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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   October 2018

What’s That Hotel Worth?

Valuing a hospitality property involves assessing it as an asset and as a business operation


How can commercial mortgage brokers and the clients they represent determine the value of hotel assets that are being eyed for acquisition? To answer that question, we must first know what tools are available to assist commercial mortgage brokers.

In terms of the financial realities, it’s best to think of hotels as having two lives. One life involves the real estate property itself: the actual building and the value of the real estate from the vantage point of what a replacement of the hotel would cost.

The other life revolves around the financial performance of the hotel. Let’s first address the easier one — the value of the hotel as an asset — and explore it in more depth.

Replacement cost

The cost of building a hotel is determined by the status of the hotel. Simply put, there are five levels, from one star to five stars. To make it a bit more confusing, there are several “types” of hotels, such as economy, select, extended-stay, convention, resort, boutique and more.

So, step one is to understand the differences among the levels and types, as well as the costs related to developing each. If a loan is being requested on an existing hotel, then the crucial factor is the replacement cost. It should be intuitive that if an existing hotel has a replacement value of X, and the price of the hotel that the borrower is looking to buy exceeds the replacement value, some yellow flags should be raised.

Of course, this is a broad generalization. The property could be in a location that is one of a kind and hard to duplicate. That creates value. Also, the business performance of the hotel could be very strong with no end in sight. If that can be determined, then this also raises the value of the hotel. Another major factor is the condition of the hotel. Hotels must be renovated, and the cost of this renovation must be added to the price and compared to the replacement value.

So, let’s assume a 100-room, Holiday Inn Express property is for sale. The cost of building a new hotel, including land-acquisition costs, is $130,000 per room, or a $13 million total expense for new construction. You then get a loan application involving the purchase of this Holiday Inn Express.

The purchase price is set at $15 million. The loan application is for $11 million, and the borrower must put up $4 million in equity. The hotel is 15 years old. There is a property-improvement plan drafted by the hotel-management company to improve the condition of the asset. It calls for installing brand-standard upgrades and refreshing the asset at an additional cost of $4 million. With closing expenses, this deal has a total cost of $20 million.

As the mortgage broker on this deal, you should feel some sense of caution because the total cost of the deal is about 35 percent higher than the property’s replacement value. As the lender, your concern is how the buyer will one day retire the loan. What is the exit strategy? Will the buyer be able to find a future buyer willing to pay a price that is a much higher percentage of replacement value?

Income approach

The second approach to understanding the value of a hotel, and to determine whether financing can be arranged, is to understand the financial realities of the business. This second approach works in tandem with an analysis of the real estate’s value.

A hotel is an operating business as well as a real estate asset. The operating business involves renting rooms and, in some cases, additional revenue comes from the sale of food, beverages and other items. All these revenue sources create the total revenue of the hotel and impact its value beyond the value of the real estate itself. In other words, a well-performing hotel property — all other things being equal — is worth more than a poorly performing property.

Room sales are the most important aspect of assessing performance. The factor used to measure room revenue is called RevPAR, or revenue per available room. RevPAR is calculated by multiplying the average daily rate, or ADR, by the hotel’s occupancy. There are a variety of reports available to the mortgage community to help with this evaluation. Probably the most important one is the Smith Travel Report, or STR. Using this information, the broker can evaluate how the hotel is performing in comparison to other similarly situated hotels in the area. This is known as the comp set, or the competitive set.

Using reports like the STR and others can demonstrate not just how a hotel is performing but also can provide brokers with a looking glass into the future. Understanding the existing competition in the area as well as any incoming supply of additional hotels also can be instructive in understanding whether the volume of future business projected for the target hotel is being overstated. Again, if the borrower cannot demonstrate that the asset being targeted for purchase will continue to experience revenue and profit growth, then a red light should come on.

Revenue is used to operate the hotel. These operations also generate expenses. When all of these are calculated, including the fixed costs of insurance and property taxes, the mortgage broker will be able to determine the property’s net operating income, or NOI, which is essentially the hotel’s profit.

The profit of the hotel is a key data point in understanding its value. Using another formula, the capitalization rate, the broker can measure this value. The cap rate — which is the property’s net operating income divided by its current market value — is a generally accepted industry formula for determining a real estate investment’s potential rate of return, and it is mostly a risk-based assessment. When the real estate cycle is performing well, occupancy is strong and the ADR is high, which results in the cap rate being lower because the risk is lower.

When the cap rate is lower, the value of the hotel asset is higher. Conversely, when the market slows and the risk is greater, the cap rate will rise, and the value of the asset will decrease.

• • •

These methods of assessing value are critical. When used alongside an assessment of market strength from the STR report, they can give commercial mortgage brokers a better handle on how a particular property may perform in the years ahead. This should play a big role in decision making related to the financing process.


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