Assets in Hotel Valuations’ and define it as: “An allowance that provides for the periodic replacement of building components, and furniture, fixtures, and equipment, which deteriorate and must be replaced during the building’s economic life”. Hence, there is a significant difference in definitions, since some of definitions include only FF&E and other definitions cover all fixed assets. However, replacement of FF&E is only part of all CapEx that are necessary to be realised in hotels to maintain competitiveness. For example, according to the latest ‘Development Costs Study’ by HVS International, FF&E creates only 16% of development cost for the average full-service hotel in USA (Sahlins, 2005). Stephen Rushmore, President and Founder of HVS International, also highlights that the FF&E reserve cannot cover all replacements and, furthermore, that the needs for replacement/renovation are increasing (2003). According to Rushmore, 40 years ago a hotel needed about 2% of revenues for replacement of FF&E; however, now-a-days hotels are facing intensifying functional obsolescence of assets especially in hotel rooms. This combined with the high competition pushes the FF&E replacement needs up to 4-5% (Rushmore, 2003). However, Rushmore also predicts that tomorrow’s hotel rooms will contain highly sophisticated and expensive technology that will require another 2-3% of total revenues for replacement. In addition, Rushmore points out that at some time any hotel will
  43. 43. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201043 need to replace/renovate permanent components such as plumbing, electrical systems, heating and air conditioning, exterior façade and structural components (Rushmore, 2003). According to Rushmore, these items are not covered by FF&E reserve and usually will require an additional 1-3% of total revenues. When all these needs are compounded together, it can be calculated that an average hotel needs to put aside between 7-11% of total revenues to protect its assets from functional obsolescence and physical deterioration (Rushmore, 2003). Even though Rushmore does not suggest establishing a specific reserve for all these inevitable expenditures he highlights that investors need to realise that FF&E reserve is just a part of the whole picture in regards to CapEx needed. Surprisingly, Stephen Brener, a president of another hotel valuation and consultancy company, had very similar opinion already in 1992. Brener (1992) forecasted that by the late 90s full service hotels will require to set aside 5-7% of gross revenues for FF&E replacement and another 1-2% for capital improvements. In addition, the Brenner believed that after year 2000 a five year hotel will need to put aside approximately 10% of revenues to remain competitive. Interestingly, Brener (1992) believed that those reserves will be required by long-term investors and not operators. In relation to the Replacement Reserve, it is important to realise that some investors factor-in the replacement reserves when appraising hotels. For example PWC Study (Korpacz, 1999) found that 46.3% of investors use direct capitalization methods of income that deduct the Replacement Reserve. Hence, the perceived standard for escrow level of Replacement Reserve may have a significant impact on investment to hotels. According to 2004 USRC Survey, hotel investors used in their estimates an average of 4.2% of gross revenues for Replacement Reserve, however, some investors applied up to 6%. The following table provides a summary of USRC Survey findings in regards to the Replacement Reserve.
  44. 44. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201044 Table 5 ‐ USRC Hotel Investment Survey, Reserve for Replacement (US Investors)  Winter 2003 Winter 2003 Winter 2004 Winter 2004 Reserve for Replacement Limited Service Full - Service Limited Service Full - Service Average 4% 4.2% 4.1% 4.2% Range 3.0% - 5.0% 3.0% - 5.0% 3.0% - 6.0% 3.0% - 6.0% Source: USRC Hotel Investment Survey, US Realty Consultants, Inc. Also PWC Survey among investors asked the participants about rates they use in regards to reserves, in particular the Replacements Reserves of Fixed Assets. The results from the study ranges between 2-8% of the total revenues (Korpacz, 1999). This relatively wide range of constants for the reserve is interesting, however it needs to be clarified that most of the investors in the survey quoted to use 3-5% of the total revenues as a constant for the Reserve for Replacement of Fixed Assets (More details can be seen in Appendix 2). However, Pagliari (1995) argues, that too low constants for replacement reserve, used by valuers/investors, is a drawback in many hotel appraisals. According to Pagliari, when calculating net operating income (NOI), appraisers need to deduct more than 3% of total revenues to account for future CapEx. In addition, Pagliari (1995) warns that many appraisers do not account for the position of the hotel in its life cycle. Pagliari gives the example of a 20 year-old property that will require major refurbishment within a few years which may approximate 10-30% of the market value of the property which is much more than 3-4% of gross revenues (1995). Another important stakeholder that usually require the establishment of a replacement reserve in hotels are lenders such as banks. The intention of lenders is to ensure that the loan security (usually the hotel facility itself) will be well maintained (Denton, 1998). For example, Wilder (2004) informs that most lenders in the USA require a monthly replacement reserve often approximating 4 percent of gross sales. Wilder (2004) gives some advices on how to negotiate with lenders but admits that some lenders, especially those providing commercial mortgage backed securities, are less flexible in negotiating escrow levels for Lenders and Replacement Reserves
  45. 45. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201045 replacement reserve because their strong reliance on ability to resell the loans to end-buyers. According to the author, the ability to resell to end-buyers is influenced by debt rating from a credit-rating agency, such as Moody's or Standard & Poor's, and these agencies usually impose tight requirements that inhibit the loan originator's ability to negotiate terms (Wilder, 2004). It seems that CapEx are officially underestimated despite the data in available research.
