The $85 million overhaul of the Fairmont Hotel in San Francisco in 2001 was still fresh in management's mind last year when another remodeling of the century-old property commenced. It was time for flat-screen televisions, MP3 players, pillow-top beds and Frette Italian linens. A new café opened and meeting spaces were updated with the latest digital technology.

Total cost for the work at the Fairmont came to $10 million, peanuts in a construction-mad hotel climate in which older, often tired properties are being recast and remade as the latest in luxury.

“There is a real competitive spirit in the marketplace. Luxury brands are expanding,” says Michelle Gilman, regional marketing director for the Fairmont Hotel. “Everybody, including us, wants to keep up with the latest in technology.”

The fundamentals of the hotel business have steadily improved over the past five years, and there is a growing recognition among developers that hotels currently offer the best return on investment of all real estate classes. With the right deal, developers can often count on internal rates of return of 18% and more, cash on cash, while returns on office and retail centers have often fallen to 15% and below in many places.

Investors are focused on older urban centers with an eye to acquiring distressed — albeit historic assets — on the cheap and making them new again. The expense can be imposing. The Plaza Hotel in New York is undergoing a $400 million makeover that will result in a mere 282 guest rooms along with 152 condominiums, but the eventual profits are enticing.

A PricewaterhouseCoopers survey of hospitality investment estimates that $5.5 billion was spent on renovations and upgrades to existing U.S. hotels last year, up from $5 billion in 2006 and just $3 billion in 2004.

The New York consulting firm forecasts the total investment in improvements will rise to $5.85 billion in 2008 (see chart p. 62). “There has been a lot of spending in recent years to implement high-speed Internet access and flat-screen TVs and improved bedding in hotels,” observes Bjorn Hanson, the consulting firm's lodging practice leader.

Ultimate Rust Belt rehab

The current spate of spending, however, often goes far beyond routine remodeling. Mega-projects are sprouting everywhere, some carrying terrific risk. The Ferchill Group in Cleveland, for instance, owned just two Hampton Inns and a single Hilton Garden Inn in Detroit when the firm started work on the revival of the legendary Book-Cadillac Hotel in Detroit.

Opened in 1924, the 33-story Book- Cadillac was for decades Motown's showplace, host to presidents and movie stars. But it fell into decline as the neighborhood around it suffered through the 1960s and 1970s.

The Book-Cadillac went completely vacant in the mid-1980s and was a home to vagrants and the subject of demolition threats until Ferchill Group came along two years ago and struck a deal to spend $168 million on rehab. The construction is underway and the hotel is scheduled to reopen in late fall as the Westin Book-Cadillac Detroit Hotel.

How tough is historic hotel work? On the Book-Cadillac, the Ferchill Group lined up 22 different funding sources, including $18 million in Section 108 loan guarantees from the U.S. Department of Housing and Urban Affairs. In all, the developer raised $75 million in historic tax credits, municipal and state aid and other assistance.

CEO John Ferchill initially thought he could gut the interior and build the hotel's 455 rooms anew for $250,000 apiece. In fact, the cost is going to exceed $350,000 per room. Much of his return will be pinned to 66 condos and 119,000 sq. ft. of retail space included in the structure.

“The basic structure of the building was fine,” Ferchill says. “But we dug inside and found far more asbestos than we had expected, and that had to be remediated.” In addition, copper detailing on the roof turned out to be unsalvageable and had to be rebuilt at a cost of $10 million.

In the end, Ferchill concedes that the new Book-Cadillac would have been cheaper to build from scratch after demolishing the original building. “But if we had done that we wouldn't have qualified for the $75 million in government assistance,” he says. “That's what makes this project go.”

The fact that the city, which owned the Book-Cadillac, handed it over to the developer for all of $1 also provided a major incentive. “A commitment and cooperation from local public officials is essential in doing any historic hotel rehab,” Ferchill emphasizes.

The auto industry has fallen on hard times of late, and so this might be seen as an odd time to be rescuing the Book-Cadillac. But the city recently has come alive on other fronts. For example, two casino hotels opened for business last fall — Detroit's first temporary casinos opened nearly nine years ago — and the restored Detroit Institute of Arts was unveiled on Thanksgiving weekend.

Meanwhile, mortgage lender Quicken Loans announced that it was moving its headquarters to downtown Detroit, bringing 4,000 employees from the suburbs as part of a major push by local leaders to stimulate the economy.

“The new casinos will be important to the Book-Cadillac and its success,” Ferchill says. “With the casinos and other things happening downtown Detroit is gaining new credibility as a place to go.”

West Coast gamble

The Book-Cadillac is an example of extreme rescue of an old property. In San Diego, Michael Kelly had to go nearly as far, though on a smaller scale. Opened in 1914 in time to host visitors to the city's 1915 World's Fair, the Maryland Hotel was for decades a landmark.

But by the time Kelly, who heads the investment firm Kelly Capital LLC as chairman and CEO, stumbled on the property in the city's Gaslamp District, the Maryland Hotel had been reduced to a blighted home offering single-room occupancy for the poorest of transients. Its brick façade was covered by spray-painted pre-fab metal sheeting.

