Hotel valuation is a subjective process that involves many variables and assumptions. Consequently, the final value or value range can vary greatly from one appraiser to the next. However, it is important to remember that at the end of the day the valuation results must hold up to the “reasonable appraiser” test.
The value estimated is dependent upon the purpose of the report and the Approach taken. For instance, an appraisal for insurance purposes will invariably result in a much different value than an appraisal for mortgage financing purposes. The following is a look at the three Approaches to value in relation to hotel valuation:
This method involves 2 primary steps:
- Determining the market value of the underlying land by applying the Direct Comparison Approach, which is the most often used approach for land valuation.
- Determining the cost of the buildings (improvements) after consideration for depreciation. This estimate is then added to the market value of land as determined through step “A”.
Land value is typically estimated using the Direct Comparison Approach, which is also known as the Market Comparison Approach. Within this Approach a unit value is determined for comparative purposes, which in the case of land is most often a per square foot of surface basis or on a per buildable square foot basis. The per square foot of surface basis requires the appraiser to simply estimate the market value of the land based on the per square foot values of the comparable sales evidence relative to the Subject property. The per buildable square foot basis requires the appraiser to estimate the market value of the land based upon an analysis of the allowable buildable densities of the comparable sales data relative to the Subject property. Ideally comparable sales evidence will be available, which will indicate a reliable per unit value. For instance, the following sales data can be analyzed as follows:
The above example of sales data indicates that the current market value for similar lands is in the range of $20.00 to $25.00 per square foot of surface area or $10.00 to $12.50 per buildable square foot.
In reality, sales data is never this clean and simple, thus adjustments to the sales data are required to varying degrees to reflect differences in: sale date; property size; zoning; location; etc. Nevertheless, the intention of the above chart is to provide an overview of two common techniques for valuing land within the Cost Approach.
Building cost is often estimated using a reliable cost manual system provided by an internationally recognized firm, such as Marshall & Swift/Boeckh. An important aspect about these costing manuals is that they attempt to estimate the replacement cost value of the improvements as opposed to the reproduction cost of the existing improvements. What this means is that the cost of improvements is based upon the cost (as of the effective date of the appraisal) to replace the utility of the improvements versus the cost to reproduce the existing improvements. If the purpose of the appraisal is to cost the replacement of improvements as they exist in their current utility then a quantity surveyor would likely be ideal in estimating this value. A quantity surveyor often uses manual costs, however they are also well informed about current costs and are experts at estimating the costs of replacing improvements as they exist in their present form.
Probably the single biggest reason the Cost Approach is not considered to be an accurate representation of market value is due to the difficulty in estimating depreciation. In theory, the difference between market value of buildings and the replacement cost of buildings is depreciation. For example:
Depreciation or obsolescence as it is known in appraisal circles is the loss in value of buildings over time due to wear and tear, physical deterioration, age, economic conditions and/or locational obsolescence. Estimating depreciation is difficult, arbitrary and unreliable. Consequently, if the objective of the appraisal is market value, then the cost approach is not considered the preferred method. The cost method is preferred if the purpose of the appraisal is for insurance purposes or another purpose where the replacement value of buildings is primary.
Direct Comparison Approach
This method relies on the assumption that a matrix of attributes or major features of a property can be analyzed in order to establish an estimate of value. With regards to hotels, the most commonly used unit for comparison is the value per room, i.e.:
As shown above the indicated value for comparable hotels is in the range of $93,750 per room to $111,000. The obvious weakness of this approach is the fact that a range of dissimilarities are ignored. Although all hotels have rooms, there are many other aspects that affect value including: food & beverage outlets, retail tenancies, health clubs, land size, and so forth. For this reason, the Direct Comparison Approach is not preferred when looking at an income producing property such as hotels. Rather it is considered to be a reasonable secondary guide to value, typically providing a range of value. It may be reasonable to rely upon this approach if you are appraising near identical properties, such as motels without many amenities. However, it should not be relied upon without also considering the Income Approach.
