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Considerations in the valuation of hotels.

The accurate valuation of a hotel can be a trying assignment for those who are not routinely exposed to this complex property type. The singular nature of many of the determinants that drive value requires in-depth analysis of factors often overlooked, or at best treated improperly.

Hotels differ significantly from any other form of real estate and, from a valuation perspective, can be far more complex. The following factors serve to distinguish hotels from other property types.

* Office buildings, multifamily residential properties, and retail space are typically subject to leases ranging from one month to several years. Conversely, hotel rooms must be rented daily, thereby requiring sophisticated and ongoing marketing. With rapidly changing supply and demand conditions, hotels are vulnerable to competition and subject to dramatic swings in utilization. This translates directly into an increase in the risk associated with a property. As will be discussed later in this article, hotels normally command higher rates of return, primarily because of the inherently risky nature of the property type.

* As much as 40% of a hotel's operating expenses is devoted to payroll costs and benefits. This high degree of management intensity is seldom appreciated in the valuation process, yet can be crucial to the ultimate success or failure of a property. Even temporary lapses in service can result in a loss of customers that may be difficult to recapture.

* Affiliation and management are of critical importance in the lodging market. The image and perception of the brand with which the property is associated can be a primary determinant of the success or failure of a property. Some hotels obtain over half of their accommodated room nights through a central reservations system. As a result of these factors, the presence or lack of a strong national affiliation and competent management team can have a substantial impact on operations and, therefore, on value.

* Properties that fail to produce sufficient cash flow have severely reduced market values. On average, an occupancy of 65% to 70% is required to break even, assuming typical debt structure. As a result of the high level of fixed costs associated with hotel operations, a drop of 10 to 15 occupancy points can eliminate all net operating income (NOI) or even prevent a property from meeting operating costs. Occupancy declines of this magnitude are not uncommon in light of a hotel's sensitivity to market conditions. Consequently, the value of a property can be reduced to a fraction of cost in a relatively short period of time.

Currently, many hotel properties are operating in markets in which there is little chance of covering debt service. The industry, in aggregate, has experienced losses for over a decade. The unique characteristics of hotels, combined with the industry's poor financial condition, can make hotel appraisal assignments particularly difficult. What method and valuation techniques are applicable? What pitfalls should be avoided? This article addresses these questions in more detail.


The three recognized valuation approaches that apply to most other property types are also applicable, with some modifications, to the appraisal of hotels.

Cost approach

Although land value is frequently an important decision point, a full cost approach often fails to result in a reliable value indication for a hotel. Even though the market participants for distressed hotels often refer to the "percent of cost" for which a property is sold, supply and demand imbalances can result in significant external obsolescence that is difficult to quantify and is outside the scope of this article.

Sales comparison approach

Hotel investors tend to focus on product type (e.g., full service versus limited service), operating within certain types of markets (e.g., resort versus airport), and located within certain regions of the country (e.g., Sunbelt versus Northeast). A buyer seldom targets a specific location. Consequently, comparable sales should be similar with respect to the product, market orientation, and region, but need not be located in the same market area. In fact, recent transaction data in different geographic areas are superior to dated comparables in the same market as the property being valued.

In the sales comparison approach, a traditional price-per-room analysis may be inconclusive because of the subjective nature of many of the adjustments. For example, two physically identical hotels in similar locations could bring vastly different prices per room as a result of dissimilarities in affiliation, management, financial performance, and numerous other items. A hybrid approach that combines features of both the income and the sales comparison approaches is often a useful tool for clarifying the confusion that can result when an attempt is made to employ a traditional sales comparison approach with positive and negative adjustments for various individual factors. After adjustments for other items that may be more readily quantifiable (e.g., property rights conveyed, financing terms, conditions of sale, date of sale, location, physical characteristics), a ratio analysis using NOI per room is a useful tool that can often be employed to adjust for income differentials between the sales and the subject property. This analysis involves obtaining the relationship or ratio of NOI per room between the subject property and each of the comparable sales. For example, if the subject produces $5,000 NOI per room while a comparable generates $4,000 NOI per room, the ratio is 1.25. In this procedure, the factor of 1.25 is multiplied by the sale price per room of the comparable. When applied to each of the sales, the result is often a more reliable range of value than using subjective adjustments alone in a price-per-room analysis.

