Using estimated values to invest prudently
Part of evaluating every hotel investment is figuring out what the property is worth.
- You, as the owner, need to know the maximum you can invest and still earn your target return. It puts boundaries on your negotiations for the hotel. You must know when to walk away and when to pursue.
- Lenders will need to know the value so they can decide how much money they can prudently lend on the hotel. If you can’t anticipate how a lender will value the hotel, you might be wasting your time.
- Equity investors (the ones who help with the cash down payment) need to the know value so they can calculate their potential ROI (return on investment) and decide whether to take the risk. This will help you anticipate their questions and prepare your pitch to them.
Your decisions as owner also affect the value of the property. The valuation analysis lets you compare projections for choosing one brand over another or deciding on a high-end renovation or developing product for a more moderate market position.
Everyone involved in the project uses valuations. This includes you, investors, lenders, and management companies. They will start with your valuation but will do their own due diligence. They are also likely to run several scenarios to evaluate their risk. It’s common for owners to do their own valuation before having a consultant or accountant take an independent look. The consultant’s independent evaluation can also be shared with prospective investors.
Lenders study your valuation to decide if your business plan is carefully thought out and whether to do business with you. In addition, the lender’s underwriter commissions an independent state-certified appraiser to do a form of valuation called an Appraisal Report.
Valuations are commonly done using proprietary or custom spreadsheets. They typically add on to a spreadsheet used to create a projected income statement. There is a template on Fortuna’s Table.
As the future owner and project lead, you use the valuation to guide your negotiations and plans for the hotel. At some point, a proposed deal just might not be worth further attention and money. You also use the valuation to illustrate how much cash flow will be available to pay the mortgage (what lenders want to know) as well as a share of the profits to people who are considering investing equity and yourself.
The simplest way is to look at a stabilized year, after the renovation or ramp up. Of course, there is risk in getting “through the woods” so when you turn that stabilized year cash flow into a value, you need to pick a conversion factor that adequately addresses that risk. The conversion factor is called a “Cap Rate”. Cap stands for capitalization. You will most likely be doing a “Direct Cap”.
A consultant, accountant or appraiser probably does the hotel valuation by applying a Discounted Cash Flow (DCF) analysis to a financial projection. A DCF looks at a 5, 7-or 10-year forecast of net operating income, and estimates the net present value of the stream of income by discounting it. Discount rates are another kind of conversion factor, but take inflation into account. DCFs also assume you will sell the hotel for more than you paid to buy and fix it up. The sale, (or “exit” or “reversion”) is turned into a value in today’s dollars too through discounting. At the end of a DCF, you add together the value of the return ON your investment (the stream of income) and the value of the return OF your investment, which is selling it at the end of your holding period. Discounting takes these future payments, and reduces them for the time value of money (a dollar today is worth more than a dollar in 7 years) and the lost opportunity, i.e. the other investments you might have made if you hadn’t invested in this hotel.
Quick value estimates and Cap rates
The simplest technique is to “cap” net, net operating income, which is also called EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). EBITDA is divided by a “cap rate”, which is expressed as a %, since it is grounded in interest rate percentages and percentage rates of return. A Direct Cap is a short cut to taking net present value of a series of years.
Here are 3 calculations, using the same EBITDA and different Cap rates:
|Low Cap Rate||Moderate Cap Rate||High Cap Rate|
|Value estimate||$50 million||$18.8 million||$10 million|
Why would someone use a 3.0 percent cap rate, if the mortgage interest rate is 5 percent? Normally, you wouldn’t. You would only do that if the $1,500,000 were an unreasonably depressed NOI, (say, during a pandemic or a highly disruptive renovation) and the investor believed that the EBITDA was going to double, or triple quickly. Why would someone use a 15 percent cap rate, if the mortgage interest rate is only 5 percent? Because there was a reasonable belief that things could get worse, very fast. Or, you might have only 15 or 20 years left on a ground lease.
Hotel cap rates vary from year to year but tend to be in the range of 6% to 10%. Remember, a high cap rate reduces the value of a hotel. Hotels that are highly desirable and have multiple bidders may have lower cap rates, much closer to mortgage interest rates. Trophy hotels have very low cap rates, and therefore low returns to their investors, who may be more interested in “bragging rights”. It seems counter intuitive that a low cap rate correlates to high value. However, that is the result the technique of dividing by a percentage. You get used to it.
