cap ex2005 australia

The Hotel School Intercontinental Tourism and Hospitality Industry Project

Borivoj Vokrinek 11/1/2010 1

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



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



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



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



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



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



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



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



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



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.



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.



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



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.



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



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



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



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



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



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.



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)



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



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



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,



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



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



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.



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



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%


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



Figure 2 below illustrates the difference in average CapEx in Full-Service hotels

and Limited-Service hotels.


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



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



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


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



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.



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.



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



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”.



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



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



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.



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



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



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



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



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.



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



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.



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.



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.



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).



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



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:



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



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



• 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).



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).



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:



- 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



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



table summarises the main focus areas of owners and operators according to

Ransley & Ingram (2000).

Table 8 – Interests of Hotel Owners and Operators

Owner Focus Operators Maximise return and long-

term asset value Objective Maximise fee and retain asset

under its long-term management control

Derived from net income after debt service

Return Derived mainly from revenue, some from gross profit

Decline in asset value (or total loss of investment)

Risk Loss on income and reputation

On refinancing of sale of asset Value Addition to the brand and ability it further spread system overhead

Source: Ransley & Ingram, 2000:47

As can be seen, the interests of both parties are not conflicting as it is suggested in

the literature; both stakeholders have a long term view in regards to hotel assets,

returns of both parties are dependent on hotels revenues and profits and both

subjects undertake risk in case the business fails (Ransley & Ingram, 2000).

However, authors of New Investment Frontier (NIF study) believe that there is a

misalignment of objectives between owners and operators due to the fact that the

operators’ future business depends on the quality and state of repair of the facility

while some owners may achieve better return when ongoings are reduced (No

Author, 2003). However, according to the NIF study (2003), the number of

investors that have experience with hotel investment is small and operators have

more power in the relationship because of their control over operations and a

better experience with hotels, especially in regards to fractioned owners.

Most of the arguments regarding the conflicting objectives of operators and

owners are based on typical conditions of management agreements (i.e. Denton,

1998; Crandell, 2002). There is a great deal of literature regarding hotel

management agreements (i.e. Schlup, 2004; Rouse, 2004, Rushmore, 2002 or



Eyster, 1997) However, it is above the scope of this literature review to address

all issues in regards to management agreement, despite the fact that most of the

issues are indirectly related to CapEx. Some of these issues, such as contract

provisions regarding budgets or asset manager, were already discussed in this

paper; hence this section will focus only on management fees and its interrelation

between CapEx and Replacement Reserve.

According to the literature (i.e. Denton, 1998; Crandell 2002, Adams, 2003) the

standard structure of management fees does not motivate operators to manage

CapEx of the property in the best interest of the owners and, it gives operators

incentives to capitalise items that would otherwise be expensed. However, the

current literature also informs about developments in fee structures that change

the situation.

Management Agreements contains two major fees; the base fee, usually based on

revenues, and an incentive fee based fee on some form of profit or return (Schlup,

2004). Rushmore (2002) informs that, in agreement negotiations, operators will

tend to base the management fees solely on the percentage of total revenues or

attempt to maximise this percentage, on the other hand, owners will try to

minimise this percentage and will attempt to base the fee solely on net income

after debt service and will require a minimum return to equity. According to

JLLH study (Haast et al., 2005), current management agreement reflect this as the

base fees have been slightly declining in recent years to current level of 1.4% of

gross revenues (in average). The study also recognises a growing trend towards

agreements with no base fee (Haast et al., 2005). However, from a CapEx

perspective, it is important that more and more management agreements base

incentive fees on adjusted Gross Operating Profit (GOP), which is the result of

deducting repairs/renewals provisions (replacement reserves) and base

management fee from the GOP (Ransley & Ingram, 2004). This is a significant

finding in regards to CapEx since in this way, the reserve for replacement reduces

MANAGEMENT FEES AND CAPEX



the operator’s income. Also the JLLH study (Haast et al., 2005) found that the

reserve for replacement may influence the incentives fees. For example, according

to the study there is an increasing number of management agreements in the USA

that structure incentive fees as a percentage of Net Operating Profit (NOP) and

after the payout of an Owners Priority Return (Haast et al., 2005). This includes

reserve for replacement since NOP is defined as “Gross Operating Profit less

incentive fees, property taxes, reserves, ground rental, owner’s costs and

insurance” (JLLH study, Haast et al., 2005:18). Also some management

agreements in the Asia Pacific region including Australia, were found to calculate

incentive fee from adjusted GOP thus deducting the reserve for replacement from

incentive fee base. However, Rushmore (2002) points out that if an incentive fee

is calculated on the basis of NOP (or adjusted GOP) then the part of reserve for

replacement is actually funded by the operator. This brings this literature review

back to ‘Replacement Reserve’.

Even though the literature regarding replacement reserve has already been

discussed in this paper, there are still some issues that are related to management

agreements and have not been mentioned yet.

According to Rushmore (2002), the operator will typically require the

establishment of a replacement reserve (in particular FF&E reserve) as large as

possible whereas owners will more likely agree on a reserve funded on an “as-

needed” basis. However, Rouse (2004) argues that management companies

actually do not want to see high escrow percentage for replacement reserves in the

agreements since the sum of funds transferred into this sinking fund reduce the

operators’ incentive fees. This clearly illustrates how the provisions regarding

management fees and replacement reserves are interlinked. In addition, both

Rouse (2004) and Rushmore (2002) underline that this issue may become

important when the agreement is terminated. Rouse informs that operators may

claim part of the replacement reserve that has reduced their incentive fees (2004).

Rose argues that owners should resist this claim and include in their management

agreements with operators, a provision stating that any balance remaining in the

REPLACEMENT RESERVE AND MANAGEMENT FEES



replacement reserve account, at the end of the contract, should be transferred to

the owner. On the other hand, according to Rushmore’s example of management

contract, any remaining amounts on the reserve should be added to total revenues

when computing incentive fees in the year of management agreement termination

(2002). It seems that there are different opinions in regards to provisions in

management contract and that this area is still evolving.

Rushmore (2002) provides a complex example of management contract with

several alternative provisions, including provisions regarding replacement

reserves. These provisions include alternative methods of reserve funding,

provisions for the establishment of not only FF&E Reserve but also Reserve for

Structural Repairs, provisions specifying the use of the fund by operator and

clause about CapEx funding in case on insufficient reserves. The relevant parts of

this sample can be seen in Appendix 4. Rushmore (2002) also calls attention to

detailed FF&E definition in management agreements since it needs to be clear

what items should be funded from FF&E Reserve – the sample definition is also

provided in Appendix 4.

The management of CapEx and the relationship between operator and owner may

become a very complex issue in situations where ownership is fractioned like in

the case of Strata or Condo hotels.



2.11 New trends in hotel ownership and development

Many hotels developments in Australia in recent years are strata title or condo

hotels. As already stated, Strata titled and condo hotels are a very complex issue

especially in terms of legal rights and responsibilities of all stakeholders involved.

However, due to the limited scope of this paper, only a brief overview of literature

regarding CapEx and strata and condo hotels will be provided.

More and more hotels, motels and especially service apartments are managed

under ‘management rights scheme’ (McCarthy. 2005). According to The

Australian Securities and Investments Commission (ASIC) “a management rights

scheme is an arrangement under which the owners of strata units in a hotel, motel

or serviced apartment complex make their units available to an operator who

conducts a letting service. Each strata unit owner is entitled to a share of the

income earned by the operator in letting out all the participating strata units”

(AISC, 2004:1). Batchelor (in McCarthy, 2005) highlights the major difference

between traditional hotels and serviced or holiday apartments based on Strata title.

According to the author, whilst hotels are typically managed through management

agreement between operator and single owner, the strata service apartments or

holidays apartment facilities are based on letting agreements signed with many

individual unit owners – all of whom have different financial expectations and

capacities (McCarthy, 2005). In addition, Gibson in McCarthy (2005) informs

that many strata-titled holiday apartment facilities do not have established FF&E

reserve and it is up to individual owners to upkeep, repair and refurbish their

units. This leads to problems with consistency in standards across the facility

(McCarthy, 2005). However, Batchelor (in McCarthy, 2005) also informs that the

situation is improving with branded operators that are entering this sector and are

requiring individual owners to contribute to FF&E reserve. However, it needs to

be stated that ASIC just recently (July 2004) released a new ruling that enables



operators to hold payments from investors on trust to repair, replace and refurbish

the investors’ service apartments. The new rule (order) has three conditions:

Payments into each investor's Fund do not exceed 3 per cent of gross

scheme revenue attributable to the investor;

The balance of each investor's Fund does not exceed $5000 for each

strata unit made available by the investor for use in the scheme; and

Each investor's Fund is audited annually.

In regards to Strata title, the FF&E Reserve needs to be distinguished from the

sinking fund as required by Australian law. According to the Office of Fair

Trading sinking fund covers common areas and is established for “necessary

long-term future expenditures such as painting and replacement of guttering

fencing” (OFT, 2003:8). Interesting point is that this sinking fund is not

refundable even when the owner decides to move out of strata scheme (OFT,

2003).

