By Anwar Elgonemy
In this article, we take a look at the best practices to overcome the challenges of developing airport-connected hotels.
Background
Certain customer segments are more likely to stay in airport hotels than others. For example, passengers departing on early flights or arriving on late flights will consider staying closer to the airport to save travel time and costs. “Fly-in-fly-out” meetings, passengers stranded due to over-booking or weather-related cancellations and mechanical delays, and, of course, airline crews, are essential demand segments. But these segments are seeking more than typical airport accommodations.
Up until the mid-2000s, there was negativity surrounding airport hotels, because properties built in the 1980s and 1990s were essentially “room boxes” with cookie-cutter designs. However, recently built airport-connected hotels transcend this stigma. More sophisticated and design-driven, such properties offer amenities tailored to savvy travelers, increasing their relevance to business and leisure travelers alike.
Business and leisure travelers have become one and the same. An increase in “bleisure” travel, in which business guests extend their stay to include a weekend of leisure, has contributed to the interest in airport-connected hotels as conveniently located oases of hospitality. Today there is strong demand among bleisure travelers seeking airport accommodations. By providing a unique sense of place through locally commissioned art, plane-watching, coupled with amenities such as spas, large fitness centers, and upscale culinary outlets, these properties are able to better meet the needs of a wider variety of travelers while increasing airport non-airline revenues.
Figure A provides a summary of the 21 airport-connected hotels in North America. These full-service properties have an average size of 444 rooms, an average age of 26 years, and most are managed by either Marriott International or Hyatt Hotels Corporation.
Airports have the responsibility of determining whether to allow the development of hotels on their sites, where such properties should be located, how they should be linked to the terminals, as well as the optimal business structure for such projects. Because land at many airports is scarce and lodging facilities are complex to construct, the development of airport-connected hotels is a challenging venture.
Financial Viability: Does the Deal Pencil-in?
Assessing whether the airport and the surrounding market generate sufficient lodging demand to support additional hotel development should be one of the first steps in the process. Before contracting design and engineering studies, a rigorous financial feasibility study needs to be commissioned. Global hospitality consultants analyze potential revenue opportunities such as day-use rooms, fitness center usage, and restaurant/bar patronage; existing and future supply and demand patterns; and the room rates attained by existing properties in the area. They provide an assessment of critical hotel performance metrics and local socio-economic growth projections.
Fundamental hotel metrics include annual occupancy (the percentage of existing hotel rooms in the market that are sold); average daily rate, or ADR (the average rate paid for each room sold); as well as rooms revenue per available room, or RevPAR (occupancy x ADR). If the occupancy level is strong enough, an estimate of the number of additional rooms that could be supported, and the profitability of a hotel of a specific size and type, can be assessed. A basic rule of thumb is that no new hotels should be developed in markets that have occupancy levels of less than 80%.
Hotel construction costs vary widely depending on location, size, type of hotel, and amenities offered. Excluding land, the average cost of constructing a full-service hotel in the U.S. according to the latest data from HVS is approximately $426,000 per room. However, for a full-service four-star product, the cost can be in the range of $700,000 per room (excluding land).
Performance metrics, including RevPAR, profitability of nearby hotels, and lodging market growth projections, will determine if the venture can meet profitability expectations. After paying for all operating expenses, management fees, property taxes, insurance, any ground rent, and capital expenditures (but before debt service, taxes on income, depreciation, and amortization), full-service airport-connected hotels should have a net operating income (NOI) ratio of at least 25% upon stabilization.
Focus Groups
Tailoring the hotel to the specific needs of travelers will lead to a successful development. After determining what size and type of hotel to develop it is recommended that airports conduct focus groups with lodging sector professionals. The focus groups should be hosted by the airport for half-day sessions. They will look at who stays at airport-connected hotels and why guests choose them. The focus groups will identify the unique requirements of niche demand segments such as women business travelers and small group meetings. They will also be able to identify ways to overcome locational disadvantages of airport-connected hotels, such as the limited outdoor offerings and inability to access shopping or restaurants in the immediate vicinity.
Location Advantage
Airport-connected hotels are properties that are either built on an airport’s premise (known as “on-airport hotels”), or properties located within the terminals (“in-terminal hotels”). Per Figure A, 57% of all airport-connected hotels in North America are in-terminal. However, since 2005, more than half of lodging projects have been built on-airport. In-terminal hotel developments are more costly and complex to build compared to on-airport “greenfield” properties.
If guests with lots of luggage must get on a shuttle bus to reach their off-site hotel, the extra 15 minutes or so will be balanced against factors such as the accessibility, brand, customer loyalty program, and online reviews of the airport-connected hotel. Therefore, since airports are seeking to provide an enhanced passenger experience, a hotel with a seamless, direct terminal connection via air-train or skywalk is recommended. Also, passengers often prefer to spend the night away from the bustle of terminals.