Usually, the EBITDA from a stabilized year is capped. A stabilized year is after the hotel’s ramp up period and is typically the third year of operation. Sometimes, it is last year’s EBITDA or a Trailing-12 month’s performance. Publicly traded hotel REITs usually use the EBITDA for the first year of their holding period. They call that the “going-in” cap rate.
Here’s a quick screening tool. Take the hotel’s EBITDA from the prior calendar year or prior 12 months and divide it by the asking price. That will give you the seller’s wishful cap rate.
|Low Cap Rate||Moderate Cap Rate||High Cap Rate|
|Asking price||$50 million||$18.8 million||$10 million|
|EBITDA from P&L||$1,500,000||$1,500,000||$1,500,000|
|Calculation||$$1.5 million/$50.0 million||$1.5 million/$18.8 million||$1.5 million/10 milion|
If a seller is asking a 3 percent cap rate on a standard hotel, there needs to be a very good reason to expect performance to improve dramatically, very quickly. Low EBITDA due to a year of COVID might be a reason, for instance. As the buyer, you would study the market to figure out if the opportunity is good enough to justify the price. An 8 percent cap rate might give you a decent return if you can get a mortgage in the 4 to 5 percent range. Remember, your return should be better than the bank’s, since your profit is riskier than their mortgage payment. Your profit comes from “the last dollar”.
Appraisals are prepared by state certified appraisers. Some of them have an extra credential called an MAI (Member of the Appraisal Institute). To value a hotel, the appraiser should have substantial hotel experience because these assets include business risk and operations so specialized knowledge matters.
Appraisals are done for virtually every acquisition or new hotel development. They are an integral part of the lender’s assessment of the risk of making the loan. For this reason, appraisals are commissioned and paid by the lender and then reimbursed by the borrower (you). By law, the lender must use an independent appraiser and must commission the work directly (not through you). This is to enable appraisers to provide truly independent values and is intended to protect the bank and the FDIC which insures bank deposits.
Appraisals report on market value, which is:
“The most probable price as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably and, for self-interest, and assuming that neither is under undue duress.” The Appraisal Institute’s Dictionary of Real Estate Appraisal, 6th Edition
Appraisals arrive at an estimate of the value of the project by reconciling three approaches to value.
- Income capitalization approach: is used to derive a value indication for assets that generate income. It is generally the most relevant approach for hotels. Income capitalization can be done in two ways. You have seen the math behind the Direct Cap Technique. The other, the Discounted Cash Flow (“DCF”) technique Is where the appraiser takes the net present value of each year’s income and adds them together along with the net present value of your anticipated sale of the hotel at the end of the holding period.
- Cost approach: estimates the cost that would be required to construct a replacement or reproduction of the hotel. Since the hotel is not new, if it is an acquisition, the appraiser makes deductions for accrued depreciation due to obsolescence or wear and tear. If it is new, the appraiser uses standard tables to estimate costs. Everyone likes to know if they are getting “a discount to replacement cost”. Gather information on what new hotels in your region have cost to build, and put it in your pitch for financing.
- Sales comparison approach: compares recent sales of similar hotels. Then the sale prices are adjusted for any extra land, amenities, age of hotel, condition of hotel, location, market, brand and other factors to arrive at a value comparison for your hotel project. You do not need to make any adjustments but do include sales information on other hotels in your pitch to the lender or equity sources. Both lenders and equity investors will want to know, directionally, “what hotels are trading for”. You should do research, make call on the budgets for planned renovations, and to be able to explain circumstances of distressed sales (for example, a bankruptcy or the need for a mold remediation) to explain to the lender why your acquisition is a good deal and has value upside.
More information is available in a detailed webinar on hotel appraisals on the Fortuna site from Karen Johnson, President of Pinnacle Advisory-West.
To show potential returns, valuation models may include a “waterfall”. The waterfall shows how much each investor gets – including you – when the hotel is sold, assuming all assumptions come true. Waterfalls are seductive. You can adjust assumptions at the front of the model and, like magic, more money comes to you in the waterfall. Take it with a grain of salt and make sure that your projection has a cushion for changing circumstances.
Waterfalls are added onto a valuation spreadsheet to calculate returns for each investor, including you. They reflect the terms of the investment as shown in the operating agreement.