Herthel (2003) provides an overview of Condo, Fractional and Timeshare hotel

products and describes hotel-condominium as a project where the developer

“condominumizes” a hotel and sells fee interests in the individual hotel rooms to

purchasers who consequently enter into agreement with developer (or manager of

the project) to rent out their units. On the other hand,

Time-share product provides to individual purchasers the exclusive use of

accommodation unit within the property for a particular number of days each

year.

A similar product is the Fractional Interest Product that involves the creation of

long term exclusive rights to use real property for short-term recurrent fixed or

floating periods. According to Herthel, especially fractional product is currently a

high growth segment of the lodging and leisure industry.



In addition Herthel (2003) provides an overview of mixed-use hotels. According

to author, this product represents an increasing trend within hospitality industry

projects and includes a hotel component, fractional or timeshare component and

sometimes also a residential component (Herthel, 2003). The issues with all these

ownership forms stated above are very complex, especially in regards to mixed-

use hotels, and it is above the scope of this paper to analyse it. However it is

important to realise that with these types of projects CapEx management is

becoming even more difficult due to:

The high number of subjects involved (developer, condominium owners,

fractional owners, owners associations and other representative bodies,

operator) and,

The different objectives and expectation of these subjects.

(Herthel, 2003)



3 RESEARCH DESIGN AND METHODS

The broad objective of this pilot study is to explore issues related to CapEx from

the perspective of different stakeholders and to establish a base for further

qualitative research. Thus, the study is based on qualitative research method since

this approach is appropriate in situations where the researcher needs to first

identify the variables that might later be tested quantitatively, or where the

researcher has determined that quantitative measures cannot adequately describe

or interpret a situation (Strauss & Corbin, 1990). In addition, qualitative research

is used to better understand any phenomenon about which little is yet known or to

gain new perspectives on things about which much is already known, or to gain

more in-depth information that may be difficult to convey quantitatively (Strauss

& Corbin, 1990). This research is, in particular, based on the thorough review of

available literature and interviews with different stakeholders using open-ended

questions that will support the discovery of new information.

The research was realised individually by the author of this paper. However, it

was supported by HVS International - Sydney, which is a leading consultancy

firm in the hospitality sector (for information about the author of this paper, HVS

International and supervisors of the research see appendix 5 - ‘About the Author’

and ‘HVS International, Sydney’). From an academic perspective, Paul Weeks

from the Hotel School Intercontinental - Sydney, supervised the research.

General Characteristics of the research



As already indicated, the study is based on both; primary and secondary data. The

primary data were derived from interviews with industry practitioners. However,

first a thorough review of relevant literature was undertaken and available

secondary data were gathered. This was conducted, as Doyle (2004) suggests it, to

gain a command of the relevant topic area and the associated terminology hence

to have a better idea in advance of what information is necessary and to be able

think fast during the interviews in order to adjust questions depending on what the

interviewees say.

An in-depth qualitative interview was selected as a primary data collection

method. This method was employed since this type of interview is very flexible

and exploratory tool that allow interviewer to adjust later questions depending on

how the interviewee answers earlier questions in order to clarify the responses, to

follow promising new lines of inquiry, or to probe for more details (Doyle, 2004).

The interviews were based on predefined open-ended questions although a further

open discussion was encouraged (The initial interview plan with broad topics can

be seen in Appendix 6). Furthermore, to ensure the final high understanding and

the depth of interviews, a procedure of ‘constant comparative analysis’ was

applied. This is a process whereby data collection and data analysis occur on an

ongoing basis (Doyle, 2004). The first interview was unstructured and analyzed

before the next interview was taken and all the interesting findings were

incorporated into the next interview. This process was repeated with each

interview. In regards to this technique, it is important to note that the different

categories of stakeholders (i.e. owner, operator) were deliberately alternated to

ensure that different points of views are reflected in the questions/topics raised in

the subsequent interviews. The objective of this continuous fine-tuning was to

graduate the understanding of the issues based on the principle that more specific

questions and sophisticated discussions should consequently lead to a deeper

understanding of the issues with higher quality of the research outcomes.

Interviews

RESEARCH DESIGN



Eventhough the interviews were open and flexible, there were four major parts in

their structure; Introduction & Interviewee Background, General Issues,

Hypothesises and Research Feadback. Thus the interview followed advice by

Doyle (2004) who suggests to start qualitative interviews with the investigation of

the background of the interviewee then adress general issues and consequently

proceed towards more specific areas. In regards to ‘Research Feadback’, the

interviewees were asked at the end of the interview whether and how this research

will be valuabe for them and what areas they would prefer to be researched

further. In addition, the respondents were asked whether they felt that the

interview was biased in any way or that the interviewer was giving them leading

questions. This enabled the researcher to improve and maintain the neutrality of

the interview which is evidenced by the fact that only the first interviewee had the

feeling that the interview was not absolutely neutral and that it was “pro-operator”

oriented. The interviews were documented via handwritten notes since audio tape

recording would have had a negative impact on the desired atmosphere of trust

and comfort.



To reduce general doubts regarding validity and credibility that are typically

connected with a qualitative research a ‘maximum variation sampling’ technique

was employed. This technique does not require a high number of respondents but

seeks the highest possible variety of opinions (Doyle, 2004). Thus, to minimise

room for criticizim for only interviewing people whose opinions fit with the

expectation of the researcher, the interviews were conducted with as many

categories of stakeholders involved in CapEx as possible. The following table

provides a list of interviewee categories in chronological order, as they were

interviewed.

Table 9 – List of Categories of Interviewed Stakeholders (in chronological order) Interview No. Category

1 Legal 2 Asset Management 3 Operator* 4 Lender (Bank) 5 Owner** 6 Operator* 7 Owner 8 Operator*

* the operator also owns some hotels, but main purpose of the business is operating of hotels ** the owner also operates some hotels but main purpose of the business real estate investment including hotels

The interviews were arranged by HVS International and the interviewees were

selected based on the perceived knowledge of the CapEx issues, the probability

that a practitioner will participate in the study and location in Sydney. Thus, the

study sample was chosen by a non-random convenience sample approach which

is based on the proximity to the researcher and the ease with which the researcher

can access the participants (Jennings, 2001). It also needs to be stated that the

focus was on major players in the Australian hospitality industry. All interviewees

together had more than 144 years of experience in hospitality industry which

means 18 years per interviewee. In addition, the participants together have been

involved with more than 520 hotels in their work experience, which is 65 hotels

Study Sample



per interviewee in average. The following table provides further details about job

titles, expertise and association membership of the interviewees.

Table 10 – Job Titles, Associations/Membership and Expertise of Interviewees (in alphabetical order)

Job Titles Associations /

Membership Expertise

Asset Manager Accounting 3x Associate Director Director of Asset

Management & Analysis

Director of Valuations

General Manager Hotel & Portfolio

Manager Managing Director Operations Group

General Manager Special Counsel

Institute of Chartered

Accountants in Australia 3x

Property Council 2x Tourism Task Force The Cornell Hotel

Society (CHS) The Royal Institution

of Chartered Surveyors (MRICS)

British Association of Hospitality Accountants (ABHA)

Acquisition/merges Asset Management 2x Feasibility studies Finance/Controlling 3x Hotel Operations/ Management 3x Investment Banking Legal - Hotel Development Legal - Hotel transactions Legal - Management

agreement negotiation Renovation/refurbishment Repositioning Hotel Valuation Yield Management

Data were analyzed utilizing "open coding" and “axial coding" techniques. Open

coding is based on the initial identification of themes emerging from the raw data

and grouping them into categories (Hoepfl, 1997). The goal was to create

descriptive, multi-dimensional categories which formed a preliminary framework

for analysis. As Hoepfl (1997) suggests, words and phrases that appeared to be

similar were grouped into categories that were gradually modified or replaced

during the subsequent stages of analysis that followed. A scheme for identifying

the data according to their speaker and the context was also developed. To

maintain anonymity, each interviewee was assigned a name based on his/her

category and the chronological order of his/her interview, for example; ‘first

operator’, ‘second operator’ and ‘third operator’ or ‘first owner’ and ‘second

owner’. Hoepfl (1997) recommends to apply this type of scheme so that the

researcher can use "voice" in the text, that is, quote participant to illustrate the

themes being described while maintaining their anonymity. The next stage of



analysis involved re-examination of the identified categories in open coding to

determine how they are linked. The discrete categories were compared and

combined in several possible ways as the "big picture" became clearer. Hoepfl

(1997) calls this complex process "axial coding". As the author suggests, the

purpose of this coding is not only to describe but, more importantly, to develop a

new understanding of a phenomenon of interest (Hoepfl, 1997). This was then

translated in into the “story line” – a report that “closely approximates the reality

it represents" (Strauss and Corbin, 1990: 57). The report follows after this section.

The research and interviews were designed with high consideration to ethical

issues. The "informed consent" was obtained from each interviewee. All

participants in the study received full research proposal a minimum of two weeks

before the scheduled interview including proposed topics to be discussed. In

addition, participants were informed once more during the introductory part of the

interview about the purpose of the study, the procedures that will be followed, and

the uses of the interview data. As Doyle (2004) suggests, participants were also

informed of their basic rights, including the fact that they may refuse to answer

any particular questions if they wish and that they may withdraw their consent at

any time even after the interview. Furthermore, the interviewees were ensured of

the confidentiality and anonymity of the information provided to encourage the

openness of the responses and the discussion. Finally, the first draft of this paper

will be sent to all participants for comments to not only ensure that the paper

approximates the reality it represents but also to obtain feedback and additional

comments hence improve the final paper.