  46. 46. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201046 2.6 Why Are CapEx Underestimated? According to Berg & Skinner (1995) CapEx include not only the replacement of worn-out furniture, finishes and soft goods, but also all wear and tear in general and replacements and renovations of building components and heavy equipment due to obsolescence, regulatory requirements such as OH&S, changing technology, franchise product demands and market demand for product change. The authors argue that these expenditures have been “long assumed to be covered with replacement reserves” (Berg & Skinner, 1995) This creates unrealistic expectation since as was already mentioned, ISHC study indicates that in reality, these expenses will probably be much higher than 3% which is the standard contribution to the FF&E reserve. Berg & Skinner (1995) provides a list of reasons why the industry continues to formally underestimate CapEx, despite the actual experience within the industry. These factors are:  Some owners (usually private owners) try to expense (as opposite to capitalise) as many items as possible.  Recognising the true CapEx level reduces the value of existing hotels, and as a result, CapEx are often hidden  Recognising the true costs of CapEx raises the feasibility threshold for new hotel development, making financing and developing hotels more difficult  Appraisers fear the loss of clients if they report a lower hotel value by recognising the cost of CapEx  In many cases, there is a poor planning and record keeping in regards to CapEx Also the authors of ISHC study recognise fear of some stakeholders that their findings will lead to the increase of funds required by lenders or/and operators to be set aside (in the form of reserves) thus consequently affecting investor’s return on investment.
  47. 47. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201047 2.7 CapEx planning According to Denton (1998) proper plans are the most effective tools to manage CapEx. “Without an effective system of defining, budgeting for, and monitoring capital expenditures, one can almost be certain that projects will be undertaken at the wrong time in the investment cycle, that too much money will be spent, and that the owner will be unpleasantly surprised by shortfalls in the capital expenditure reserve” says Denton (1984:2). This is reflected in most management agreements where operators are usually required to provide the owner with a CapEx plan, which should be updated on an annual basis (Beals & Denton, 2004). According to the JLLH Study, 85.7% of management agreements in Asia Pacific contain a requirement for budget approval by owners (Haast et al. 2005). According to Beals & Denton (2004), the plan is typically developed using a “ground up” approach, whereby the manager looks at the property’s physical condition and assesses guest satisfaction, brand compliance and the property’s competitiveness in the market place. Beals & Denton (2004) suggest developing 3-5 years plans based on this review. Crandell (2002) suggests developing 10 years capital programs, since this period reflects the renovation cycle of hotels. According to the author, a 10-year CapEx plan gives better flexibility in the CapEx timing. It also enables to set priorities so that limited funds are not spent on the early-year or “like to do” projects that might be less important than CapEx requirements in the following years (Crandell, 2002). Denton (1998) goes even further and develops a 30-years plan to provide thorough picture about long term CapEx needs including replacements that will be necessary within 20-24 years, such as elevators (cable) or roof.
  48. 48. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201048 To be relevant, long term plans should be updated on an annual basis and the expected cumulation of funds in Replacement Reserve should be compared to planned CapEx requirements (Crandell, 2002). Beals & Denton (2004) also advice to compare proposed CapEx against the projected funds in property’s Reserve for Replacement. In the case where the funds are determined to be inadequate to cover requested CapEx, Beals & Denton give two options to the owners:  defer or eliminate non-essential items to conserve funds; or  infuse additional capital into the property to complete all the requested projects (Beals & Denton, 2004) To enhance the decision making process, items in the CapEx plan should be ranked according to their importance for the survival of the building and the business. Crandell (2002) suggests three categories:  Have-to-do CapEx (i.e. fix the roof when it leaks)  Nice-to-do CapEx (i.e. replace carpeting and other soft goods)  Smart-to-do CapEx (those items that require additional investment to generate higher revenues, such as the makeover of a restaurant or upgrading meeting facilities) Ransley & Ingram (2000) suggest to plan for CapEx already during the design stage of hotel development and recommend applying ‘life-cycle costing’. According to the authors, ‘life-cycle costing’ is a technique used to examine the capital, operating and maintenance costs and revenues of an asset. Ransley & Ingram argue that this method enables to realise that greater initial investment might provide higher return since it can reduce replacement and repair costs over the life of the building. It is especially true for hotels where the asset value is based on the profitability of the operations rather than bricks and mortar, and where current expenditure on running expenses will, over time, exceed the initial capital expenditure by many times (Ransley & Ingram, 2000).
