Financial Due Diligence
Financial due diligence is crucial because ultimately, you want to make money with your hotel. Big picture, you want a hotel to make you money in two ways:
- Cash flow from operating the hotel: the profitable net of revenues less expenses
- Capital gain from selling the hotel: the profit you receive when the hotel is sold, mortgages and other liabilities are satisfied, investors are paid and the remainder is yours
Due diligence about cash flow from operations includes studying market demand and supply so you understand the risks and opportunities with future revenue. Due diligence also includes studying historic and projected expenses so you can evaluate your prospects for profit.
You also do due diligence about the project’s value currently and in the future to evaluate your prospects of making capital gains.
Historical Financial Analysis
If you are acquiring a hotel, you will have the opportunity to analyze the hotel’s past income statements. Whether or not you have a financial background, this is crucial. So evaluate the data yourself and also go over it with your accountant or someone who is knowledgeable about hotel financial performance.
You can purchase benchmark data on hotels from Smith Travel Research or CBRE in annual publications like the HOST Almanac. You can also purchase custom reports on a particular set of comparable hotels you choose. Benchmark information may also be available through your management company, consultant, appraiser or the seller. Use benchmark statements to compare the hotel’s performance to its own history and to industry benchmarks of like hotels.
- What expenses are out of line with industry averages? Whether the actual is too high (something may be misclassified or there may be a problem like mold removal because the roof leaks) or too low (for instance bills may not be recorded to make performance look better), these flag questions to ask. Every hotel is different so there are always expenses that are out of line. It doesn’t necessarily indicate a problem, but it does indicate something to research as part of your due diligence.
- What expenses are out of line with prior year performance and with budgets? Understanding the answers to this question will prepare you operate the hotel. For instance, if marketing is much lower this year than last year, you may have to catch up (put additional money in your projection) when you take over in order to keep sales up.
You should have questions. That is appropriate and the management company, broker, seller and your accountant and consultant should be able to address those questions. Be courteous about their time. Keep track of the answers so you don’t repeatedly ask the same thing. Focus your attention on material items. If the owner’s mother charged a set of sheets to the hotel, check for a pattern that will affect your projections. If there isn’t, let it go.
USALI is the Uniform System of Accounts for the Lodging Industry. Accountants and consultants with a hotel specialization will use a format close to USALI. Sometimes accountants and consultants use a system of accounts adapted from an apartment or retail business. This is an indication that they are not knowledgeable enough about hotels to be reliable advisors on a hotel project. This is a business in which industry knowledge is valuable and a lack of industry specialization can be dangerous for you.
There are small changes in the USALI format every few years. Generally, people knowledgeable about the industry will provide a statement close enough to the current USALI to enable you to benchmark results and compare your projections to the hotel’s historic performance.
Financial Projections and Estimates
You need a financial projection to evaluate if this is a good investment for you. You also need a financial projection (projection of income and expense) to show your lenders and investors how you expect the hotel to perform. A projection will be critical to your planning and negotiations.
Your projection will be based on the specific ideas you have for the hotel in terms of management, marketing and facility when you are the owner. Remember that all projections are about an uncertain future. All projections reflect the interests of the entity doing the preparation. They are estimates and actual results will vary.
You can do your own projections. There is a template in Fortuna’s Table. There is a more in-depth template in the She Has a Deal class. You can have your consultant add financial projections to your market study. It is also appropriate to have your accountant work on projections. Whoever does the projections should have hotel expertise and should present them in USALI format.
Financial projections will be part of the appraisal your lender has done for the project. USALI should enable you to correlate your projections to the appraiser’s projections.
Your broker may have projections available if the seller has done budgets (short term projections) or longer-term projections with a consultant.
Don’t expect all these visions of the future to match. An appraiser’s projections reflect the lender’s interest in loan security. A management company’s projections reflect their interest in winning the business and in managing your expectations so they can be successful as your operator. A seller’s projections reflect the optimism they would like a buyer to have about the hotel.
As a prospective owner, you can do sensitivity analysis. This shows optimistic and pessimistic versions of your projection to let you assess the upside and the downside of the project.
Feasibility is the reasonableness that this project can be made, done or achieved. In a financial or economic sense, The acronym TELOS refers to the five areas of feasibility – Technical, Economic, Legal, Operational and Scheduling.
ROI (Return on investment)