Ethical Considerations



4 INTERVIEW FINDINGS AND DISCUSSION

First of all it needs to be stated that the interviewees made a great variety of

interesting points and raised many issues that led to further questions which

consequently explored another issues. It is clear that CapEx is a very complex

topic which is directly or indirectly linked to almost everything related to hotels.

Unfortunately this makes it very difficult to comprehend in a single study. Hence,

the most frequently raised and the most interesting issues will be discussed. The

first part of this section will address the broad but significant matters. Then the

attention will be paid to objectives of different stakeholders and provisions for

CapEx that are used or recommended by the participants. Finally, factors that

according to interviews affect CapEx and are important for further research will

be examined.



4.1 Main Issues in regards to CapEx

One of the objectives of this study is to explore the issues regarding CapEx hence

the first question asked during the interviews was simple: What are the main

issues? The table below summarises answers to this open question. (Number ‘1’

means that issue was raised as first after the question, ‘2’ means that issue was

raised as second and so forth. Negative number ‘-1’ means that not only the

issues was not raised but when asked, respondent rejected the issue as significant.

Interviewee cat./

issues Legal Asset

Mng. 1st

Operator Lender 1st

Owner 2nd

Operator 2nd

Owner 3rd

Operator

Problems with funds allocation/Quantifying return on CapEx/CapEx Justification/

3 2 3 1 1

No/insufficient return on CapEx 2 1 2 2 Underestimation of CapEx by stakeholders 2 1 2 2

Getting the money 1

Conflicting Objectives: Operator vs. Owner 1 3

Benchmarking of CapEx 1 Brand Standards and CapEx 3

Definition of CapEx 1 -1 0 -1 -1 -1 3 As can be seen the most frequently mentioned issue was related to the difficulties

with the determination of return on CapEx or the justification of CapEx to obtain

funds. The second frequently raised issue seems to be similar but there is a

significant difference. According to some respondents, there is not only a problem

with the quantification of return on CapEx but there is also a problem with

ultimately inadequate returns on some CapEx. In other words, respondents argued

that there is a difference between what stakeholders would like to, and what is

actually financially viable. In terms of the third issue, respondents believed that

many stakeholders involved in hospitality industry do underestimate CapEx in



terms of true financial requirements to maintain a hotel’s competitiveness. This

has significant consequences as will be discussed below. As for the other issues,

only two interviewees mentioned conflicting objectives between owners and

operators. One owner also highlighted the issues of CapEx benchmarking and

brand standards. Finally, only one respondent (an asset manager) pointed out the

problem with CapEx definition.

It is important to understand that the table above lists only issues that were stated

by the interviewees as an answer to the first question. However, some respondents

related to some of these issues later during the interview, even though they did not

mentioned it initially, or some new issues were also explored. However, it is

assumed that the issues in the table above are major problems since they came

into the respondents minds immediately after the question. The first three issues

should be especially considered as credible findings since they were raised across

the spectrum of stakeholders. These issues will be now discussed in further detail.

This issue is actually a group of issues that were grouped together for their

similarity, since all revolve around the difficulty with quantifying outcomes of

CapEx and their prioritising. As can be seen from the table above, this issue was

the most significant for the operators. This is not surprising since it is usually the

operator who is expected to justify proposed expenditures to the owners. All

operators talked about the difficulties to find the best CapEx allocation of limited

funds due to large scale of options, limited time and, the problems with the

calculation of returns for certain types of CapEx, such as design upgrades. The

‘second owner’ also pointed out the unpredictability of some CapEx. In effect, all

interviewees argued that there are some CapEx with no positive return and the

return must be calculated by determining how much can be lost (from the

existing returns) if the expenditure is not realised; for example replacement of

out-dated furniture. However, according to respondents, this is also difficult to

Problems with the funds’ allocation, quantifying return on CapEx and CapEx Justification



estimate since it is influenced by many factors. For example, both owners as well

as some operators admitted that “if the market is strong you can get away without

it” (‘First Owner’, 2005), meaning that if the demand is high the customers will

stay in the hotel anyway, even without refurbishment, thus the owners do not see

the return. This confirms the trend towards increasing the emphasis on financial

performance away from traditional hospitality as the measure of success as

identified by Ransley & Ingram (2000). However, it must be stated that all

respondents also underlined that there are CapEx that are understood as “must be

done”, such as CapEx necessary to comply with safety regulations. The following

table provides examples of some CapEx categories as used by the three

interviewees.

Table 11 – CapEx Categories used by interviewees

Asset Manger 2nd Operator 3rd Operator 1) Safety of guest and

employees 2) Legal 3) Revenue Generation or

Expense Reduction (calculate return)

4) ‘Nice to Have’ 5) ‘Just not Doing It’

1) Legal & Safety (we do not calculate ROI)

2) Profit Maintenance alias "If You Don't You Loose"

3) Revenue Generating CapEx ("we try to spend minimum 60% of budget on those")

1) Regulation/Legal/H&S 2) CapEx necessary to

maintain guest experience

3) CapEx Increasing Returns

Even though it was not the purpose of this study, the respondents were asked

what capital budgeting method they usually use. It is worth noting that the most

frequent technique was NPV and IRR but the respondents had difficulty

determining cash inflows (or savings) as results of several CapEx. This has

interesting links to the literature. It confirms Philips’ (2003) findings regarding

the difficulties hoteliers have with performing post-investment appraisals of

CapEx. However, in terms of pre-investment appraisals, it seems that despite the

fact that many researchers (i.e. Damito & Schimdgall, 2003; Eyster & Geller,

1981) have studied the usage of various capital budgeting techniques in the

hospitality industry, the problem related to the quantification of future CapEx



outcomes have been overlooked with attention being paid predominantly to the

type of the technique used, assuming that future benefits can be estimated. In

addition, based on the interviews, it seems that stakeholders are not concerned

too much about whether the expenditure is increasing the flow of economic

benefits or not, to classify it as CapEx. This is surprising given the view of a

number of authors discussing this issue in the literature.

These issues are very closely related with the previous problem but, as already

stated, there is an important difference that makes it worth discussing separately.

According to ‘Lender’ (a bank representative involved in lending to hotels) the

biggest issue in regards to CapEx is that “you can never spend that much money

that you need/want, it is not feasible commercially…there is not sufficient return

on investment” (‘Lender’, 2005). Also ‘Second Operator’ (2005) stated that “it is

difficult to match the owners’ expectations and do what needs to be done to

satisfy customers“. In general, this suggests that not only it is difficult to

quantify some CapEx, but that there are also CapEx required by the demand but

not acceptable for the owners/investors. This is reflected in the operators’

comments during the interviews pointing out that one of the major CapEx issues

is to “get the right amount of money at the right time” or that “most hotel owners

do not spend enough on CapEx.” The ‘Third Operator’ mentioned his experience

with owners who had short-term investment horizons and for whom the returns

on many, typically long-term CapEx, were understandably unviable; in his point

of view.

However, the findings indicate that there is an ultimate conflict between owners’

and costumers’ desires which can adversely affect other stakeholders such as

operators who are in the middle. Hence, it might be valuable for all stakeholders

to research what are the causes and possible cures to these mismatching

expectations. It seems that this might lead to the issue of the underestimation of

the true CapEx needs by investors as indicated in the literature as well as by the

No/insufficient return on CapEx and getting the money



respondents. On the other hand, someone may argue that the overgrowing

customers’ expectations are fed on intensified competition among brands/hotel

chains that are promising to their customers more than investors are willing to

fund, as pointed out by Higley (2003).

According to four interviewees the major issue in regards to CapEx is that many

stakeholders do not realise true capital needs of hotels. Indeed, all stakeholders

have mentioned this issue at least once during the course of the interviews and

usually stressed it as a problem. Most of the respondents claimed that many

stakeholders believe that 3-4% of gross revenues should be enough to cover

CapEx in hotels in the long-term; however, the respondents themselves also

acknowledged that it is perhaps not enough. Owners, especially, had higher

perceptions about true CapEx in hotels. Both owners stated that CapEx are about

6% of gross revenues (as ain long-term average). Other interviewed stakeholders

believed that it is slightly less, about 4-5% with exception of one operator who

stated that it should be about 6% and that it includes only soft refurbishment and

replacement without major refurbishments and replacements. Both owners based

their statements on their experience. “Second Owner” even provided ten-years

data for CapEx in six owned properties. These data were used to develop the

Figure 7 below.

Underestimation of CapEx



Figure 7 – Combined CapEx spending as a % of gross revenues; 6 hotels over 10 years (Australia)

The long-term combined average for all six properties (over ten years) is 6.2% of

the total revenues (6.2% Line) which is twice more than 3.1% which is the

average fee level for FF&R reserve as found in the management agreement survey

across Asia Pacific including Australia (John LaSalle Hotels study, Haast et al.,

2005). Furthermore, as can be seen, CapEx fluctuate significantly within the years

and may rise up to 15% of gross revenues. However, it has to be kept in mind that

the graph represents relatively small sample of up-market hotels that are owned

by the same company. More importantly, the data represent all CapEx including

major renovations of hotels that were as high as 77% of total annual revenues for

a particular property. In addition, it also includes the CapEx spent on increasing

generating capacities of hotels, such as gaming machines. Thus the findings need

to be taken with considerations. However, the graph illustrates that CapEx may be

significantly higher than 3-4% of gross revenues that are formally considered as

standard for the industry. Based on the literature and interviews it seems that

there are two reasons for such as formal underestimation; ‘lack of experience’ and

‘lack of support for alternatives.’