Critics argue that this type of procedure has many similarities to an overall rate analysis used in the income approach and therefore lends to the sales comparison approach a tone of being driven by the income a property is capable of producing. In reality this is what actually does drive the sale of any income-producing property. Income potential may be the only value determinant that results in diverse prices being paid for otherwise similar assets. In sum, while the weaknesses are acknowledged, the strengths appear to outweigh the disadvantages because this technique is often the only way to make sense of the sale data.

Frequently, even under a "best case" scenario insufficient income is generated to produce a positive return to the property. Does this mean the asset has no value or is no longer the highest and best use of the site? Often the answer is no. Ample evidence that some value is left in the improvements is typically found in sales of other distressed properties. Except in unusual cases, a buyer almost always exists who is convinced he or she can run the property at a profit. While the number of transactions may be few and the prices dramatically depressed, such properties do sell and often command prices enough above land value to undeniably support the fact that the current use is still the highest and best use of the property as improved.

In severely distressed situations, negative income is projected throughout the analysis period. This wreaks havoc with the income approach but often draws an appraiser back to basic fundamentals regarding the sales comparison approach; that is, sales of other distressed hotels. A somewhat narrow range of value often results from sales and listings of severely distressed hotels regardless of their physical characteristics. Such data appear to indicate value ranges of $5,000 to $15,000 per room. A severely distressed, relatively new, full-service hotel may sell for no more than an older, limited-service property.

Effective room revenue multiplier analysis is again gaining favor with the market and is used frequently in both pricing and buying decisions. The procedure is especially applicable to lower priced hotels that lack sophisticated management. Buyers of these properties are concerned primarily with revenue-generating potential without regard to a property's operating expenses.

Both the direct capitalization and discounted cash flow (DCF) techniques provide valid indications of value for hotels. During the 1980s, DCF became the most popular valuation method because it enables an investor to see the changing income stream over the course of a holding period. Nevertheless, some investors consider this technique to be suspect because numerous assumptions are made and extended well into the future. As a result of the rigid mathematical process involved, an initial premise/assumption that is slightly inaccurate would be compounded in subsequent years of analysis.

The difficulty in accurately projecting cash flows over an extended holding period has led many investors back to direct capitalization, which is simple in application and requires only an estimate of one year's NOI. Many of the assumptions for a DCF analysis are included in the direct capitalization method, but are primarily built into the overall capitalization rate. This results in a major benefit because specific assumptions are limited and the measurement of value is a direct reflection of the market's actions. The obvious shortcoming of direct capitalization is its failure to recognize the inevitable swings in NOI typically experienced by hotels.

Factors such as increased risk perception, the intense management required, and volatile supply and demand considerations tend to cause hotels to have higher return requirements than many other types of real estate. Discount rates and capitalization rates appear to be especially sensitive to the added risk associated with hotel investments. In actual sale data and investor surveys, discount rates are typically found to be 200 to 500 basis points above other property types, while overall rates indicate a 100- to 300-basis-point premium. Delinquency rates on hotel loans are far greater than on other property types, thus contributing to the increased spread in rates of return attributable to risk.

Market analysis

Regardless of the technique employed in the income approach, a thorough market analysis is required to obtain a reliable estimate of NOI. Much has been written about the importance of market analysis, the general economic environment, site and area analysis, and the physical features of hotels. Adequate supply and demand analysis, market penetration analysis, and reliable financial projections that are sensitive to the fixed and variable components of each line item of expenses, however, are often overlooked. The remainder of this article addresses these items in more detail.

A market analysis for a hotel involves a substantial amount of research. An analyst must understand the general environment in which the hotel operates as well as specifics that could influence the success or failure of a property. As such, a market study requires skill in data collection, interviewing techniques, data analysis, and the use of a variety of information to reach conclusions regarding the market viability of the property. The market analysis should, at a minimum, consist of the following steps.

* Site and area analysis

* Assessment of general economic conditions

* Supply and demand analysis

* Facilities review

* Market penetration analysis

* Projections of cash flow from operations

While these procedures are common in the analysis of most forms of income-producing real estate, their application to hotels may differ in some respects.

Site and area analysis

The objective of a site and area analysis is to determine whether the sales potential in the market area can be realized on the subject site. Although the old adage "location, location, location" still applies, the importance of access and visibility may vary depending on the nature of the property and the market. In lodging markets dominated by commercial travel, guest rooms are usually booked in advance by repeat customers. Accordingly, immediate access and visibility may not be as important. Similarly, resort hotels are typically destination oriented and may not require excellent access and visibility. Conversely, access and visibility are critical to an economy property located on an interstate highway. These properties often cater to "impulse buyers" and slight inconveniences can result in lost room nights.

