Your due diligence for a hotel acquisition you are considering will test the investment by gathering critical information and analyzing it to determine if the acquisition meets your criteria for a wise or advisable investment. You as well as your bankers, management company, franchise company, investors and every other stakeholder will do their own due diligence. Some things may get studied more than once because everyone, including you, does due diligence with their own interests in mind. At the core, due diligence is about discovery which will enable you to make many decisions about the investment opportunity such as whether to proceed at all, how much to pay, how much debt you can carry and on what terms, whether you need equity partners, and how much working capital you will need until the hotel is cash positive. This article focusses on due diligence for an acquisition. For new development, there are additional steps and experts.
Thorough due diligence will highlight the following for you:
- Magical thinking: You will have an emotional investment in the deal; so, it’s important to let your due diligence be comprehensive enough to guard against the “magical thinking” that makes a project unrealistically rosy.
- Unforeseen conditions: Every hotel has surprises; you want to uncover as many as possible during due diligence so you can address them, and either negotiate about them or reject the acquisition, sooner rather than later.
- Fish or cut bait: Some deals “pencil” and some don’t work financially. If it’s a good deal, catch that fish. If it’s not, pay attention to your due diligence so you can “cut bait” and move on to a better project. This is the one of the hardest decisions you will make in this process.
Due diligence specialties
When you want to pursue a hotel, you start working with the broker or hotel representative. Then you do your own due diligence to decide if you are interested enough to dig deeper. This process of “digging deeper” involves identifying experts, negotiating for their services, overseeing and coordinating their work, listening and asking questions until you really understand the asset enough to do the necessary investment analysis. The kinds of information you will collect, working with your experts, include the following:
- Market due diligence: includes analysis of historical market data and the market assessment you do yourself as well as market studies and feasibility studies that are done by consultants. If there isn’t a market opportunity that provides you upside, there is no point in pursuing the hotel. You will probably do some level of market due diligence on several hotel opportunities before you choose one to pursue. In that first level, you will look at many hotels offered through hotel brokers, comparing the opportunities from reading broker packages. From there, you can evaluate the hotels further on the internet, reading the property websites and reviewing sites like TripAdvisor. For those that interest you, you then drive the neighborhood to get a feel for the community and market dynamics. You walk through the hotel to get a feel for the property. Then you will engage consultants, as needed.
- Financial due diligence: translates the market assessment and hotel concept into a financial projection of potential revenues and expenses. Financial due diligence for an existing hotel also includes analysis of past performance and a determination of the extent to which increases in revenue and/or reductions in expenses are achievable and what is needed to achieve those improved results. You do review the numbers to determine if you are interested. Your accountant and consultants will do additional work on this for you.
- Investment due diligence includes creating various scenarios of cash flow, sources and uses of capital, financing terms and covenants, working capital, IRR, hold and exit strategy to determine the potential investment return over time and whether the investment makes sense under different scenarios of likelihood for each of the assumptions in the analysis.
- Valuation due diligence: builds on the financial analysis by converting the income projection into an estimate of what a willing buyer would pay a willing seller. Valuations estimate the value of the project based on its income stream. Appraisals test the income-based valuation by reconciling the valuation with how much similar hotels sold for and by calculating what it would cost to build or replace the hotel. You make an assessment to decide whether to pursue the project. Your lender will have an MAI appraiser do a formal appraisal.
- Legal due diligence: makes sure that you will be the legal owner of the project once you buy it. It also makes sure that you are not acquiring any debts or unpaid bills you don’t know about. Your attorney defines assets and obligations being assumed, covenants, escrow and schedules as required to close. Through your attorney, you will have a title search and survey review done and will buy title insurance.
- Operations due diligence: uncovers any unexpected complications with the operation and sets up your takeover of the hotel. It includes understanding the executive team and organizational chart, expense review, analysis of staffing and productivity, working capital needs assessment, and plan for oversight and integration. If there is a union for any of the positions, you or your operator will probably be required to assume the contract and therefore, will be subject to all of its requirements, costs, and restrictions. Therefore, reviewing the collective bargaining agreement with your attorney will be critical to understanding the asset and the real potential to improve labor costs, which will be your largest operating expense.