The results from interviews may sound like an oxymoron since if all the

participants that represent the different categories of stakeholders are aware that

CapEx are probably underestimated, then the question is; who then

underestimates it and why? What needs to be remembered is that the interviewees

were highly experienced representatives of major players in the hospitality

industry, thus the study does not cover all spectrum of stakeholders involved in

this sector. Indeed, according to the interviewees, there are subjects even within

their category lines that do not realise true CapEx needs of hotels, although the

respondents felt that the situation is improving. Worth noting is that the

interviewees did not agree with the literature on the point that many institutional

owners do not understand hotels. For example according to ‘legal representative’

(2005) “institutionalised investors usually have very good knowledge, they have

experts and departments specialising in the hospitality sector…they might not

know the figures but they will employ experts to find out.” On the other hand,

some wealthy individuals or ‘new players’ on the market and especially fractional

owners were considered as less aware of the real CapEx requirements.

In regards to fractioned owners of strata titled units in hotels, resorts and serviced

apartments, the respondents predicted that this may become a serious issue as now

aging properties will soon require major renovations. Respondents pointed out

that many of “M&Ds“ (Mums and Dads) that typically invest in strata schemes

projects might not be prepared to provide funds above those in replacement

reserves and levies. It needs to be reminded that in the case of serviced strata

schemes ASIC limits the funds that can be retained from revenues by maximum

3% of gross scheme revenue attributable to the investor and maximum $5000 per

each strata unit. This, as already discussed, might not be sufficient to cover all

CapEx, however many M&Ds do not know it, hence, they might be unpleasantly

surprised. For example ‘First Operator’ shared his experience with strata owners

saying that these individuals “are less knowledgeable and they do not read

contracts carefully…yes there have been developers who exploited low awareness

Lack of Experience



among strata owners, but it is also the investors’ own mistake, they make

significant investments and they have a responsibility to make sure that they

understand everything…part of the responsibility is also on investors’ valuers and

lawyers and lenders, they should inform their clients about this issue”. ‘Legal

Representative’ also argued that strata owners of hotels and resorts do not realise

potential problems with CapEx; according to him “strata management contracts

are usually very long complex documents, and somewhere inside, hidden on page

50, there is a percentage…there also will be forecast including CapEx but it might

not be exact.” The interviewee believed that “strata developments/contracts are

recipes for disaster, owners are locked, some developers want to get as much as

possible, get operator in, wash their hands and move to another project”. A quick

review of two prospectuses for strata hotel projects that can be found on the

Internet suggests that not all developers specifically inform the potential investors

that costs related to refurbishment, repairs and maintenance of the unit will

probably be above 3-4% of gross revenues that are put aside in the reserve. For

example, one of the prospectuses diplomatically informs investors that in regards

to provisions for refurbishment, repairs and maintenance “a portion of the income

which would, in normal circumstances be distributed to owners will be retained

within the managed investment for future refurbishment. This should help

eliminating the need for special levies in the future and will help maintain the

quality of your apartment and the complex in general”. The portion was set at 4%

of room revenues in year five and each year thereafter (the source is not

provided due to legal and ethical considerations).

It seems that it might be interesting and useful to conduct study that would

research and promote awareness of CapEx issues among strata owners and their

retrospective experience.



Again there are two sub-factors that contribute to status quo in terms of CapEx

being formally perceived somewhere around 3-4%. First, there seems to be a lack

of supporting data about real CapEx. Second, there is lack of motivation for

pursuing change.

As the literature review revealed, the majority of market studies focused on

budgeting techniques and reserves. The only comprehensive quantitative CapEx

study that was found, the CapEx2000, was conducted by ISHC in USA. However,

even this extensive study is careful with the ultimate statements and warns that

the findings are just “a broad-brush tool, not an appropriate figure for any specific

hotel per se” (Mellen et al., 2000:7). In addition, if there are available data, they

may be inexact due to problems with record keeping as argued by (Berg &

Skinner, 1995) who also add that some owners (usually private owners) try to

expense (as opposed to capitalise) as many items as possible, thus reducing

documented CapEx.

As for Australia particularly, the author of this paper could not find any

quantitative research or even published individual case study that analysed CapEx

spending in Australian hotels. Furthermore, real CapEx spending in hotels does

not seem to be a topic covered in Australian periodicals, and ABS does not

disclose separate CapEx data for the Accommodation Sub-Division. Thus, it is

not surprising that new players entering the market and M&Ds may base their

estimates and expectations on traditional standards for reserves in management

agreements. Also the ISHC CapEx2000 study finds that the reserves for

replacement and CapEx are sometimes perceived to be synonymous terms despite

their significant difference. It is also not surprising that major players, that have

many years of experience in the industry, are relatively well aware of true CapEx

needs since they have access to their internal data. However, interesting is why

there is no pressure for enhancement of CapEx awareness across the whole sector.

Lack of Support for Alternatives



Based on literature review and the interviews, it seems that there are factors for

the recognition of real CapEx spending in hotels as well as against, especially in

terms of its increase. Some of the factors that may work against the recognition of

higher CapEx levels have been already provided in the literature review. These

are:

There is a fear that “hotel lenders and/or operators would ultimately

mandate that more money be set aside (in the form of reserves) to fund

CapEx, which would in turn impact an equity investor’s return on

investment.” ISHC study CapEx2000 (Mellen et al., 2000:2)

Recognising the true CapEx level reduces the value of existing hotels, and

as result, CapEx is often hidden (Berg & Skinner, 1995)

Recognising the true costs of CapEx raises the feasibility threshold for

new hotel development, making financing and developing hotels more

difficult. (Berg & Skinner, 1995)

Appraisers fear the loss of clients if they report a lower hotel value by

recognising the cost of CapEx (Berg & Skinner, 1995)

Similar arguments were stated during the interviews. For example:

“If CapEx would be seen higher, for example as 6-7% of revenues, it

would kill the hotel industry, there is no return on it” (‘Lender’, 2005)

“…the operators will not go higher, they do not want to scare owners”

(First Operator, 2005)

“ ..in a way we like discrepancies on the market, it gives us advantage”

(‘First Owner/Investor’, 2005)

When market underestimates CapEx; “it is advantageous when selling

hotel” (‘Second Owner/Investor’)

On the other hand, there are some serious arguments that support the recognition

of the true level of CapEx in the hotels. For example, the authors of ISHC study

CapEx2000 argue the “the truth will set us free”, meaning, that if the real cost of

Lack of motivation for pursuing change



owning hotel property is established, then the yields to be earned on this

investment can be predicted with greater accuracy which should consequently

attract more capital to the industry (Mellen et al., 2000:2-3). The authors build on

arguments by Kirby (1999) who, in brief, points out that even though the costs of

owning real estate property would be found higher than it had been assumed and

the market would recognise it, the attractiveness for the investors should be at

least maintained due to reduced risk. In other words, the investors should require

a lower return, in return for less risk. This brings the issue into the area of

financial theories such as the ‘risk/return trade-off’ concept or ‘Efficient market

hypothesis’ (EMH), which is above the scope of this paper. However, it might be

an interesting area for further research.

However, it needs to be added that both interviewed owners admitted that the

underestimation of CapEx can be disadvantageous, especially in regards to the

tenders for hotel properties when less knowledgeable bidders typically do not

factor-in enough for CapEx in their bids, thus pushing the purchase prices

unreasonably high.

Other undesired consequences that were pointed out during the interviews was the

bad image that the underestimation of CapEx may create for the whole industry.

For example, the ‘Legal representative’ noted that ‘new players’, large investors,

who entered the industry with relatively high expectations which consequently led

to higher dissatisfaction when the return did match the targets. Poor image of

timesharing that was caused partially by poor information misleading/not

informing individual investors regarding real CapEx needs was also highlighted

by the respondents. In addition, there is obvious benefit for operators since there

would be fewer arguments with owners if the CapEx were seen realistically across

the industry which could consequently lead to the increased satisfaction of the

customers.



It is clear that there are conflicting forces in regards to the recognition of the true

value of CapEx. However, it needs to be emphasised that the arguments above are

not provided to establish that true CapEx are actually higher then it is believed,

especially since there seems to be heterogeneity among stakeholders about what is

actually believed. In effect, the author of this paper agrees with the authors ISHC

CapEx2000 studies (Mellen et al., 2000) who argue that there are too many

factors that affect true CapEx to consider any average to be applicable for

individual property at a particular time. Neither the author of this paper wants to

suggest that more funds should be set aside for the replacement reserve since this

is a different issue. These two subjects, factors affecting CapEx and replacement

reserve, will be discussed in the next section. Also the other issues, conflicting

objectives between operators and owners, CapEx benchmarking, brand standards

and CapEx definition, will be examined within this part, since these issues are

related to these subjects.