Hotel development tends to occur in clusters. In theory, the "critical mass" of hotels and support facilities at a given location enhances overall market area demand. This is particularly true in highway markets. In evaluating a property's location, consideration should be given to emerging clusters. Often when a new cluster of properties is developed, market area demand shifts to the new location. As a result, the properties at the new location perform well at the expense of the older properties. Despite the claims of general managers that their customers are loyal, in reality most hotel guests are quite fickle and, absent a strong frequent-guest program, will change properties with little incentive.

General economic environment

Because demand for hotel rooms may not be locally generated, area demographics tend to be less important in hotel market analyses than in other property types. These data do help, however, to define the general economic environment in which a hotel operates and serve as a partial basis for projecting growth in room night demand.

Supply and demand analysis

Often referred to as the "guts" of a market study, a supply and demand analysis is of critical importance in determining future market conditions. An appraiser's primary goal should be to:

* Define the current supply of rooms considered to be competitive with the subject property.

* Investigate the status of proposed competitive properties and decide which have the highest probability of being constructed.

* Analyze the market segments that are demanding rooms at the competitive hotels, the rate at which demand is growing, and future sources of demand for rooms.

Supply. Analyzing proposed supply additions can be difficult, particularly with the increasing influence of foreign investors in U.S. hotel markets. Development projects that appear to have little appeal to domestic investors have longer term investment horizons and focus on equity growth rather than immediate cash flow. Further complicating the analysis of future supply additions is the difficulty of obtaining financing for hotels. The recent financial troubles of lending institutions combined with overbuilding in many markets have made hotel financing difficult, if not impossible, to obtain. Consequently, even projects that offer the greatest market potential may never reach fruition.

Dramatic supply increases were experienced throughout the 1980s causing many markets to be overbuilt. The extensive supply growth was caused by three primary factors: 1) the availability of funds, particularly through savings and loans; 2) the favorable tax treatment afforded real estate in general and hotels in particular (e.g., up to 40% of a hotel's hard costs could qualify for the investment tax credit); and 3) product segmentation. Financing is now limited, tax incentives have been abolished and, although further segmentation of the industry is continuing, this phenomenon has diminished to a large degree. Consequently, supply expansion has begun to abate.

Demand. The identification of demand sources is usually best accomplished through interviews with managers of area hotels. General managers often keep detailed records that identify primary customers. Management of a subject property (if an existing property) may even be able to provide the specific number of room nights sold to each major customer. This information can be supplemented by interviews with the demand generators that focus on their future accommodation needs as well as their level of satisfaction with the subject.

When a proposed hotel is being appraised and competitive hotels cannot be easily identified, prospective levels of demand can be obtained through a survey of potential users. For instance, if a proposed resort hotel in a remote location is being appraised, a survey of meeting planners designed to determine their potential propensity to book the property is useful.

Most hotels, particularly those that are group meeting oriented, have some sort of marketing plan. A review of a property's marketing plan helps to identify demand sources and to facilitate a better understanding of the property's position within a particular market. The property's positioning may not be appropriate and a change in affiliation or market orientation may be necessary. An appraiser must be able to recognize these deficiencies and adjust his or her value accordingly.

Procedures for analyzing demand growth vary and should be dictated by the nature of the market. In a market dominated by office parks, the future absorption of office space may be a good indicator of commercial demand growth. Traffic volume may be the best indicator in a market in which demand is generated by interstate highway motorists. On the other hand, an airport market may require an analysis of historical and projected enplanement activity. Regardless of the basis selected, the focus must be on future growth. Historical demand growth may or may not be relevant. A new convention center, tourist attraction, stadium, or other major development can dramatically increase demand levels. Conversely, the loss of a large employer, airline carrier, or other source of demand can have the opposite effect. Future demand should be analyzed by segment (e.g., commercial travelers, group meetings, tourists). Each of these demand sources is driven by different factors. For example, a severe economic downturn may have an immediate impact on commercial travel, yet because of the lengthy advanced booking of conventions, impact on the group-meeting segment might be delayed.

The supply and demand analysis is a critical stage of a study and requires a number of subjective decisions. It is important to be as accurate as possible because the supply of guest rooms, the identification of demand, and the growth rates projected are the primary rationale for establishing the customer base available to a hotel.