  49. 49. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201049 The benefits of life cycle costing are as follows:  It enables understanding of long-term consequences of the design and capital expenditure decisions and,  the relation between capital expenditure, design and operating costs  It considers design and CapEx in accordance with the clients own investment criteria (Ransley & Ingram, 2000) Denton (1998) suggests detailed long-term CapEx plan. According to the author, each functional component of the hotel, such as guestrooms, bathrooms, corridors, exteriors, building systems should be itemized and replacement costs with anticipated life expectancy should be assigned to each item. This should be transformed into CapEx plan with a synoptic table, thus helping to manage appropriate funding (Denton, 1998). Examples of CapEx budget tables can be found in Appendix 3. In addition, the detailed list of required CapEx should be accompanied by the full description of the expenditure, a concise reasoning for expenditure including the identification of the aspect of the facility it will improve and the determination of funding (Rushmore, 2002). Denton (1998) summarises the benefits of such as detailed long-range capital planning model as follows:  The model provide an effective financial planning tool that allows owners to anticipate future requirements and not to be caught unprepared for major renovations  Concerned lenders can track the level of escrowed funds and adjust their contribution requirements accordingly  If the contribution to replacement reserve is not set as constant from revenues and is adjusted according to estimated CapEx needs, the model eliminates gaps of undefended reserves or underused capital  It allows owners of multiple properties to coordinate capital requirements and thus maximise use of capital and reduce fluctuation of Cash Flow  Having long range capital planning model facilitates annual budget reviews and approvals, since once there is an agreement among
  50. 50. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201050 parties on general assumptions of the model, there will be less discussion regarding timing and payments of CapEx  Having specific annual spending targets for capital expenditures, determined life expectancies and replacement costs of the items will enable owners to hold management accountable for maintaining assets and allows monitoring of the effectiveness of preventive maintenance and purchasing programs  Applying the model to acquisition analysis for existing hotels can provide a potential purchaser with a reasonably clear picture of future capital requirements, thereby helping the owner make an appropriately priced purchase offer However, Beals & Denton (2004) warn that many plans tend to be developed around available funds rather than through thorough assessment of the property’s true capital. In addition, there are several potential pitfalls that might occur when the plans are developed by operators. These are as follows: • The CapEx plan provides no incentive and actually is a disincentive for Operators to be thorough in their analysis of capital needs or to address the replacement of expensive mechanical items or major repairs. By drawing attention to a major expenditure that the Owner would otherwise not be aware of, the Operator reduces the funds available for other items or risks throwing the reserve" into the red.” Thus, items like carpet replacement and restaurant refurbishment are always included in Operator-generated plans, but less visible yet equally essential items like replacing a chillier, roof repairs, or plumbing and electrical updates are often excluded, leaving the Owner to fund those items on an unbudgeted basis when the repairs are needed. • The system requires the Operator to be adept at cost estimating for their requested expenditures, placing a burden on managers who may not have adequate experience or corporate resources to develop accurate estimates and creating an opportunity for human error to render the five-year plan dangerously misleading. For this reason, a formal Asset Register is often developed, through the services of a specialist cost consultant. • If the Operator is given discretion over the timing of items within the five- year period of the plan, the opportunity exists for the Operator to accelerate" pet projects" and defer projects that may be more important for the overall wellbeing of the property. • When Operators have to "fit" Capital Expenditure needs to the availability of funds, this often leads to partial solutions, such as renovating a portion of a property's guestrooms in one year and deferring the remainder until more funds are available. Although acceptable on a limited basis, this tactic can ultimately result in a property that has dramatically inconsistent quality levels, thereby diluting the overall impact on the guests. This approach often also results in more money being spent in total because economies of scale are compromised when work is accomplished piecemeal or over a protracted period of time. Pitfalls in the CapEx planning process:
  51. 51. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201051 Beals & Denton (2004) Another problem with CapEx planning is the difficulty of determining the time when the asset will need to be replaced. 2.8 Expected life of the Assets Accurate assessment of assets replacement needs in the future of a property is the core element of CapEx plan (Denton, 1998). In regards to assets’ life, Rushmore (2002) talks about the ‘useful life’ of the asset which is affected by uses to which these assets are subjected, amount of guest traffic, quality and durability of its construction. Australian Accounting Standards (AASB) handbook (Kemp & Knapp, 2005) defines useful life as: (a) the period over which an asset is expected to be available for use by an entity; or (b) the number of production or similar units expected to be obtained from the asset by entity (Kemp & Knapp, 2005:521) The AASB standards also inform that following factors need to be considered in determining the useful life of an asset: (a) Expected usage of the asset. Usage is assessed by reference to the asset’s expected capacity or physical output (b) Expected physical wear and tear, which depends on operational factors such as number of shifts for which assets are to be used and the repair and maintenance programme, and the care and maintenance of the asset while idle. (c) Technical and commercial obsolescence arising from changes or improvements in production, or from a change in the market demand for the product or service output of the asset (d) legal or similar limits on the use of the asset, such as the expiry dates of related leases (Kemp & Knapp, 2005:521) It is clear that some factors, especially commercial obsolescence and legal changes may be difficult to predict for 5-30 years ahead. The British Association of Hospitality Accountant (BAHA, 2000) provides a guide for hotel valuers and
  52. 52. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201052 accountant and defines the following useful lives of tangible fixed assets that reflect refurbishment cycles for a typical hotel. Table 6 ‐ Suggested Useful Economic Lives of Categories Tangible Fixed Assets   Category Range of Useful Economic Life Land - Freehold Infinite - Leasehold Life of lease. Building Core - Freehold Determined by directors. - Leasehold Life of lease Building Surface Finishes and Services 20 to 30 years Plant and Machinery 15 to 20 years Furniture and Equipment 5 to 10 years Soft Furnishings 5 to 7 years Computers – PMS/PC hardware and software 3 to 5 years - Major systems installations Up to 10 years Motor vehicles Up to 5 years Source: British Association of Hospitality Accountants (BAHA, 2000) Even though CapEx replacement plans are not developed for tax purposes, the guidance given by the Australian Taxation Office (ATO, 2005) might be useful for the determination of expected life of assets. ATO uses the term ‘effective life’ of depreciating an asset and describes it in broad terms as follows. “Effective life of a depreciating asset is how long it can be used by any entity for a taxable purpose or for the purpose of producing exempt income, having regard to the wear and tear you reasonably expect from your expected circumstances of use and assuming reasonable levels of maintenance”. (ATO, 2003:8) In general, ATO gives two options for businesses to determine the effective life of the assets. First, organizations may determine the effective life by themselves and ATO provides guidance for this option plus suggests using the following information: • manufacturer's specifications • independent engineering information • your own past experience with similar assets
  53. 53. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201053 • the past experience of other users of similar assets • the level of repairs and maintenance commonly adopted by users of the asset • retention periods • scrapping or abandonment practices • the physical life of the asset ATO has also its own estimates of the effective lives of depreciating assets which are reflected in determinations by ATO commissioners. ATO recently issued a revised table for the effective life of depreciating assets including assets specific to the Accommodation Sector (Schedule 1, Table A). Excerpts of this table are presented below. Table 7 ‐ Effective Life of Depreciating Assets in the Accommodation Sector  Item Effective Life Audio-visual entertainment assets including 5 years (amplifiers, speakers, televisions and projection equipment) Carpets, mattresses and guestroom furniture 7 years Window blinds and curtains 6 years Bed spreads, blankets and quilts 5 years Bedding (including mattress protectors, pillows and sheets) 2 years Crockery and cutlery 4 years Glassware 2 years Hot water systems (excluding commercial boilers and piping) 10 years Source: ATO Determination, 3 June 2005 It is necessary to realize that items are not replaced according to the initial schedule (or tax office requirements) but according to when they actually fail, become damaged or worn, or when competitive conditions dictate (Beals & Denton, 2004). Hence monitoring of assets’ condition and regular up-dates of CapEx plans are necessary (Beals & Denton, 2004). In addition, the effective life of the assets is closely linked to the quality of maintenance. If an asset is well maintained, its effective age may be less than its actual age and, if an asset is not maintained properly its effective age may be less than initially estimated (Beals & Denton, 2004).
  54. 54. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201054 It is clear that the management of CapEx is a very complex process that requires a good knowledge of relevant issues and expertise. Swing suggests owners to employ an Asset Manager (1994).