4.2 Factors shaping CapEx

This study pays high attention to the factors that influence CapEx since it is

important for understanding of the issues and it needs to be considered in future

quantitative research. To illustrate how CapEx may vary between different

properties, individual lines of CapEx spending were added to the graph that was

already provided on page 76 – Figure 7. As can be seen below, the volatility of

CapEx spending by individual property, on time, is very high.

Figure 8 – Graph of CapEx as % of total revenues, 6 properties over 10 years Australia

The average CapEx for individual property over 10 years ranged from 4.5%-

11.7%. However it has to be reminded that this is a relatively small sample of the

4-5 star hotels, and that it includes not only replacement of FF&E but also the

revenue increasing CapEx as well as major renovations. As can be seen from the

graph and the table below, this significantly squeezes the combined average.



Table 12 – CapEx as percentage of revenues; individual averages over 10 year (6 properties, Australia)

Property Average over 10 years 4-star hotel I. 4.5% 4-star hotel II. 4.5% 4/5-star hotel I. 6.1% 4/5-star hotel II. 6.3% 5-star hotel I. 11.7% 5-star hotel II. 4.1% Combined Average 6.2%

However, it is not the purpose of this study to quantify CapEx needs for hotels.

Nevertheless, the data illustrates how significantly CapEx may vary in time. For

example, even though 10-years’ cumulative average for both 4-star properties is

similar (4.5% of gross revenues), the CapEx spending of ‘4-star hotel I.’ was

relatively stable over the whole 10 years period whereas ‘4-star hotel II.’

undertook major refurbishment in 2001/02 with CapEx above 11% of the

revenues. This highlights that there are property specific factors that influence

real CapEx spending. The following table summarises the factors that were

identified and discussed in the literature review.

Table 13 – Summary of Factors influencing CapEx spending based on the literature review Less dynamic factors More dynamic factors Geographical Location Occupancy Construction Competition Ultimate age of the property Owners financial resources Stage in the life cycle of the property Costumers Expectations (i.e. fashion, trends) Hotel Type Events Technology Difference in Local Cost Factor

Segmentation strategy Brand

Philosophy and strategic operating approach

Ownership Structure Economics Government Incentives Broad Tourism Demand & Business environment



The table above divides the factors based on their ‘tendency to change’ (more/less

dynamic) as perceived by the author of this paper. Interestingly, it seems that the

impact of the events on CapEx is especially significant, since the combined

CapEx for six properties, as provided above, were relatively high before year

2000 (Sydney Olympic Games) and then dropped below 3% level. This is

confirmed by the development of total CapEx for the whole statistical division

‘Accommodation, Cafes and Restaurants’ as recorded by ABS (Australian Bureau

of Statistics). The graph based on ABS CapEx data is provided below.

Source: ABS 2005

Figure 9 – Accommodation, Cafes and Restaurants; CapEx Actual Expenditure in Current Prices 1996 – 2005 ($ Millions)



Many of the factors stated above were confirmed also by the interviewees when

asked; “What factors influence CapEx?” The answers are listed below.

Table 14 – Factors shaping CapEx spending as identified by the interviewees

FACTORS Total

Frequency Average Position

Competition 5 2.8 Return on particular CapEx 5 3.0 Market 4 1.7 Legal/Regulations changes 4 3.0 Age of the facility/equipment 3 1.5 Technology Changes 3 2.5 Physical Condition of the hotel 3 3.5 Type of the Owner 2 2.5 Opportunity for Expansion/additional revenue generation 2 3.5 Hotel Type (full-service/limited service; B&B, Resort...) 2 4.0 Owners overall business situation 2 6.5 Owner's investment objectives (short term/long term, image)

1 1.0

Cost of Capital 1 1.0 Bargaining Position of Owner/Operator 1 1.0 Brand Standard 1 2.0 Economic Situation 1 3.0 Economic Life Cycle of the Hotel 1 4.0 Stylistic Changes 1 5.0 Hotel Positioning/brand 1 5.0 Total value/amount (of particular CapEx) 1 6.0 Trust/Relationship between owner/operator 1 8.0 Investor’s managers (agency factor) 1 N/A Hotel Management - Top Managers (agency factor) 1 N/A

Total Frequency = how many respondents mentioned the factor, Average position = in what order

It is clear that CapEx spending may be influenced by many internal and external

factors. This partially explains difficulties in determining the applicable averages

for the industry, the sector or the hotel type/class.



In terms of the major impact and trends, the sample was too small to make

judgements but the interviewees confirmed the shift towards a strong financial

focus as indicated in the literature review but respondents also pointed out that

image still may play the role in the decision making process of some owners and

investors (i.e. trophy hotels). Noteworthy, the interviewed operators also

emphasised the importance of competitors in the particular market and argued

that, in terms of CapEx spending, hotels must react to the actions of their

competitors and “pick up the market” (First Operator).

Interestingly, it was suggested that several factors that have been identified above

may vary by country or specific location. For example, legal/regulation changes,

cost of capital or the intensity of competition may be very different in USA as

compared to Australia. This is an interesting finding since it suggests that CapEx

averages and standards established abroad (i.e. in USA), are not applicable in

Australia. Thus, the interviewees were asked whether there is something specific

for Australia in terms of CapEx. Some of the respondents believed that there is

and pointed out the different costs levels, small sized market with tougher

competition and more corporate owners. However, most of the respondents were

either neutral (due to limited experience with other markets) or argued that there

is not any common ‘Australian’ uniqueness related to CapEx since there is too

high heterogeneity across local markets within Australia. This brings to light the

issue of benchmarking of CapEx spending as percentage of revenues, since

revenues (more specifically RevPAR) can vary significantly by location.

According to ISHC CapEx2000 study, estimating CapEx as a percentage of total

revenues is, simplistic but the most reliable measure which can be consistently

utilised within the industry (Mellen et al., 2000). Also one of the interviewed

operators strongly emphasised that cost must be measured in relation to revenues

since it reflect the commercial aspect of CapEx and the business. On the other

hand, Denton (1998) argues that revenues and CapEx are not correlated thus it

should not be used for CapEx planning. Also one of the owners interviewed for

Difference between international markets and CapEx

CapEx benchmarking



this study had strong opinions regarding this benchmarking practice. In

particular, ’Second Owner’ argued that “it is ridiculous” and gave example of

three hotel brands of same hotel chain (3-star, 4-star and 5-star) that have very

different revenues per room but quite similar replacement costs. The interviewee

made a point that all three brands have the same type of bed thus same cost of

replacement of these important FF&E items. The interviewee suggested

measuring CapEx as a percentage of the initial value of the property, in respective

of the original value of the items or group of items such as FF&E. In addition, the

interviewee stated that the CapEx standards are based on US conditions and that

this does not apply for Australia, since there is a different Revenue/Costs ratio. To

research further this idea, the author of this paper investigated revenues in major

international markets. As can be seen on the figure below, there is a significant

difference in average revenues per available room (RevPAR) across the spectrum

of countries.

Source: Global Lodging Review - Global Lodging Industry Performance for the Month of May 2005. Deloitte / Smith Travel Research, Deloitte/STR, 2005)

Figure 10‐ Comparison of Hotel Revenues at International Markets; RevPAR 2004/2005

Even more significant differences are between the major city markets. For

example, according to the recent ‘Global Lodging Review’ by Deloitte / Smith

Travel Research (Deloitte/STR, 2005), Sydney hotels achieved approximately

22% lower RevPAR than the hotels in London and 31% lower than the hotels in

[in US dollars]



New York, for the year ended May 2005. (details about performance of hotels in

major international markets can be seen in the Table 15).

Table 15 – Performance of Hotels in Major City Markets, YTD May 2004/2005

Source: Global Lodging Review - Global Lodging Industry Performance for the Month of May 2005. Deloitte / Smith Travel Research, (Deloitte/STR, 2005)

There are no doubts that it would be very interesting and useful to see the

differences in revenues within the cities in conjunction with the differences in

costs, respectively CapEx per unit. Unfortunately, any international comparison of

hotel replacement and improvement costs has not been found. However,



according to the ‘Planning and Research Centre’ at the University of Sydney, the

hotel development costs in Sydney are three times higher than in New York or

London (Deloitte/STR, 2005). This indicates that also CapEx per unit/item may

be higher in Sydney than in the other two cities. This would, however mean that

Sydney hotels in comparison to New York and London hotels, may have

remarkably lower base of funds available for CapEx, due to lower revenues (per

room) and higher cost levels. Consequently, it can have significant impact on the

competitiveness of Sydney hotels and their attractiveness for investors.

Furthermore, it suggests that applying any CapEx standards established outside of

Australia may not be appropriate.

Another idea that was revealed during the literature review, and that was

investigated further during the interviews was the suggestion that CapEx needs

are intensifying and/or the replacement cycle is fastening (Rushmore, 2003;

Brener, 1992; Gunter, 2005). Half of the interviewees agreed on it and

emphasised increasing technology requirements and impact of frequent changes

in regulation. In addition, ‘Third Operator’ argued that also people tastes are

changing more frequently and referred to higher frequency of new hotel/design

concepts that have been recently coming out. This suggests that historical data

regarding CapEx may not exactly reflect future needs.

This brings to light the issue of replacement reserves since replacement reserves

are designed to account for future CapEx needs and the standards are traditionally

compared across the countries.

