Hotel conversion and development finance

What is conversion and development finance?

Development finance funds the building of a new hotel from the ground up. Conversion finance funds changing the use of an existing building into a hotel, most commonly an office, but also redundant retail, a former public building or a tired property being repositioned. Both work the same way: the lender funds a project that is not yet earning, releases the money in stages as work progresses, and is repaid when the finished hotel is refinanced or sold. Because the lender is taking construction and lease-up risk, the rate is higher than a term mortgage and the term is short.

This is a guide to funding a hotel project as a business. It assumes you intend to build, convert and trade the hotel, not simply hold a site.

The two routes differ in risk and so in finance. A ground-up development carries construction risk, planning risk and lease-up risk, and usually a longer programme, so lenders price it cautiously and watch the build closely. A conversion of an existing building can be quicker and cheaper, because the structure is already there, but it brings its own technical risk: an older building may not lend itself to efficient hotel layouts. Both are funded on the same staged, cost-and-value basis, but a lender will scrutinise the cost plan and the contingency hard, because cost overruns are the commonest cause of a project running short of money before it can open and trade.

Office-to-hotel and other conversions

Office-to-hotel conversion has become a notable trend as demand for some older office space has softened while well-located buildings suit hotel use. Savills has written about the rise of office-to-hotel conversions, and grand civic and heritage buildings can make distinctive hotels. A conversion can be faster to market than a new build and can secure a prime location at a lower entry cost, but it carries technical risk: floor-to-ceiling heights, servicing, plumbing for ensuite bathrooms, fire strategy and accessibility all need to work for hotel use.

Planning and use class C1

Hotels sit in use class C1 in England. Converting a building from another use to a hotel is a material change of use that normally requires planning permission, so you should expect to apply rather than rely on permitted development rights, which are limited for hotel use. Engage a planning consultant early, confirm the local plan supports hotel use on the site, and factor the timeline and the risk of refusal into the project. Listed buildings and conservation areas add further consent requirements.

• Confirm the proposed use falls within class C1 and what consents are needed
• Check whether permitted development rights apply, as they are limited for hotels
• Engage a planning consultant and pre-application advice early
• Allow for listed building or conservation area consent where relevant
• Build the planning timeline and risk into the finance and programme

How the finance is structured

Development and conversion finance is sized against cost and against the gross development value, the expected value of the finished, trading hotel. The lender advances a proportion of each and lends the lower resulting figure, so you need equity to fund the gap.

The money is released in stages, or drawdowns, against a monitoring surveyor's certificates confirming the work done, which protects the lender and keeps interest costs down because you only draw what you need when you need it.

Lenders almost always expect the borrower's equity to go in first or alongside, not last. That is why a development typically needs around 35 to 40% of cost as equity, with the lender funding the rest in arrears against verified progress. Interest is often rolled up into the facility rather than paid monthly, since the project has no income during the build, and is settled on exit. Understanding this cash-flow shape is important: you carry the equity and the early cost, the lender funds the build as it proves out, and the rolled-up interest is repaid when you refinance or sell the finished hotel.

Costs beyond the build

A hotel project costs more than the construction. Budget for professional fees, the FF&E that fits out the rooms and public areas, brand-standard requirements if you are affiliating, and a contingency. You also need working capital to cover the lease-up period, the months after opening before the hotel reaches stable occupancy and RevPAR. Underfunding the lease-up is a common cause of distress on otherwise sound projects.

The contingency deserves particular care. Conversions of older buildings frequently uncover surprises once work starts, structural issues, services that need replacing, or planning conditions that add cost, so a thin contingency can leave a project short before it opens. Lenders expect a sensible contingency built into the cost plan and will stress the figures, because a project that runs out of money mid-build is the worst outcome for borrower and lender alike. A realistic budget with proper professional input and a genuine contingency is what gets a development funded on good terms.

• Construction or conversion cost, with a sensible contingency
• Professional fees: architect, cost consultant, planning, legal
• FF&E and fit-out of rooms and public areas
• Brand-standard spend where affiliating to a flag
• Interest and finance fees during the build
• Working capital for the lease-up period after opening

Exiting the development loan

Development and conversion finance is short-term bridging to a trading hotel, so the exit is planned from the outset. The usual exit is to refinance onto a term commercial mortgage once the hotel is built, open and trading, at which point the going-concern value and the EBITDARM support long-term debt at a lower rate. The alternative exit is to sell the completed hotel. Lenders will want to see a credible exit before they fund, because the development rate is not sustainable over the long term.

Timing the refinance matters. A hotel that has just opened has little trading history, so a lender refinancing it cannot yet size against mature EBITDARM and may offer less. Many borrowers therefore plan a short stabilisation period on a stabilisation or extended development facility, then refinance once the hotel has built a few quarters of trade and can be valued on a fuller going-concern basis. Building that bridge period, and the working capital to fund it, into the original plan avoids being forced to refinance at a weak moment. We map the whole path, from first drawdown to long-term mortgage, before the project starts.