Airport-connected hotels consistently achieve higher occupancies than their downtown competitors. This occupancy premium has averaged approximately 11 percentage points in recent years, widening significantly since the Covid pandemic started in early 2020. The ADRs for airport-connected hotels were typically slightly lower than downtown competitors up until 2021 when the gap narrowed significantly. This is due to the aforementioned rise in bleisure demand, as well as the recent trend of most employees working from home, leading to the closure of restaurants, retail stores, and service outlets, making downtowns less attractive. Guests are also feeling safer at airport-connected hotels, given the rise in crime and deterioration of street conditions in many urban cores. Figure B compares the occupancy and ADR of airport-connected hotels with their downtown competitors between 2014 and 2022.
Ownership Structures
Hotel developments can be structured in various ways from an ownership perspective. Ground leases with a management contract are the most common. Figure A conveys that 60% of all airport-connected hotels have ground leases. But some airports have chosen the 100% airport ownership structure. As discussed below, each deal structure has its financial advantages and disadvantages.
Airport-Owned Hotels
Several large airports, such as San Francisco, Denver, and Dallas-Fort Worth, own their airport-connected hotels. Advantages of airport ownership include an influence on the building design, long-term control over the asset, shorter management agreement terms, a share of the hotel’s NOI, and potentially higher returns.
Airports that own their hotels can contract with a branded hotel operator to manage the day-to-day operations of the property. The hotel may come with a branded management agreement or may be contracted separately via a franchise agreement but operated by a separate management company. Hotel management and franchise agreements can be negotiated for shorter terms than ground leases.
Dealing with hotel operators can be challenging for airports. Few airports have the internal capability of evaluating and challenging hotel operating budgets, capital improvement plans, and marketing strategies. It is recommended that airports have an in-house hotel specialist who serves as the owner’s representative—from the development’s conception to opening.
Following opening, the hotel specialist becomes the asset manager who oversees the operation and makes recommendations with respect to budget approvals, senior management appointments, financial statement reviews, and maximizing NOI. The in-house asset manager ensures the alignment of the business interests of the airport and the hotel operator, creating a true partnership.
A recent example of an airport-owned hotel development is the 351-room Grand Hyatt at San Francisco International Airport (SFO). The on-airport $240 million ($684,000 per room) Grand Hyatt, which opened in 2019, was developed in an extremely high-barrier-to-entry market. There weren’t any four-diamond hotels built in the SFO lodging sub-market since the 1980s due to the lack of available land and the extremely high construction costs in the Bay Area. To become a top-rated airport, SFO needed a premier hotel that delivers the excitement of a world-class city and enables SFO to compete with other major international gateway airports. SFO decided to finance and own the hotel 100% (instead of leasing the land to a developer) in order to maintain control over the airport’s asset and design standards and to increase non-airline revenues.
During the 2017-2019 construction period, building costs in the Bay Area were increasing by 1% per month. Despite the monthly increases, the design and construction team were able to successfully apply value engineering while ensuring the delivery of a world-class hotel. In 2019, Skytrax ranked the Grand Hyatt at SFO as the best airport hotel in the United States. In 2022, The Wall Street Journal ranked SFO as the best large airport in the nation.
SFO used a cutting-edge, two-part financing structure for the hotel in which the airport sold (a) 40-year tax‐exempt variable rate general airport revenue bonds (GARBs); and (b) issued 3% fixed-rate hotel special facility bonds (SFBs) which can be pre-paid without penalties. The airport used the GARB proceeds to finance the hotel’s air-train station and purchase the underlying SFBs. The SFB proceeds provided funding for the design and construction of the hotel and related costs. The SFBs are held by the airport and are not publicly traded.
The transaction was structured so that the hotel revenues provide sufficient funds for the operation of the property, payment of debt service on the SFBs, and the accumulation of various reserves to allow the continued operation and maintenance of the Grand Hyatt in case of a temporary economic downturn.
The RFP Process
Airport-connected hotel developments require a myriad of expertise. The request for proposals (RFP) for a branded hotel operator should be the first to be issued. A branded hotel operator is recommended in lieu of an independent third-party management company because branded hotel operators are contractually obligated to ensure that their brand standards are adhered to. In turn, the enforcement of quality standards of franchise agreements with a separate management company is more difficult.
Additional RFPs are issued for design-build services, which include the general contractor and interior design team, as well as a project management support services firm. The design team includes the architect and the interior designers. It is recommended that the interior design team be comprised of separate firms: one for the public areas and guestrooms, and the other for the food and beverage venues. This is ideal as each area needs highly specialized expertise. It also creates positive “creative tension” between the interior design firms, bringing out the best of their creativity. Moreover, the architect and the interior designers should be locally based. This will keep unnecessary travel costs down, enable the owner to interact with the team on a frequent basis, and ensure that the team translates its knowledge of the local area into a strong sense of place that’s incorporated into the hotel’s design.