Are CapEx needs intensifying?



4.3 Replacement Reserves and CapEx

Before any discussion regarding the replacement reserves can start, it needs to be

once again highlighted that there is fundamental difference between Replacement

Reserves and CapEx. Conceptually, CapEx represent actual spending on assets;

the cash outflows or the creation of liability (Dictionary of Real Estate Appraisal,

Third Edition in ISHC CapEx 2000, Mellen et al., 2000) whereas, ‘Replacement

Reserve’ is a provision for future spending on these assets. Both literature and

respondents in the study confirmed that these two subjects are sometimes used

interchangeably which consequently may lead to serious confusion. More

specifically, it seems that some stakeholders believe that the ‘Replacement

Reserve’ actually reflects the true needs for CapEx spending, in the long term.

This, however, is a fundamental error which may lead to the underestimation of

true CapEx since there are several reasons why different stakeholders deliberately

or inadvertently set the reserves more or less below the true CapEx (in long term).

Several of these reasons were already discussed above in the section regarding the

underestimation of CapEx. Unfortunately, even though there is a very clear line

between the CapEx and Replacement Reserve, the understanding and using of

each term is very much confusing.

As can be noticed above, more detailed definition of CapEx was omitted. It was

identified in the literature review that there are different definitions of CapEx and

the author does not take the responsibility to decide which definition is right.

Interestingly, it is not an issue for the majority of the interviewees. Indeed, only

one respondent, and not surprisingly the asset manager, identified definition as an

issue since it may have consequences for owner’s tax duty and the amount of the

fees paid to the operator. As for the others interviewees including the owners,

only after being specifically questioned about ‘the issues with CapEx definition’,

respondents admitted that it is sometimes the subject of discussions, however, that

it is usually about small issues. In other words, high value CapEx are usually clear

CapEx



or, in the case of discussions, official accounting standards are followed (AASB

or USALI), and the advice of auditors is respected. However, the “fuzzy”

definitions might cause problems for researchers; thus it is advised to always

specify in detail what is measured. Based on the advice from USALI (No Author

6, 1996) and the approach taken by Philips (2003), it might be reasonable to

differentiate between the expenditures towards maintaining existing revenue

generating capacity and development expenditures. In addition, as one of the

respondents highlighted, CapEx are closely linked to maintenance since saving on

maintenance usually leads to higher CapEx and vice versa. Thus measurement of

spending on boths; maintenance and CapEx, would reflect, as ISHC CapEx2000

study emphasises, the true costs of keeping the hotel competitive (Mellen et al.,

2000).

According to a resent JLLH management agreements survey (2005) replacement

reserves in Asia Pacific (including Australia) are in average set at 3.1% of the

revenues which is less then in USA and Europe. This is surprising, since as

already indicated, the average RevPAR in Australia are lower and development

costs are higher. However, this diminishing role of reserve in Australia was also

confirmed by the interviewees. Indeed, both interviewed representatives of the

hotel owners revealed that their organizations do not use replacement reserves at

all, since it is “unsophisticated” (First Owner, 2005) and “ridiculous” (Second

Owner, 2005). Both owners argued that reserve is not an effective tool for

management of CapEx and that it leads to an inefficient use of money which is in

line with some literature (i.e. Denton, 1998). However, it needs to be realised that

both owners represent large and financially strong organizations that have strong

bargaining power and, more importantly, the confidence of the operators and

other stakeholders that funds will be provided when necessary. On the other hand,

the interviewed operators informed that they usually require the reserve for

replacement in their management agreements but it was admitted that sometimes

it is only an accounting entry, which is in line with the findings of JLLH study

(2005). This consequently raises a question: why is then the reserve established?

Replacement Reserves



First, it is required by the lenders who usually also require to set aside actual cash.

Second, in terms of the ‘just accounting entry’ reserve, the operators argued that it

“at least creates expectations” (Second Operator) and “establishes

acknowledgment” (Third Operator, 2005). However, based on the literature

review it seems that some stakeholders may misunderstand this signalling through

the reserves due to misleading usage of the terminology.

Even though the definition of replacement reserve is not the subject of as many

discussions in the literature as the definition of CapEx, there is confusion in

terminology that may lead to even more serious consequences. It seems that some

authors and stakeholders use the term ‘Replacement Reserve’ as a title for the

funds put aside for periodic replacements of FF&E (ISHC CapEx 2000, Mellen et

al., 2000). However, others (i.e. Rushmore, 2003) understand ‘Replacement

Reserve’ as a general term for funds put aside to finance all necessary future

spending on existing assets, including reserves such as FF&E reserve and reserve

for capital improvements (spends on permanent property components). This may

lead to situations when some stakeholders, typically private owners (M&Ds) or

less sophisticated new players, will believe that the replacement reserve will cover

all CapEx that will be needed to maintain the hotel whilst it is designed by the

operator/developer to ensure or signal how much funds will be needed for

periodical replacements of FF&E. However, the reverse may also be true and as

confusing. In particular, some stakeholders may argue that for example 5% from

the revenues as the contribution fee to FF&E reserve is not enough to fund all

CapEx even though FF&E reserve is supposed to cover only periodical

replacements of FF&E which is just a part of all potential CapEx. Unfortunately,

the problem is even more complicated since some respondents stated that they

usually agree on some minimal contribution to FF&E reserve knowing that real

needs for FF&E replacements will be higher. In addition, the confusion is even

enhanced by frequent practise of using funds in FF&E reserve for any CapEx that

are necessary at hotel and not only for replacement/renovation of FF&E, as

Reserves and Terminology



indicated by the interviewees. Although it is an effective usage of the funds, it

seems to contribute to misunderstanding of FF&E reserve purpose.

There are two points arising from the discussion above:

Replacement reserves are typically designed just to support financing of

the future CapEx needs thus,

any averages or standards for the reserves, as established in the industry or

founded by the surveys, most likely do not and/or will not represent the

real needs for CapEx

Unfortunately, as revealed in the literature review the standards for replacement

reserves (in particular; FF&E reserve and reserve for replacement of fixed assets)

are used in feasibility studies and hotel valuations to estimate/account for the

future CapEx needs. Thus, any underestimation or overstatements may have a

significant impact on the investment activity in the industry. Hence, high

attention must be paid to the sources of data that are used, since the feasibility

studies and valuations should be based on estimates of real CapEx needs and not

on the reserves’ standards.

It seems that despite the indices that the real CapEx needs in hotels have been

intensifying in recent years, the replacement reserves may tend to stagnate or

decrease. According to the literature (i.e. Denton, 1998) and the respondents, the

owners are not willing to put aside large amounts of money since it is perceived

as an inefficient way of using limited resources. The interviewees also confirmed

that the bargaining power of owners is improving, which consequently may

reinforce the diminishing role of the reserves. Furthermore, the trend towards

incentive fees based on adjusted GOP or NOI in management agreements, as

identified in the JLLH study (Haast et al., 2005), may also reduce the motivation

of operators to require higher contributions to the reserves since it lowers their

management fee takings. Thus, it seems that both major stakeholders, owners and

operators, have limited motivation to increase replacement reserves. However,



the literature (i.e. Gunter, 2005) as well as the interviewed stakeholders

(especially the operators) highlighted the importance of CapEx spending to

maintain brand standards in the light of intensifying competition. This might put

higher requirements on other provisions for managements of CapEx, especially

the CapEx planning.



4.4 CapEx planning

All interviewed stakeholders were unified in emphasising the importance of

CapEx budgets and plans. The budgets were seen as core elements of CapEx

management which is in line with the suggestions of the literature (Beals &

Denton, 2004; Crandell, 2002; Denton, 1998). The table below summarises

provisions used by respondents.

Table 16 – Summary of provisions for CapEx as used by the respondents Short term plan Long term Plan Reserve Comments Legal N/A N/A N/A Suggests using experts Asset Manager

N/A Service Report - updated every 3-4 years (external experts)

Recommends no more than 3% (on behalf of owner)

1st Operator

1 year operational budget including CapEx

3 years budget 3% (but, knowing it is not enough)

No reserves in strata titled properties

Lender Analyze yearly budgets

Require 5-10 years budgets

Accept standard 3% (Know it is not enough)

Also require hotel to be revalued every 2-3 years

1st Owner

1 year detailed plan which is reviewed during the year

5 years budget No 6% of revenues as long-term limit (max)

2nd Operator

1 year operational budget including CapEx

5 years CapEx plan 3-4% (Know it is not enough)

Including comparison with competitive set

2nd Owner

1 year detailed CapEx analysis

5 years CapEx plan No

3rd Operator

Yearly CapEx plans 5 years plan 3-4% (Know it is not enough)

Use Asset Management Strategic Plan - based on owner's investment horizons (sets long-term vision)

As it can be seen, the most popular are the 5 year long term plans that are

combined with 1 year detailed budgets. Although, the literature suggests even

longer plans (10-30 years) due to the long term nature of fixed assets and high

cost of major renovations in later years (Crandell, 2002; Denton, 1998).

However, as one of the respondents pointed out, 5 years plans are updated on a

yearly basis (by 1 year forward) thus there is less risk that there will be any major

surprise since 5 year horizons are continuously maintained.