Combining the analysis of supply additions with anticipated demand growth, an appraiser develops projections of market-area occupancy for several years. The dynamic nature of most markets is likely to result in fluctuating occupancies that can ultimately affect the operation of the property being appraised.

Market penetration analysis

The basic approach in conducting a market penetration analysis is to evaluate the effect and importance of numerous, generally unquantifiable factors that can affect the competitive ability of a hotel to penetrate a market. These factors include:

* Size of the property

* Room rate structure

* Overall decor and physical appearance

* Quality of management

* Chain affiliation

* Quality and character of neighborhood

* Facilities and amenities offered

Each of these factors must be considered and evaluated relative to each competitor in each demand segment. The result of these analyses is the projection of occupancy and average room rates for the subject hotel's next several years of operation.

Many analysts employ a "fair market share" approach to penetration. In this method, a property's ability to capture levels of demand above or below its fair market share is projected. For instance, a 100-room hotel operating in a market that consists of 2,000 hotel rooms would have a fair market share of 5.0% (i.e., 100 / 2,000). If an appraiser felt that the property was exceptionally competitive within a particular demand segment, he or she might project the property to capture 125% of its fair market share, or 6.25% (i.e., 5.0 x 1.25) of the accommodated demand in the market. Conversely, a lack of competitiveness would result in a hotel's capturing less than 100% of fair market share. The advantage of the fair market share approach is that it recognizes the capacity constraints of a hotel. This approach, or a variation of it, is widely used by hotel appraisers and is well suited to markets that operate at capacity during peak demand periods. In an overbuilt market, however, capacity constraints may not be a factor and this method could be misleading. Unfortunately, most appraisers and lenders tend to focus on penetration levels as a percentage of fair market share without considering property size. Again, this is acceptable in healthy markets but not in distressed markets. For example, consider the following situation.

* A 200-room hotel operates in a market having 1,000 rooms; accordingly, its fair market share is 20% (i.e., 200 / 1,000).

* Market-area occupancy is 50% and the subject property is operating at 100% of its fair market share. Therefore, its occupancy is 50%.

If a property is evaluated solely on the basis of fair market share, it may be concluded that the property is equally as desirable as its competitors because it is operating at 100% of its fair market share. But what if the property were hypothetically downsized to 150 rooms with all other facilities remaining the same?

Because the property sells 100 rooms per night, it never reaches capacity and probably never sells as many as 150 rooms. Therefore, at 150 rooms its occupancy would be 66.7% (i.e., 100 / 150) and its fair market share would be 15.8% (i.e., 150 / 950). Its penetration as a percentage of fair market share would thus be 127% (i.e., 66.7% / 52.6%). Again, based solely on fair share penetration analysis, one would conclude that the property is highly desirable relative to its competitors, when in fact the property's desirability has not changed. It has only decreased the number of guest rooms.

This scenario demonstrates the importance of considering property size when analyzing a hotel in a weak market environment. In such markets, it is not unusual for smaller hotels to achieve penetration levels significantly in excess of fair market share even though these hotels may not be more desirable than their larger competitors. Consequently, it is difficult to draw meaningful conclusions from the comparison of market penetration as a percentage of fair market share between hotels. In distressed markets, an analysis of penetration levels (i.e., the percentage of room nights captured by the subject relative to total accommodated demand) without regard to fair market share is more appropriate.

Hotels differ considerably in terms of their competitive attributes or lack thereof. Variations in occupancy can be far greater than those experienced by office buildings, retail projects, or residential developments. Certain hotels frequently perform at levels 15 to 20 occupancy points above or below market area occupancy. This can result from a number of factors, including size, location, facilities, rate structure, and brand affiliation.

As the number of independent hotels diminishes, a property's brand affiliation is becoming increasingly important. Some brands provide good value to hotel owners by generating substantial room nights through their reservations system, frequent guest programs, or national marketing efforts. Others provide product awareness but do not necessarily generate a material number of room nights. Brand affiliations are expensive, often costing up to 8% of total revenues. Accordingly, a nonproductive brand can severely diminish cash flow and, therefore, value. When appraising an affiliated hotel, a thorough understanding of the brand is required. Questions that must be answered include:

* What percentage of a property's room nights are generated by the reservations system?

* What marketing synergism exists as a result of the presence of other hotels in the region having the same brand? Particularly with respect to group-meeting demand, referrals from "sister" hotels can be helpful.