  55. 55. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201055 2.9 Role of Asset Manager According to Swing (1994) the hotel sector is rapidly evolving due to technology enhancements, legal statute refinement, and new competitive requirements and many owners do not have the professional hotel expertise to handle the broad scope of demands associated with hotel assets. However, Swing highlights that investors and owners cannot rely on operators to protect their assets and suggests employing an asset manager; either internally or through an outside firm that provides specialty asset management services (1994). According to Bridge & Haast in Ransley & Ingram (2004) there are three areas where asset managers play a major role:  Product Definition – Ensure a consensus between owner and operator about hotel positioning and the volume of CapEx to maintain that position, plus the assessment of new opportunities. Achieving a balance between the needs of current and future guests, the standards of the operator and the volume of investment required to be made by the owner  Service and operating standards – Ensuring maximising of sustainable Cash Flow while at the same time maintaining the quality and character of the hotel. To challenge and support the operator to ensure that the most appropriate service and operating standards are set to support the value and of the hotel and its operating performance.  Financial Supervision – Monitoring of performance and ensuring that budgets are challenging but also achievable (Bridge & Haast in Ransley & Ingram, 2004:255-262) According to Ransley & Ingram hotel properties are typically high-value; capital- intensive assets that require concentrated management in order to generate adequate returns on the capital employed, (2000:38). “Asset management is “the process by which a property with money value is effectively controlled and managed as a business” (Ransley & Ingram, 2000:38). Ransley & Ingram, (2000:39) define the roles of asset managers and provide three main factors that contribute to the increasing role of asset managers in hospitality industry, it is:
  56. 56. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201056 - The increasing value of the property asset brought about by hospitality properties becoming larger and more complex structures requiring greater amounts of capital and being much more substantial businesses requiring integrated on-property operations - The increasing trend, begun in the USA in the late 1960, for the traditional owner/operator framework to be superseded by a structure in which the ownership of the asset is vested in one entity and while the day-to-day management of the hospitality business is carried out by third party - Increasing emphasis on financial aspects of hospitality operations and how ownership brought about by shift of focus to financial returns and away from traditional hospitality as the measure of success (and in part brought by the entry of large financial institution into hospitality ownership) Ransley & Ingram, (2000:39) According to (Beals & Denton, 2003) the CapEx process should ideally be governed through four critical activities, typically carried out by the owner or an Asset Manager acting on behalf of the owner. These activities are:  Monitoring and directing property maintenance to maintain or extend the useful life of the assets;  exercising oversight over capital budgeting and expenditures to ensure that the owner’s funds are expended judiciously;  creating an effective system (the Capital Expenditure plan) for monitoring and anticipating Capital Expenditures, enabling the owner to plan for future expenditures and thus allocate financial resources appropriately; and  strategic decision-making regarding upcoming Capital Expenditures, whether required or discretionary Source: (Beals & Denton, 2003) Ransley & Ingram (2004) suggest recognising the importance of the asset manager’s role in management agreement, especially in the case of investors who do not have direct experience in hotels. Thus, a management agreement should provide rights for an asset manger to receive budgets, reports, attend meetings and generally act as the owner’s representative (Ransley & Ingram, 2004). It is subject
  57. 57. The Hotel School Intercontinental Tourism and Hospitality Industry Project Borivoj Vokrinek 11/1/201057 to negotiation whether the fees and expenses of the asset manger will be recognised as operating expense or not (Ransley & Ingram 2004). This brings to light the relationship between owners and operators and management agreements. 2.10 Owner/Operator Relationship and Management Agreements The relationship between owner and operator is formally represented in the conditions of a management agreement. The final conditions in management agreement are the result of negotiations between owner and potential operator (Ransley & Ingram, 2000). The relative positions of the parties are given by the number and level of interest of operators in a property which is determined by the nature of the property and its location (Ransley & Ingram, 2000). In addition, the competition among operators and conditions in the particular market place has a significant impact on bargaining positions of the parties. Ransley & Ingram hold that the owner’s position is improving as the capital is in shorter supply and there are more operators than new management opportunities, especially in the locations where development opportunities are constrained by the scarcity of sites and the restrictive and complex planning legislation (2000). Eyster (1997) agrees and adds that the owners’ position is improving also due to the experience of hired third party or in-house asset managers and other experts, which is even enhanced by the active exchange and sharing of experience though associations and forums of owners and industry professionals. According to author, the only factor that offsets the bargaining power of the owners is the consolidation movement in the hospitality management sector (Eyster, 1997). The following

×