Hospitality

Birth of a Boutique Hotel

This Hospitality Niche Proves Profitable for a Canadian Developer.

With modern designs, personalized attention, and unique amenities, boutique hotels offer an alternative to hotel chains for travelers — and developers.

Growing affluence, greater mobility, and sophisticated tastes have increased this niche property's popularity, creating opportunities for commercial real estate professionals.

While the definition of a boutique hotel varies, most agree that it is unbranded, smaller than regular hotels, and more exclusive. It also targets a specific market.

Boutique hotels can offer many benefits to developers. Without a brand enforcing specific design and operational standards, a boutique hotel can be designed cost-effectively to offer more of what its target market wants. This flexibility extends to the property's operational aspects as well. Finally, management, franchise, and other fees associated with chain hotels are eliminated.

However, boutique hotels also present challenges to developers. Obtaining financing is more difficult without the backing of a brand. Since it does not follow a cookie-cutter plan, design elements must be introduced early in the development stage because they can be costly to change later. Boutique hotels also don't have the support of a national or international reservation system and marketing campaign. Further, high service levels can be challenging to achieve without a large operator's recruitment and training programs.

While boutique hotels are not for first-time hoteliers, experienced, independent-minded operators may be able to create a better product — both physically and operationally — for less capital and operating dollars. This can leverage returns nicely.

Recently, Westcorp, a real estate investment company in Edmonton, Alberta, successfully executed a boutique hotel project.

Westcorp focuses on developing a long-term income-producing portfolio. Equity capital is internally generated and augmented through joint ventures with high-net-worth, entrepreneurial individuals. The company does its own development, leasing, construction, and property management. Although a small part of its business, Westcorp has owned and operated full-service hotels for more than 20 years.

During the mid-1990s, Westcorp began looking for an opportunity to develop a boutique hotel in Edmonton. The hotel would target both business and recreational travelers who were affluent baby boomers or younger and who would become loyal, repeat customers if offered an interesting, exclusive, and comfortable experience. The company also pursued a strong female customer base, which it felt was fast growing but underserved.

The Edmonton Market Edmonton is a city of contradictions. It boasts a prosperous economy that is diversifying from its resource-based roots. However, Edmonton's property prices are among the lowest on the continent due to overbuilding in the 1980s.

Recently, the hospitality industry has not fared well. It reached saturation with about 12,000 rooms, and the only new supply in 20 years has been limited-service product in the suburbs. The market exhibits one of the lowest revenue per available rooms in Canada. Many hotels are not financially viable.

Still, with its booming economic base including the energy and biotechnology industries, Edmonton is predicted to be one of Canada's fastest-growing cities, so a turnaround is expected.

One area in particular shows promise. The trendy, historic area known as Old Strathcona is close to the central business district, a major university, and a large research and teaching hospital. It also boasts some of the best street-front retail between Vancouver and Toronto.

During the early 1970s, a small hotel with some retail space and an attached parking garage was built in the area. By the mid-1990s, it had not produced a positive net operating income in several years, and the lender, a large local bank, was pressuring the owner to sell. Westcorp considered the property's location and its mixed-use aspect and decided it presented the perfect opportunity for a boutique hotel development despite the overall hospitality market.

Financial Obstacles Westcorp hit a snag when it decided to buy the property. The bank decided that the company's offer was too low by at least 50 percent and the bank only was willing to give the purchaser 21 days for both due diligence and financing. After several meetings, Westcorp walked away from the deal.

A couple of years later, Westcorp tried again to negotiate a deal with the bank but again the deal fell through. However, the due diligence investigation had included environmental, structural, mechanical, electrical, and financial studies. The site was clean and structurally sound with all other systems at or near the end of their life cycles.

A redevelopment would require gutting the structure, providing the opportunity to rebuild with fewer constraints. Normally Westcorp requires a development margin of 15 percent to 25 percent of the project's final value, depending on the risk. While the development wasn't a risky venture, obtaining conventional financing would be a significant challenge. The property was in a strong retail location, and the retail space could garner significant lease income.

Ultimately, Westcorp arranged 50-50 joint venture financing with an individual it had worked with previously. The company promised to repay the individual's senior loan within two years of the project's completion with takeout financing.

Design Considerations With financing in place, redevelopment commenced. The physical property included three distinctly different portions: a 225-stall parking structure with 9,000 square feet of retail space; the main food and beverage area that contained two large bars, a restaurant, and banquet areas; and a six-story tower with 89 rooms and suites.