- Accounting due diligence: (technical financial analysis) reviews the general procedures, cash, revenue/accounts receivable, purchases/accounts payable, inventory, pre-paid expenses, deposits, related party transactions, vendors and service providers. Typically done with an accountant (yours or from the management company), this has two purposes. First it prepares for closing so you pay for goods, payroll and services, property taxes, etc. used after the handover (say midnight on the day of closing) and the seller pays for those used before midnight. These are pro-rated as part of the closing process. The second purpose is to set you up to take over operations seamlessly without any surprises for you or negative impact on guests.
- Survey: Your lender will require a survey. Your broker may have one already available from the seller. If not, you can look up local surveyors, get quotes, and have a survey done. Surveys tell you about boundary lines/property lines; overlaps and gaps; right of way, easements and abandoned roads, surface water, joint driveways, walls and rights, and existing improvements that may be in violation of laws or restrictions; setbacks and measurements. Not only is it important for you to know exactly what real estate you are buying but also it might identify limitations which will inhibit expansion or renovation plans which are central to your investment analysis.
- ADA: Your architect, based on their review of the hotel, may recommend having an ADA (disability accessibility) assessment done, or may be able to do an ADA assessment for you. They may recommend a consultant but you should get two to three quotes. The ADA assessment will tell you what work needs to be done to make the hotel ADA compliant, what can be grandfathered in, and what will be required if you make other property improvements. The ADA is complex and unavoidable so if your architect anticipates significant issues, they cannot advise you on, it makes sense to have a specialist’s professional evaluation done.
- ESA Phase I: Your lender may request an Environmental Assessment, but may tell you that it is optional for your project. Your broker may have one that was done previously for the seller, or you may choose to have the work done (or not). It is unusual to do more than a Phase 1 for a hotel and only some kinds of financing require Phase 1 ESAs.
- Property Condition Report or Assessment: This process will examine the hotel’s furniture, fixtures, and equipment (FF&E), building and other structural features, and mechanical, electrical, and plumbing systems (MEP). When appropriate, a specialized consultant would review the elements of each category to provide descriptions, deficiencies, and recommendations. The building and structural reports should comply with ASTA standards. If you plan significant renovations, your engineers, architects, designers, and professional specialists will tell you if your concept to add or modify equipment or facilities is practical at a reasonable cost. The property condition assessment will also include a review of the furniture and décor as to the need for replacement and/or improvements based on your new vision and the intended market position, especially if the existing or new brand has provided a property improvement plan (PIP) of improvements required to keep or convert to the brand. Every item on the PIP and any replacements beyond the PIP will need to be costed out completely as part of the acquisition’s financial analysis.
- Technical due diligence: tests the physical asset and might include environmental assessment, fire/life safety review, seismic review and others. Which technical evaluations you need depends on the observed condition of the property and lender requirements. You hire specialists for these reviews and to translate their information into an understanding of capital investment required.
- Property Tax: There will be a property tax expense line on the financial statements for any hotel you buy. However, this may not reflect the actual property tax you will incur as the owner, and which you’ll need to estimate for your operating pro forma. Property tax is based on the value of the hotel which is determined by the price you pay so the tax in future years might be much higher than the expense on the historical financial statements. You can calculate this from information on the local Property Assessor’s website. The formula is (hotel price paid x assessment rate x millage rate). On the assessor’s site you can also verify that prior property taxes have been paid so you can get these settled before you take title because they follow the real estate and you would otherwise be obligated for that liability if it’s not paid by the seller.
Some due diligence gives you facts, like there is a leak in the roof or mildew in guest room 310, or the lobby bathroom is ADA compliant, or there are no unpaid property taxes. Other due diligence gives you estimates, projections or expert opinions like “the hotel is projected to operate at 80 percent occupancy in year 3” or “the estimated value is $15 million”. Estimates and projections give you an idea of a future that is reasonable. However, estimates and projections may or may not come to pass so your analysis should accommodate different scenarios. Think of each estimate or projection as a possibility and expect that actual results will vary depending on a host of variables from weather to war.
You are not expected to be an expert in all things and even experts bring in other experts to provide the best (and unbiased) information and opinions. Consultants who specialize in various aspects of due diligence for hotels can be found at www.ISHC.org. The International Society of Hospitality Consultants (ISHC) is a professional organization known for its highly regarded members. When you need a specialist, you can also get referrals from brokers, architects and designers, your brand representative, other consultants, your management company, other operators and other research. In each case, you should get 2 to 3 proposals and make a determination about whether you really need the service (sometimes you don’t) the quality provided, pricing, and ease of working with the specialist.