Unfortunately, the limited time and control over in-depth interviews did not allow

for further investigation of approaches to the planning especially the techniques

used for determination of useful lives of the assets. Interestingly, problems with

determination of useful lives have not been mentioned among the issues, perhaps

due to the fact that the interviewees were not always directly engaged in the

technical aspects of budgeting and planning.



5 CONCLUSION AND FURTHER RESEARCH

The most important limitation of this qualitative research is that the findings

cannot be directly generalized to the larger population since the sample is very

small and the participants have not been selected randomly. Indeed, the

interviewees were top executives of relatively large organizations or the

professionals that are usually involved with those organizations. Thus the findings

are biased and do not include views of small independent owners and investors. In

addition, the interviews were recorded via hand-written notes thus enhancing

possible subjectivity of interpretation by the researcher.

This pilot study reviewed available literature and employed in-depth interviews to

explore issues evolving around CapEx with focus on Australian context. It is

clear that the subject of CapEx in hotels is a very complex phenomenon that is

linked to almost all areas of hotel business with important impacts on marketing,

operations, finance as well as strategic and corporate functions of the hospitality

organizations. The study also suggests that CapEx are subject of close attention

among all stakeholders such as owners/investors, operators, lenders and other

professionals.

In contrast to the literature, it seems that with intensified competition,

sophistication of the organizations and experts involved in the industry, the major

issues revolve more around the actual spending and financial aspects of the

Limitations

Conclusion



CapEx than around the definitions, provisions for CapEx or their impact on stake

holder’s relationships. Even though, these factors remain issues that need to be

considered in further research to improve understanding by less sophisticated

stakeholders thus improving the image of the industry and its attractiveness for

new investors.

Both, the literature review and the interviews reveal that there is a great variety of

factors that affect CapEx which makes the issues even more complex. The study

also suggests that these factors are changing and may vary across international

markets thus highlighting the need for further research within Australian context.

As for the provisions for CapEx and the industry practices, it seems that

replacement reserves are important subjects of financial analysis, feasibility

studies and valuations, however, it seems to be less popular tool for the

management of CapEx; especially among hotel owners it is perceived as an

inefficient provision. This perceived inefficiency combined with the improvement

of bargaining power of owners is the major reason why the reserves are typically

set below expected true CapEx needs.

CapEx planning and budgeting seems to be well accepted practice which is

supported by the employment of asset managers and experts. However, the study

finds that stakeholders have difficulties in the quantification of CapEx outcomes.

Finally, the study suggests that true CapEx needs may be underestimated by some

stakeholders which consequently rises many discrepancies on the market thus

increases perceived risks and reduces the attractiveness of the industry for the

investors. Accordingly, this may raise returns requirements by the investors thus

maintaining the gap between the CapEx needs, as required by the demand, and

their perceived financial viability. This seems to be the most fundamental issue

that directly or indirectly affects all stakeholders including whole society, since it

limits the development and competitiveness of hospitality industry.



The findings from this study suggest that the Australian hotel industry would

benefit from more in-depth quantitative and qualitative CapEx studies relating to:

Actual/true CapEx needs in Australian hotels with consideration to a

variety of factors that may cause differences between hotels. However, the

attention needs to be kept to the differences between CapEx needed for

replacement/renovation of FF&E and the CapEx spend on capital

improvements (permanent components of the property). Furthermore, the

CapEx resulting in the increase of the revenue generating capacities

'should be separated from the CapEx necessary to maintain existing

revenues generating capacities. Additionally, research should consider

mutual relationship between CapEx and maintenance.

The quantification of CapEx outcomes, not only in terms of revenue

improvements or cost savings but also in terms of potential revenue drops

Consider monitoring and development of benchmarks for useful life of

major assets in hospitality industry (since it seems that the commercial and

functional obsolescence is fastening)

Support unification and enhance understanding of terminology and

definitions in regards to CapEx, Maintenance, FF&E, Replacement

Reserves, FF&E Reserve, Capital Improvements reserve

Further research

Other suggestions



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7 APPENDICES



Appendix 1 - The executive summary of CapEx 2000

PRESS RELEASE Contact: Rick Pastorino 703.838.9707 October 23, 2000 ISHC RELEASES CAPEX 2000 – A STUDY ON CAPITAL EXPENDITURES IN THE HOTEL INDUSTRY. Seeking to broaden the base of information available on the subject of hotel capital expenditures (CapEx), the International Society of Hospitality Consultants (ISHC), has published CapEx 2000, a successor study to the original CapEx publication released by the Society in 1995. In what the ISHC hopes will become a regular five-year look at the issue of CapEx, they again surveyed the industry at large to see whether spending patterns related to CapEx have changed over time, from the total (dollar) amount spent to the specific areas of a hotel where expenditures are spent. Similar to the 1995 study, this study was performed from two perspectives: 1) Through a retrospective analysis of what a representative sample of hotels actually spent on CapEx over time to remain competitive; and 2) Through a prospective analysis of the cost to replace the various components of a hotel based upon their typical useful lives. In order to obtain relevant data for CapEx 2000, the authors, Kathe Nylen, Suzanne Mellen, and Rick Pastorino, all ISHC members, polled hotel owners and operators for CapEx data related to the 1988 to 1998 time period. This resulted in useable survey data from approximately 350 hotels. In order to fund the cost of the research, the ISHC sought sponsorship money from the industry at large. They asked for $5,000 per sponsor – no more, no less – to avoid the possible perception that any one entity may have influenced the results. In the end, they collected a total of $50,000 from the following sponsors:

CapEx 2000 Sponsors

Baymont Inns and Suites Cornerstone Real Estate Advisors Creative Hotel Associates Four Seasons Hotels & Resorts Hyatt Hotels and Resorts Molinaro Koger Starwood Hotels and Resorts Strategic Hotel Capital, Inc. Sunstone Hotel Investors, Inc. Waterford Hotel Group, Inc.



The ISHC gratefully acknowledges the sponsors of ISHC and commends them on their willingness to participate in CapEx 2000. CapEx 2000 expands upon the original 1995 research and thus includes additional property types and breakouts. Specifically, an all-suite category was added to the full and limited-service hotel categories, with all categories showing CapEx spending patterns by location, average daily rate, property size and age of property. The study also investigates CapEx spending among public and private hotel owners, as well as repairs and maintenance expenditures. The publication also provides a comparison of the CapEx 2000 data with the data from the initial CapEx study, published in 1995. That study (referred to as CapEx 1995) encompassed a time period from 1983 to 1993. As a result, the sample includes over 20 years of actual data specific to CapEx for hotels.

Generally, what the historical (retrospective) data collectively reveals is that, regardless of product type, CapEx spending for a hotel generally increases as a hotel ages, as illustrated in the following chart.

What the survey doesn’t specifically tell us is whether these averages are the right amount for a given hotel. A few other highlights of CapEx 2000 findings are provided below: • Capital Expenditures (CapEx) for full-service hotels, as a ratio of total revenue, from 1988 and 1998 remained relatively consistent with CapEx spending patterns between 1983 and 1993, the period covered in the 1995 study. Specifically, full-service hotels spent an annual average of 6.1 percent of total revenue on CapEx between 1988 and 1998, compared to 6.9 percent between 1983 and 1993 (1995 study).



• Comparatively, CapEx for limited-service hotels increased significantly over the same time period. The average amount spent per year by limited-service was 5.5 percent of total revenue for CapEx 2000 (1988 – 1998), while 3.7 of total revenue was spent in the period from 1983 – 1993, as reported in CapEx 1995.

• In light of the proliferation of all-suite hotels (inclusive of extended-stay properties) over the past 10 years, the ISHC was able to collect sufficient data to include this segment separately for CapEx 2000. All-suite hotels in the survey spent an average of 4.9 percent of their annual total revenues on CapEx, covering the time period 1988 – 1998. (Comparable data for the all-suite group was not presented in CapEx 1995.) The sample of all-suite hotels is still relatively new, and CapEx averages for this group are likely to increase over time.



The second part of the study is a prospective look at CapEx spending under several different hotel prototypes, including:

• Economy Limited-Service • Moderate Limited-Service • Moderate Full-Service • Upscale Full-Service

The objective of the authors here is to provide the reader a consolidated look, useful timeline and current costs for replacement of most components of a hotel. Samples of this data are shown below:

List of Major Capital Expenditures by Year Upscale Full-Service Hotel

Item Unit of Measure # of Units Average Cost Total

Year 1

No Major Capital Expenditures $0

Year 2

No Major Capital Expenditures $0

Year 3

Technology

Office Automation Per Room 300 $125 $37,500

Total $37,500

Year 4

Guest Rooms

Bed Treatment Per Room Bay 300 $200 $60,000

Total $60,000

Year 5

Guest Rooms

Carpet/ Pad (material only) Per Key 300 $466 $139,662

Carpet/ Pad (installation labor) Per Key 300 $130 $39,066

Bathroom

Regrout Wall Tile Per Bathroom 300 $500 $150,000

Regrout Flooring Per Bathroom 300 $350 $105,000

Lobby Bar

Carpet/ Pad (material only) Per Square Yard 89 $45 $4,005

Carpet/ Pad (installation labor) Per Square Yard 89 $8 $712

Window Treatments Per Lineal Foot 40 $101 $4,022

Full Service Bar




List of Major Capital Expenditures by Year Upscale Full-Service Hotel

Item Unit of Measure # of Units Average Cost Total

Carpet/ Pad (installation labor) Per Square Yard 66 $8 $528

Window Treatments Per Lineal Foot 10 $91 $907

Three Meal Restaurant

Tables (36" Square + base) Each 20 $441 $8,816

Chairs (w/Arms) Each 75 $261 $19,575

Artwork/ Accessories Per Room 1 $13,813 $13,813

Specialty Restaurant

Tables Each 16 $320 $5,120

Chairs Each 60 $325 $19,500

Carpeted/ Pad (material only) Per Square Yard 189 $42 $7,938

Carpet/ Pad (installation labor) Per Square Yard 189 $10 $1,890

Executive Offices

Office Carpet (material only) Per Square Yard 153 $22 $3,366

Carpet (glue down labor) Per Square Yard 153 $5 $765

Wall Covering (material only) Per 54" Lineal Yard 101 $12 $1,212

Wall Covering (installation labor) Per 54" Lineal Yard 101 $8 $808

Entrance/ Lobby/ Front Desk


Carpet/ Pad (installation labor) Per Square Yard 289 $8 $2,312

Total $544,125

Together, the historical and prospective sections of the study quantify the amount of CapEx required to adequately maintain a hotel over its life cycle.