All proposals should be carefully evaluated against the specific evaluation criteria, focusing on the ability of the bidding team to deliver the desired results and the reasonableness of their projections. Ultimately, several teams should be selected as a short-list for further clarification, and finally the negotiation of the various agreements.
Management Contract Negotiations
Hotel operators are usually compensated based on revenue performance, typically in the range of 2% to 4% of total operating revenues. Compensation may also be partially contingent on the delivery of targeted operating profits. The traditional management fee structure emerged to align ownership and operator objectives. That is, as hotel performance improves, the management company’s fees increase, and if a hotel performs poorly, the operator’s compensation declines. However, airports that finance through tax-exempt GARBS are excluded from using the hotel industry’s traditional management fee structure and negotiate a flat fee, varying by year based upon pre-construction pro-forma estimates. (According to the Internal Revenue Code, such structures require a qualified management agreement or QMA). As a result, operator compensation is not tied to actual hotel performance. Aside from overall market trends and management effectiveness, returns will be influenced by the construction costs and how the hotel is financed. The advantage of using GARBs is that debt service on the property will generally be lower, enhancing the viability of the project.
Airports should recognize that the lodging sector is multifaceted and volatile, and that hotel real estate is different from other commercial property types. Therefore, specialist legal advice should be sought with respect to complex hotel-related contracts, such as a pre-opening services agreement; technical services agreement; cash management and lockbox agreement; and a trust agreement (e.g., when the hotel’s deal structure includes special facility bonds). The implications and risks associated with each contract should be carefully evaluated.
During the negotiating process, it is important for the airport to consider the effect of changes to the deal structure on returns to the airport and perform sensitivity analyses so that the implications to both parties are fully understood if the hotel is more (or less) successful than projected. Airport executives need to be cautious of overly optimistic projections and avoid using unrealistic figures as the basis for downside sensitivity projections. Sensitivity analyses should use realistic projections (generated internally and by hospitality consultants retained by the airport) to credibly assess both upside and downside risk-return scenarios.
Subsidies
Local governments are keen to see hotel developments succeed at airports. Incentives are offered that can help improve the NOI of an airport-connected hotel in its initial years of operation. For example, a transient occupancy tax (TOT)—or rooms tax—incentive should be negotiated with the local municipality. TOT rebates can reach as high as 70% for up to 10 years.
Hotel Asset Management
Once the hotel is open, the airport is responsible for the fiduciary oversight of the asset. Obviously, if the property is leased, the airport is not responsible for direct oversight, but it is important to ensure that all lease and management contract provisions, particularly with respect to maintenance and operating standards, are enforced. Hotel profits can be inflated in the short term by reducing maintenance and capital expenditures, but over time, such neglect may have a negative impact on the property and the airport’s reputation.
If the airport owns the asset, it is important to oversee the hotel management company. The airport should either hire an employee with the required expertise or retain a hospitality asset management firm. The former option tends to be less costly and ensures that the airport’s best interests are secured.
The role of a hotel asset manager is to ensure a property reaches its full potential so that it can increase non-airline revenues in the long-term. Specifically, hotel asset managers should have the expertise to challenge operating budgets, marketing plans, and operating results. Furthermore, hotels require considerable maintenance and ongoing renovations. Normally, minor makeovers will be required between the third and fifth years, and more wide-ranging renovations will be required between the eighth and tenth years of operation. An asset manager ensures that the capital expenditure funds are spent efficiently on items that will uphold the hotel’s physical condition and market position, instead of unnecessary items.
Conclusion
Hotels are an important amenity at airports. Applying the best practices for their development and efficient operation can be a challenge. Guaranteeing that the optimal team is in place to assist with market analysis, legal advice, financing, construction, project management, and asset management is vital for the long-term success of an airport-connected hotel.
To be successful, airport-connected hotels should offer a seamless guest experience in connection with terminal accessibility and a “wow” factor upon arrival. They also need to provide outstanding service, excellent soundproofing, a strong sense of place, spectacular views of runways, efficient use of natural light, and exceptional service. Financially, the hotel should pay for itself and contribute to the airport’s non-airline revenues.
With more than 800 million passengers flying in the U.S. in 2022, the future for airport-connected hotels is bright. There is strong competition among airports as they are seeking to offer an enhanced passenger experience that comes with having a high-quality hotel that is an integral part of the airport. The enhanced passenger experience is also becoming an increasingly important differentiator in an airport’s competitive position, creating a “halo effect” for airports and making them more attractive international hubs for airlines.