* What is the franchisor's policy relative to new development in the same market area? Some franchisors routinely issue franchises in markets where their brand already exists. The impact on the existing franchisee can be severe.

* How demanding are the franchisor's quality control requirements? Almost all brands espouse quality control. In reality, however, many do not enforce their requirements. Poor quality control will ultimately damage a brand's reputation and negatively affect all franchisees, even those that maintain the highest standards.

Substantial time is often spent analyzing market conditions, but little attention is applied to fully analyzing a subject property's position within the market. An analyst should avoid assuming that a hotel will perform at or near market-occupancy levels as substantial variation may exist among properties.

Financial projections

Because projected cash flow from operations is the basis for a DCF analysis, it is essential that the projection be as accurate as possible. Each line item should be evaluated on the most appropriate basis for that particular item. For example, rooms department payroll should not be based on a percentage of room sales because increases in average room rate do not result in corresponding increases in payroll. It is much better to evaluate rooms payroll on a "dollars per occupied room" basis. Similarly, hotels with large amounts of public space may incur significant energy costs without regard to guest room use. In this instance, energy should be projected on a "dollars per square foot" basis.


In all cases, comparable operating results should be used. With existing hotels, historical information should obviously be analyzed. It should be noted, however, that the historical data may not be relevant if a property has been poorly managed. When appraising a proposed property, an appraiser should obtain and use financial information from comparable, competently managed properties.

As are restaurants, hotels can be "ego" investments. Owners often do not appreciate the management intensity of lodging operations and try to manage the properties themselves. Although many owners are capable operators, those not well schooled in the industry are likely to operate inefficient properties. A number of methods can be used to evaluate operating performance relative to industry norms and may reveal obvious deficiencies. When conducting such an analysis, an appraiser should avoid focusing solely on percentage relationships as changes in a property's average room rate do not affect expenses and can materially distort percentages.

Because 30% to 40% of a property's operating costs are represented by payroll, a productivity analysis can be useful. Ideally, management is able to match labor needs to activity levels. Although an absolute matching is seldom accomplished, some properties tend to be more efficient than others. Comparing a subject's labor costs per specified unit to comparable properties quickly identifies overstaffing. For instance, housekeepers should be able to clean 12 to 14 rooms per shift. By dividing occupied rooms by eight-hour housekeeping shifts, an appraiser can determine whether a subject is within this guideline. If short, housekeeping labor costs are probably too high and should be adjusted downward to reflect competent management. This same type of analysis can be applied to many departments (e.g., covers served per waiter, check-ins handled per front desk clerk). In any event, the objective is to reflect the operating results that should be achieved assuming competent management.

Particular attention should be given to defining fixed and variable components of each line item. In light of the propensity of hotels to exhibit fluctuating utilization levels, ignoring fixed and variable components can result in a materially misleading projection. The appropriate fixed and variable components for selected line items are presented in Figure 1.

Table 1 illustrates the impact of fixed and variable components. Column 3 of Table 1 presents the projected operating results for a hypothetical 175-room hotel running 75% occupancy. Columns 1 and 2 present the adjusted cash flow assuming the occupancy was 60%. Column 1 reflects the application of fixed and variable percentages of each line item. Column 2 assumes all revenues and expenses are variable. Obviously, in this case ignoring the fixed and variable components of the line items would lead to a material overstatement of value via the income approach.


Hotel valuation is more of a challenge now than ever before in light of the state of flux that currently exists in the industry. Refocused attention toward the basic valuation foundations such as supply and demand analysis, diligent sales investigation, realistic current and likely future income expectations, and attention to the economics of both the market and the property being valued are vital in such times.

Changing market conditions require adjustments to traditional valuation methods. This article reinforces basic requirements necessary in any hotel valuation to provoke thought concerning new options that may be applicable.

Charles B. Walsh, MAI, is managing director of valuation and technical services for the Atlanta Regional Office of Landauer Associates, Inc. He received a BS in business with a major in real estate from the University of Alabama and has 19 years of experience in appraising a variety of property types both in the United States and abroad.

Henry B. Staley, Jr., of Atlanta, Georgia, is a senior vice president in the Hotel Group of Landauer Associates, Inc., a national real estate appraisal and consulting firm. He received a BS in accounting from the University of Georgia and is a Certified Public Accountant (CPA).
COPYRIGHT 1993 The Appraisal Institute
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Walsh, Charles B.; Staley, Henry B., Jr.
Publication:Appraisal Journal
Date:Jul 1, 1993
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