The Income Approach is the preferred and most commonly relied upon valuation approach, the purpose of the appraisal is to estimate market value, where market value is typically defined as (source: CUSPAP, Canadian Uniform Standards of Professional Appraisal Practice):
The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
- buyer and seller are typically motivated;
- both parties are well informed or well advised, and acting in what they consider their best interests;
- a reasonable time is allowed for exposure in the open market;
- payment is made in terms of cash in Canadian dollars or in terms of financial arrangements comparable thereto; and
- the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
Within the Income Approach there are two commonly applied techniques, the Direct Capitalization Method and the Discounted Cash Flow Method. They are summarized as follows:
The Direct Capitalization Method (DCM) is considered to be a “snapshot” of a property’s income with the Discounted Cash Flow Method (DCF) being more of a moving picture over a predetermined time period. The Direct Capitalization Method looks at a property’s income potential based on historical and current financial information as well as industry norms in order to stabilize the income for a one year period. Thereafter, the stabilized income is capitalized at an overall rate considered consistent with the market to yield an estimate of the Market Value of the property. The Direct Capitalization Method is frequently used, as it is relatively simple in application, particularly for smaller properties and for properties at normalized income levels. However, for hotels that are not at normalized levels of income, which has been particularly true since September 11, 2001, this method is considered less reliable with the Discounted Cash Flow Method being the preferred methodology.
As previously mentioned the Discounted Cash Flow Method (DCF) looks at a number of years, as opposed to relying on one year of stabilized income. The DCF is ideal if future income does not mirror the current income and when future income is subject to variances. This is typical for hotels, as they usually have various sources of revenue and are highly sensitive to both micro and macro economic factors. The DCF requires the appraiser to forecast revenue and expenses for a predetermined period of time, typically between 5 and 10 years. The cash flow for each year is then discounted to the effective date and combined with a final disposition value less any transaction costs that may arise. The proper application of the DCF involves selection of not only an overall cap. rate but also an appropriate discount rate and transaction cost amount. Industry norms as well as the property’s available financial information form part of the data analysis necessary in order to accurately forecast future revenue and expenses.
The choice of whether to select the Direct Capitalization Approach or the Discounted Cash Flow approach is an appraiser decision; however the purpose of the appraisal may well dictate one approach over the other. In the case of hotel appraisals, lenders often require several years of cash flow for mortgage underwriting purposes, consequently the Discounted Cash Flow Method will be required. The major difference between the two methods is that the Direct Capitalization method requires less forecasting, thus it is less subjective, which can be viewed as its strength. However, the weakness of the Direct Capitalization Method is that it does not fully consider the hotel’s future income potential. As a result it does not consider market uncertainty, which would lead to fluctuations in the Subject’s income. For instance, the Direct Capitalization method would not have been the preferred valuation approach in 2004 (post 911 and SARS) as the temporarily depressed hotel incomes could easily have led to artificially low appraised values. Another example of how market volatility can compromise the reliability of the Direct Capitalization Method is when there is a major anticipated shift in room supply. This would have a definite effect on a hotel’s occupancy and Average Daily Rate resulting in fluctuations in future room revenues.
The Discounted Cash Flow Method is ideal if future income forecasts are required, which is often the case when considering mortgage financing on a hotel. However, like the Direct Capitalization Method it too has weaknesses. Relative to the Direct Capitalization Method, the Discounted Cash Flow Method is riskier and more speculative in terms of value predictability. It involves more subjective estimates and appraiser assumptions/predictions in regards to the hotel’s income and hotel market trends. All things considered it is best to apply both these methods in order to examine whether or not there are dramatic valuation differences between the two techniques.
Within the Income Approach there are two key elements necessary for valuation, which is common to both the DCM and DCF methods: Net Operating Income (NOI) and Capitalization Rate. They are discussed as follows:
Net Operating Income (NOI) or Earnings Before Interest, Tax, Debt and Amortization (EBITDA)
The analysis and normalization (stabilization) of hotel financials is a critical aspect of hotel valuation.
A typical hotel financial statement for appraisal purposes has 4 distinct parts: Revenue Departments, Departmental Expenses, Undistributed Expenses and Fixed Costs. A brief explanation of each category is provided:
Revenue Departments : Include room revenues, food & beverage revenues and telephone/other revenues. Other revenues include miscellaneous items, such as spa revenues, parking, tenancies, etc.
Departmental Expenses : Include room expenses, food & beverage expenses and expenses attributed to the telephone/other category. These are expenses and costs that can be directly attributed to each related revenue department. For instance, housekeeping wages can be directly associated to rooms; therefore they are considered to be a departmental room expense item.
Undistributed Expenses – Typically Include expenses which cannot be specifically or exclusively allocated to any of the noted Revenue sources. Included within this category are: franchise fees, management fees, administration and general expenses, marketing expenses, repairs & maintenances (property operations), energy costs and an allowance for reserve for replacements.
Fixed Costs – This cost typically just includes insurance and property taxes.