Note: The ISHC does not advocate a position on the amount of funds to be reserved or the amount of CapEx required by a hotel at any point in time. Both CapEx 2000 and its predecessor, address solely the actual amount of money spent (retrospectively) by a group of hotel owners to renovate and refurbish their property and/or replace FF&E in their hotel properties, as well as an estimated amount of CapEx likely to be spent (prospectively) to remain competitive into the future.

To order CapEx 2000, please log onto to the ISHC Website at www.ishc.com, or contact the ISHC Headquarters office at 515 King Street, Suite 420, Alexandria, VA 22314, Phone: (703) 684-6681, Fax: (703) 684-6048. For further information on CapEx 2000, please contact one of the CapEx 2000 authors: Rick Pastorino, ISHC, Phone: (703) 838-9707; E-mail: [email protected]; Kathe Nylen, ISHC, Phone: (702) 384-1120; E-mail: [email protected] Suzanne Mellen, ISHC, Phone: (415) 896-0868: E-mail: [email protected]



International Society of Hospitality Consultants (ISHC) ---- is a professional organization of hospitality consultants who dedicate themselves to providing the highest quality of professional service. The ISHC was founded in recognition of the public need for competent, unbiased advice, and professional guidance on the many issues affect and influence the hospitality industry.



Appendix 2 - PWC Survey: Reserve for Replacement of Fixed Assets (Korpacz, 1999)



Appendix 3 - Examples of CapEx budget tables Source: Managing capital expenditures (Denton, 1998)



Appendix 4 – Definition of Reserves and FF&E Source: Rushmore (2003:72-75)



Source: Rushmore (2003:72-75)

…



Source: (Rushmore, 2003:126)



Appendix 5 - ‘About the Author’ and ‘HVS International, Sydney’

Borivoj Vokrinek, MBA, MSc.

Currently studying at The Hotel School Intercontinental - Sydney, Bachelor in Hotel Management (graduation expected in November 2005). MBA – Master of Business Administration Bond University, Gold Coast, Australia; September 2003 to December 2004 MSc – Master of Science, International Economic Relations Major: International Trade, Minor: Tourism; University of Economics in Prague, Czech Republic; September 1994 to September 2001

More than eight years of experience in the hospitality industry Between 1997-2003 manger for Hidden Places - Residence and Boutique Hotels Developing and implementing corporate marketing strategy Responsibility for all operations of the 8 apartment Domus Henrici,

Boutique Hotel Coordinating architects, construction companies and all subjects involved in

the opening of Domus Balthazar - 8 apartment residence Developing feasibility studies for several hotel/service projects November 2002 – HORECA, IV. Hotel and Gastronomy Fair, conducted

lecture about specifics of small independent hotels, boutique hotels and extended-stay hotels

June 2002 – Czech Real 2002, IIR convention in Prague, conducted lecture about hotel property market

March 2002 - Prague Business Journal, was interviewed about boutique hotels

December 2001 - Development News, published article about the structure, development and potential of small-scale accommodation facilities in the centre of Prague

Conducted several lectures to the students of the Tourism Institute in UEP

EDUCATION:

WORK EXPERIENCE:

OTHER ACTIVITIES:



HVS International, Sydney

HVS International is a global consulting and services organization focused on the hotel, restaurant, timeshare, gaming, and leisure industries.

Sydney office provides a wide range of consulting services for hotels, resorts, serviced apartments and mixed-use developments in Australia, New Zealand and the Pacific Islands.

The core services in Sydney include operations analysis, opportunity and market demand assessments, and a full array of market feasibility and due diligence studies, as well as valuations for mortgage security and transaction purposes. We also have significant experience in the provision of services in the of food & beverage sector.

In addition, the Sydney office offers development consulting, strategic advice, operator selection and management contract analysis and negotiations. They advise on the development of new hotels, working with developers, architects and other development team members to conceptualize the optimal lodging product for a particular site. The staff also has extensive experience in providing expert analysis and testimony on a wide variety of topics including damages, management competency, contracts and agreements and hotel industry standards.

Through the extensive and well-established network of industry contacts, the Sydney office will also be able to recommend specialists for virtually any other hospitality service you may require.



Supervisor of the research: Mr. Rutger Smits, ISHC, MIMC

Mr.Smits is a founding director of HVS International in Sydney and has wide-ranging operational experience in the hospitality industry, including nine years with Inter-Continental Hotels in various executive positions in Europe and the Far East, including Operations Analyst for Central Europe, Executive Assistant Manager, and ultimately as resident manager of a luxury hotel in Asia. He subsequently joined a privately owned hotel group in Dubai, where he was responsible for asset management of three luxury hotels and involved in various hotel development projects. Rutger's hospitality consulting career started in 1995 with Pannell Kerr Forster Associates in London. He subsequently joined Andersen and transferred to Bahrain in 1996 to help establish a hospitality consulting practice, providing professional services across the Middle East and Africa. Rutger came to Sydney in 2000 to take on the leadership of Andersen hospitality practice in Australia. Following the demise of Andersen in May 2002, he transferred to Ernst & Young holding the same position. Rutger’s consulting experience encompasses a wide range of services and product types in Europe, the Middle East, Asia and Australia, including hotel, resort and serviced apartment feasibility studies; operational and market reviews; strategic advisory, investment and valuation analyses; due diligence research; destination resort assignments, in both mature and emerging markets; mixed-use developments, including multiple hotels, golf courses, marinas, spas and residential real estate, requiring a practical understanding of market issues, phasing and master-plan considerations; land development assessments, alongside leading developers, architects and planners in the industry, where a mix of land-uses including hotel, office, residential, retail and recreational uses were under review. Over the years, Rutger has authored various industry publications and he regularly speaks at industry seminars and conferences. Mr. Smits is member of the International Society of Hospitality Consultants (ISHC) and the Institute of Management Consultants (MIMC)



Appendix 6 – The Interview plan with broad topics

Capital Expenditures (CapEx) In Australian Hospitality Industry – A Pilot Study Research

Interview Structure

The main purpose of the interview is to unveil issues and different points of view regarding CapEx. Hence, even though the interviews will be semi-structured with predefined closed and open-ended questions, further open discussion is highly desired. There are three major topics to be discussed during the interview; the importance and understanding of CapEx, provisions for CapEx and stakeholders’ relationship and CapEx. These topics are closely interlinked hence the diffusion of topics during the discussion is expected and encouraged. The preliminary structure of the interview is provided below (may be subject to change).

1. INTRODUCTION (5 MINUTES)

a. Purpose of the research

b. Basic data about the interviewee (The majority of this data will be investigated before the actual interview. These data will be used only for development of the average interviewee profile and all information gathered during the interview will be held strictly confidential. Findings will be provided without reference to sources)

i. Company: Main activity of the company’s, Years of operation in Australia, Number of hotels/rooms managed by the company*, Organizational/Ownership structure (hotel operator/owner)*, Other

ii. Interviewee: Position, Area of Expertise, Years of Experience

2. TOPICS/QUESTIONS (50 MINUTES)

a. Importance and understanding of CapEx

i. In your opinion/personal experience, what are the main issues regarding CapEx? (From the perspective of your position)

ii. How do CapEx issues affect you?



(*If appropriate)

b. Provision for CapEx

i. What provisions for CapEx do you employ/recommend?

ii. What is the effectiveness of these provisions?

iii. What is your decision making process regarding CapEx?*

iv. Other

c. Stakeholders relationship and CapEx

i. How do you perceive understanding of CapEx by the other stakeholders?

ii. In your opinion, what are the objectives of other stakeholders in regards of CapEx?

iii. How are CapEx handled in your management contracts or contracts you know?*

iv. Other

d. Other issues

3. CONCLUSION (5 MINUTES)

a. Future needs regarding CapEx

i. Is there need for further research/benchmarking?

ii. Is there need for unified guidance/standardization/best practices?

iii. Other

(*If appropriate)

cap ex2005 australia

Business

capex issues

understanding of capex

capex categories

capex spending

capex planning

composition of capex

subject of capex

understanding of true