The long side of the 396-foot by 132-foot site faced the trendy retail avenue. The buildings went to the property line on all four sides. The property was in dreadful condition with a dated appearance, so Westcorp closed it and let the staff go so it could under- take a complete rehabilitation.

The guest rooms were a reasonable size — 12.5 feet by 25 feet — and the hallways were wide. Other than that, not much else worked. Even with high levels of comfort and service, room prices only could be set so high, and no other boutique hotel existed in the area for comparison prices. Risk management demanded a cost- effective rehabilitation.

First, a new first-floor layout was designed around the concept that maximizing retail lease income would be an asset when refinancing. The hotel lobby entrance was moved from the busy front street to a quiet side street allowing for the addition of 2,500 sf of prime retail space. Eventually, the total retail space increased to 25,000 sf, and it was leased in part to experienced food and beverage operators that could service the hotel guests, yet gain from being attached to a hotel.

In addition to retail space, other features were added to the hotel. Six different-sized meeting and banquet rooms were created, the largest of which seats 150 people. Executive offices were added with enough room to house a significant hotel sales and marketing department. A small but high-quality fitness facility, a business center, and a concierge room for guests also were included. Storage and staff areas were designed to help promote pride in the workplace and provide high service levels.

The look and feel of the property was important to establishing it as a boutique hotel. As purchased, it resembled a bunker from both the front and side streets with few windows and entry points. New windows and doors opened the property up to the street, and crown molding was added to the top of the tower for architectural detail. Another molding was added between the first and second floors to provide delineation for the retail, which got new signage, storefronts, and lighting. Three different treatments were used to make the property seem like a series of smaller properties.

The hotel's interior was renovated at the same time as the redevelopment of the retail space and building exterior. It was designed to be unique, yet casual. Layout, lighting, colors, finishes, and furnishings were chosen to make a statement. Beyond impressing the most discerning guests, the hotel rooms also needed high-speed Internet access, fax lines, working desks, and armoires to provide a focal point.

Next came leasing the retail areas. Westcorp turned down 95 percent of lease offers on the basis that they did not suit the desired merchandising mix that it hoped guests would find interesting and useful. A signature restaurateur, Sorrentino's, leased 6,000 sf at a reduced rent and entered into an operating agreement to provide catering services to the hotel's banquet and meeting rooms. Second Cup Coffee Co., a national gourmet coffeehouse, adjoined the lobby along with a high-end optical store with a unique gift component. O'Byrne's Irish Pub, a high-end soap store, a spa, a juice bar, an adventure sports apparel store, and a music shop rounded out the retail component.

Aside from the restaurant, lease rates exceeded expectations, at about $30 per sf. In fact, the value of the retail covered the full purchase price of the property, the retail redevelopment, the exterior renovations, and a portion of the hotel renovations.

Because the property was not en route to a destination or a significant destination itself, an aggressive marketing campaign was designed and implemented.

Open for Business When the hotel opened in early 1997, it was renamed the Varscona. Occupancy levels met pro forma but not expectations in the first year. However, reviews from guests were superb. Second-year results exceeded expectations. Halfway through its third year, the property has hit its stride. With the exception of one other property, Varscona enjoys the highest hotel occupancy — more than 80 percent — in the city, and it has the third-highest average daily rate.

The hotel is popular with both business and recreational travelers. The ADR is increasing, and that is expected to continue over the next few years. The monthly financial statements are a pleasure to review and the community likes the changes. Investors now want to be included in similar projects.

Further development opportunities exist with the property. The parking structure can carry three more levels of building, which could be residential, hotel (more rooms or extended stay), or with a land-use change, other commercial use. Westcorp currently has an offer to lease from a national tenant for a six-screen, art-house cinema. It's not clear whether the company will be successful in obtaining the necessary permits because opposition has surfaced.

While small, Varscona's visibility is big. It has added cachet to Westcorp's corporate résumé while being one of its more profitable projects. The development margin turned out to be about 40 percent. Westcorp has been successful in obtaining financing on a nonrecourse basis for the full cost with the bank that originally turned it down.

The Varscona project demonstrates the potential of the boutique hotel format. Developed in an oversupplied market, in an off-the-beaten-path location, it has proved to be successful. 

Phil Milroy, CCIM

Phil Milroy, CCIM, is president of Westcorp in Edmonton, Alberta. Contact him at (780) 431-3333 or pjmilroy@ccim.net.

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