After the appraiser has normalized all revenues and expenses the final net number is: Revenues less Departmental Expenses, less Undistributed Expenses and less Fixed Costs. This net number is known as the net income or net operating income (NOI), or earnings before interest, tax (income), depreciation and amortization (EBITDA).
Once the NOI/EBITDA has been estimated the appraiser must then estimate and apply the appropriate capitalization rate.
The single most important factor in applying the income approach is the selection of the capitalization rate (cap. rate). This is also the most debated matter when it comes to arbitration, assessment appeals or matters of conflict relating to hotel values. The cap. rate is the yield rate that is anticipated in the market place. The anticipated yield rate is then applied to the stabilized net income of the hotel in order to capitalize the net income into an opinion of market value. In Canada the most accepted method for determining cap. rates is to analyze comparable hotels sales data. For example:
Comparable Hotel Sales
As is shown, the three sales indicate a cap. rate range of 9.0% to 10.0%. The most important step in determining cap. rates is the stabilization of the net incomes (NOI or EBITDA) of the sales data in a manner consistent with how the Subject net income was stabilized.
Index #1: Cap. Rate Stabilization Analysis
As is shown, the inclusion of a 4% reserve for replacement (4% of gross Income) lowers the cap. rate from 12% to 10%. This is a huge difference that distorts the value of the Subject Property by as much as 20%. When appraising a hotel it is imperative that a replacement reserve be considered in the NOI. Therefore, the sales data must be analyzed to ensure that a similar expense is reflected in the comparable sales’ net incomes before relying on a cap. rate extracted from that data. The same principle of consistency regarding stabilization applies to distributed and undistributed expenses. This is probably the single biggest appraisal error that occurs among hotel valuators and is a valid reason why appraisers should never rely blindly upon reported cap. rates and/or other sources of published information. The appraiser must be able to verify how the various net incomes have been stabilized, which will determine the integrity of the reported cap. rate. In conclusion, cap. rates must be applied with caution as they can greatly distort the market value.
Another common cap. rate technique is known as the Band of Investment (equity approach). This method estimates cap. rates by selecting appropriate rates of return from equity markets (risk free, mortgage and return on equity rates). This approach is not based upon actual sales data; consequently it is less preferable method. This approach is more popular in the United States and is seldom accepted by Canadian tribunals, which prefer to see cap. rates that have been derived from the market place.
A sample hotel valuation, applying the Direct Capitalization Method is provided:
As is shown, the stabilized current market value is based upon first year’s stabilized income.
The appraising of hotels is a complex analysis involving an immeasurable number of variances, subjective processes and estimates. Some variations that could easily have a significant affect on value are lump sum deductions or additions that are not reflected within a hotel’s financials, such as deferred maintenance or excess land. Only a professional hotel valuator should be relied upon to appraise your hotel, as this property type requires a special set of skills and experience, which are not universal among appraisal professionals.
Some important definitions are:
Net Income (EBITA) – Net Income or EBITDA or EBITA is the hotel’s income after expenses have been deducted from gross income, but before income taxes, amortization and depreciation. Appraisers ignore these items for purposes of establishing market value.
Reserve for Replacement – Is a notional deduction to offset the wear and tear of FF&E (furniture, fixtures and equipment) over time. In theory, FF&E wears out every 7 to 8 years, thus in order to replace these depreciating items over time, an allowance (usually 4% of gross revenues) is provided for in stabilizing the net income. Although hotel buildings also experience depreciation a notional structural allowance is not typically allowed for in the stabilization process. However, mathematically it is considered within the capitalization process.
Reasonable Appraiser – one who maintains a level of performance that would be acceptable to the professional practice peer group.
The Cost Approach – The Cost Approach to value assumes that a prudent purchaser will not pay more for a property than the cost to recreate it in its present condition provided there are no costly delays or economic factors, which might influence value. This approach involves the determination of the replacement cost of the improvements, less depreciation, plus the value of the land, as though vacant.
The Direct Comparison Approach – This approach to value is based on the Principle of Substitution, which affirms that a prudent purchaser will not pay more for a property than the price of an equally desirable substitute property available under similar conditions. This approach provides a reliable indication of value, particularly in an active market, given a reasonable availability of market data having a sufficient degree of comparability to the Subject.
The Income Approach – The Income Approach involves a conversion of anticipated future benefits to be derived from the ownership of property into a value estimate through a capitalization process, which converts the anticipated future income and/or reversions to a present worth estimate.
Special thanks to Ms. My Phung from the Vancouver/Victoria office of IHA, International Hotel Appraisers Inc. for all her contributory assistance related to the preparation and research of this article.