Expert appraisers interpret the key factors driving valuation
It’s often said hotels are much more than bricks and mortar, and this is especially true when appraising a property’s market value. In fact, it’s easy to forget a hotel’s real worth is not the capital cost of marble-lined spas, golf courses, elegant FF&E, or even its location, but the income stream all its many components generate.
“Like an apartment or other commercial property, people don’t necessarily buy a hotel for the real estate value — they buy it for the ‘rent,’” says Charles Suddaby, vice-president of Consulting and Valuations, for Colliers International Realty Advisors in Toronto.
Given the complexity of operating even a small hotel, you’d expect projecting its profit potential for the next decade — let alone next year — to be a tricky business. And it is. But there’s good news for hoteliers curious about a property’s market potential. With a few key figures, it’s also possible to do a reasonably useful amateur appraisal.
“To do a quick and dirty evaluation, you can look at a hotel’s net income and divide that by the cap (capitalization) rate,” says Nick Bilodeau, senior manager, Franchise Financing with GE Capital Solutions in Montreal. “For example, if you have a cap rate of eight per cent and a property that’s earning $2 million per year, you’d estimate a $25 million value.”
Backing up a moment for those less familiar with appraisal theory (i.e. most people), “cap rate” is the ratio between the cash flow produced by a real-estate asset and its capital cost. Essentially, this measures how fast an investment will pay for itself. Bilodeau says cap rates vary from eight to 12 per cent, depending on variables such as hotel type and market size. Of course the real trick for appraisers is selecting the appropriate cap rate to reliably calculate — and project — net income. And considering the number of zeros in a hotel’s price, back-of-the-napkin calculations are only a starting point.
Calculating net income means analyzing occupancy and ADR, market conditions affecting future ability to achieve those rates, and determining that expenses such as labour, utilities, maintenance, management fees, insurance and reserve funds are within market norms, says Carrie Russell, Vancouver-based senior vice-president with appraisal and consulting firm HVS International. “Once we know the net income, we look at the ability to leverage it: loan-to-value ratios, cost of debt, equity yield requirements, and amortization periods with the debt, which allows us to develop a sophisticated discounted cash flow,” she says.
However, like any complex calculation, appraising a property is a mix of art and science. “There is sensitivity to some of the numbers you are inputting,” says Russell. “You can see everything aggressively or everything conservatively and get a different result, so the judgment comes in trying to reflect how the market sees it,” she says. Suddaby agrees that hotel valuation is not an exact science. “We’re not right all the time, by any means,” he says frankly. “You may look at a piece of income and say the risk associated with that is X, and I’ll say it’s Y, and we could both be right in our rationale.”
Nevertheless, appraisers agree one of the most important variables to analyze is future supply and demand. “A property in Northern Alberta where the single most important demand generator is oil, is totally different from one located in Markham, Ont. (just north of Toronto) where there are multiple demand generators,” says Bilodeau. “That has an impact on sustainability of demand, which has an impact on occupancy and room rates.”
On the flip side, Russell says the factor most likely to affect a hotel’s value is new supply in a market. “When demand drops [a property’s] value may go down a bit, but it won’t be a dramatic decrease. But if a hotel [sees] two new competitors open up next door, it will have a much greater impact. Typically its room revenue will go down.”
There’s also no substitute for actually touring a property and kicking its tires, says Tim Westlake, senior vice-president with rating agency DBRS in Toronto. While not an appraiser, Westlake often looks closely at the sustainability of a hotel’s cash flow to rate the credit quality of securitized commercial real estate mortgage debt. When performing an in-depth analysis, he says hitting the road helps you assess the hotel’s physical condition, and lets you snoop around for possible environmental problems. Additionally, given the importance of competing supply, it’s also helpful to see the surrounding locale, and its potential for development, with your own eyes.
While the basic methodology for valuing a hotel is well-established, Suddaby says there are some new trends in benchmarking. “RevPAR was a fairly innovative term 15 or 20 years ago — before that everybody used to deal with just occupancy and room rate. Now there’s “revenue per guest,” “revenue per guest-day,” and “profit per occupied room,” he says. Another tool not to be overlooked is comparing a property to a similar one that’s recently changed hands. This is, however, much trickier than comparisons in residential real estate given the relatively low number of properties on the market. “In a year where we have 100 sales we think we have great data,” says Russell.
Finally, with hotel prices at an all-time high, what everyone wants to know is: What’s next? Polishing off her crystal ball, Russell says there’s currently no indication values will decline. “All the fundamentals seem to be in place: demand is strong, we don’t have a lot of oversupplied markets, and there’s a strong availability of debt so hotels are able to get good financing terms.”
Suddaby agrees, although he’s mildly apprehensive the economy may be at the top of its cycle, leading to an increasing risk of hotel revenues and performance sliding. “We’ve been on a good eight-year roll, but [someday] it’s got to slow down. I’m certainly not suggesting it’s going to disintegrate, but maybe we’re close to that peak.”