Still, the site was a prime location — near a new Major League Baseball stadium under construction, Petco Park, with the city's convention center and Fifth Avenue entertainment district both within easy walking distance. Kelly was convinced the place had possibilities.

The entrepreneur acquired the Maryland Hotel in 2003 for $8.4 million and hired a bevy of architects and advisors and by 2005 had launched into reconstruction. His initial budget was $65 million to gut the 275-room hotel and reduce the room count to 159 and build a pool and bar on the top of the six-floor building.

But a ground-floor restaurant ended up costing $8 million and there was another unexpected $5 million spent on structural steel to make the building earthquake-proof. In the middle of construction, the cost of steel and sheetrock and labor all soared.

The final cost ended up close to $95 million, or nearly $600,000 per room, a staggering sum. Kelly figures he could have built the hotel, which was opened last August with a new name, the Ivy Hotel, for $10 million less as ground-up new construction.

And yet the developer's gamble is paying off, as travelers are flocking to the Ivy. The original budget called for $250 room rates at opening. The average at the 4 1/2-star Ivy is running closer to $375. The hotel's bars, nightclub, restaurants and ballrooms have been filled since opening day. Kelly now calculates his internal rate of return on his equity investment at more than 20%.

“I could have built the Ivy cheaper as new construction, but the Maryland Hotel was protected by a historic designation and therefore I couldn't have built the Ivy where it is. A lot of its success since opening is owed to its great location,” says Kelly.

Preserving a work of art

Remodeling is typically aimed at moving a hotel property upward in the eyes of such important industry bibles as the Mobil and the AAA travel guides. In San Diego, the US Grant Hotel, a grande dame of West Coast travel since 1910, was sold in 2003 to the Sycuan Indian tribe.

The property had gone through an $88 million rehab 20 years earlier, but the new owners were intent on boosting its ranking from a middling two to three stars to at least four.

The investors plowed $56 million into a renovation, completed in October 2006, that included $6.5 million for new and original artwork. The renovation required three architects, five design teams and 21 months of work. In the end, the cost was more than double the original $20 million rehab budget.

When the US Grant closed late in 2005, it commanded an average room rate of $165, with an average occupancy of 76%. In 2007, occupancy averaged 71%, but room rates had risen to $295, far above the downtown average of $198.

“The hotel has returned money on the remodeling investment in just the first year, which we didn't expect,” says Mark Dibella, the US Grant's director of community relations. “We wouldn't have invested this kind of money if San Diego overall wasn't enjoying such strong occupancies in its hotels.”

Chicago Cinderella story

Timing is everything. Just ask Chicago's Harp Group, which along with its investment partners paid $47 million in 2005 for the old 286-room Ambassador East Hotel on Chicago's near north side. The hotel was once a favored haunt for Frank Sinatra.

The new owners expected to begin renovations immediately, but then something funny happened — business picked up all by itself. Nightly rates that had been at $135 prior to the acquisition suddenly soared to $175 before renovations ever started.

Peter Dumon, the president of Harp, considered reselling the Ambassador East, and drew offers exceeding $60 million. But the bigger returns promised by restoration were too potent to ignore.

Work will begin soon on a $30 million facelift of the Ambassador East that will replace window air conditioners with a central system along with new windows and fresh furnishings. The project will qualify for 20% in historic tax credits, reducing the total outlay to $24 million.

The Ambassador East will be repositioned as a four-star hotel when the work is finished, up from three stars. Dumon originally expected nightly rates to rise to about $200, but now he calculates that he'll get $240 a night post-rehab. His total investment, including hotel acquisition, will amount to about $275,000 a room.

Dumon estimates that to reproduce the Ambassador East new today would cost $400,000 a room — with its prime site alone worth $16 million, or more than $50,000 a room. “We're essentially going to end up with a like-new hotel at close to a 30% discount to its replacement cost,” he says.

Bargain hunting

Developers like Roberts Hotels Group LLC in St. Louis are still finding opportunities at attractive prices. Last year the company gutted the old Marriott Atlanta in Marietta, Ga., and transformed it into a Crowne Plaza. Room rates rose from $89 to $160. The company has just finished performing similar alchemy on the historic 1925 Mayfair Hotel in downtown St. Louis, which has 182 suites.

“We have got these properties like new for a fraction of their replacement cost,” says Michael Roberts Jr., executive vice president of Roberts Hotels Group. “You need deep pockets so you can buy these assets on short notice when they become available, and then you need patience and special expertise in dealing with the construction and contractors.”

Of course, there is also plenty of downside risk in these investments, which is one reason they typically yield superior returns. Paul Wischermann, a hotel consultant in Minneapolis, worries that there are too many new deluxe hotels coming on line in many cities. If the economy goes into recession, he warns, then pro forma expectations for rising occupancies and rates will get squashed in many overbuilt markets.

On the other hand, Wischermann points out, hotel owners can't afford to put off remodeling. “There is more new product being built now than at any time in the past 10 years,” he notes. “Older hotels have to upgrade to compete. The hotel that had its last remodeling just 10 years ago is obsolete today. That's how fast the market is changing.”
— Lee Murphy is a Chicago-based writer.