They call it “real estate,” but assigning a cash value to a business is — at least partly — an imaginary exercise that requires assigning a dollar figure to intangibles such as “desirability” and “charm.” And if it’s tricky to appraise a storefront or a residence, how much more difficult is it to determine the worth of a hotel, whose value rises and falls with the whim of fashion and the fortunes of the region it’s located in? It’s no wonder hotel valuation is the realm of experts.
In general, there are three methods of hotel valuation: income, direct comparison and cost. The income approach is essentially an assessment of the property’s revenue-earning power. “Since purchasers buy hotels as income investments, the income approach will be the primary method of analysis for the vast majority of hotels,” says Edmonton-based Perry Gereluk, vice-president and licensed appraiser, Valuation & Advisory Services with Colliers International Hotels. He notes that there are several different types of income approach.
The first is overall income capitalization, which he describes as “the most common and useful.” In this method, “capitalization rates are referenced for a wide range of hotel types within most geographical areas.” (The “cap rate” is expressed as a ratio comparing income and capital value.) Discounted cash-flow analysis is “also useful for major full-service hotel assets in large cities. It’s not as relevant for conventional limited-service hotels or for full-service hotels in secondary cities. Finally, the gross-income multiplier method “only considers revenue and not expenses and has some relevance for older motel properties in smaller communities, but little usefulness to most other hotels.”
The direct-comparison approach establishes a comparison with the price per room paid for comparable properties in the same type of market. This approach “isn’t as accurate, because income is such a critical factor in hotel acquisition, but vendors and purchasers frequently speak about price-per-room, so it should be part of the conversation,” Gereluk says.
The cost approach is an estimate of the current value of the land, the replacement cost of buildings and other structures and any potential loss in value from depreciation. Gereluk says this approach is “irrelevant to hotel valuation, since vendors and purchasers don’t use this technique. In addition, the difficulties in determining developer profit, functional obsolescence, external depreciation and a variety of other factors make this valuation method a poor predictor of value.”
In order to arrive at a valuation, “the first thing we typically do is a comprehensive review of the hotel itself. We benchmark top-line performance against its competitive market. We’re looking at whether the hotel is under- or overperforming [compared to] its competitors; it gives us an idea of how well the hotel is being operated,” says Brian Flood, VP and practice leader, Hospitality & Gaming Group with Cushman and Wakefield ULC in Toronto. “After that, we’d review the various operational expenses, benchmarking against other properties to make sure the property is operating efficiently. Then, we put together a pro-forma projected revenue and expenses over five to 10 years. Once we have a grasp of the income-generating ability of the property, it’s a matter of converting the cash flow to value. We look at what kind of returns investors are looking at; we interview investors and market participants. We’ll also look at what else has transacted in the market. From that we use a capitalization rate.”
Flood says he also looks at the price per room. “With those metrics, we can convert the estimated cash flows into an estimated value.”
These methodologies have not varied much over recent years, but Flood says lenders are now examining hotel valuations more closely than they might have done in the past and there’s more scrutiny of the quality and condition of the asset and of potential capital-improvement costs.
Gereluk cautions “it’s critical that appraisers understand how comparable sales have been analyzed and not just take capitalization-rate or internal-rate-of-return information at face value, lest there are inconsistencies between the stabilization of the comparable sales versus the subject property. This is one of the dangers that’s evolved with the emergence of technology,” he says. “It can separate the appraiser from the sources of data. Appraisers should try to avoid relying on superficial third-party claims about the physical, transactional and financial details of comparable hotel sales.”
Because hotels differ so much from other types of real-estate asset in terms of their diverse features, tangible personal property, such as spa and restaurant equipment, and intangible assets, such as reputation, brand affiliation and staff, hotel valuation is “very different than a conventional office, retail, or industrial-property appraisal,” says Gereluk. Consequently, “a hotel appraiser needs to be skilled in reading financial statements. Such statements need to be translated into stabilized net-operating income. Accounting–oriented expenses, like depreciation, debt-service costs and a variety of other items, need to be excluded in order to maintain a consistent analysis.”
“Hotels are unique; there are never two that are exactly the same,” says Flood. “They’re physically different, in different locations; the management is different.” Additional complexities include the volatility of the hospitality market and the external factors that can affect value, such as new competitors in a formerly uncontested market. “You can have an asset that’s doing well, but if it’s doing really well, chances are other properties will spring up,” he says.
Hotel valuation necessarily changes according to geography and market segment. “If you look at central Canada and the West Coast, clearly, hotels are performing much better in those markets than in Saskatchewan and Alberta, so pricing is significantly higher,” he notes. “In markets that are underperforming, investors have to be willing to take on a lot more risk.”
In summary, Gereluk says, “hotel valuation is arguably the most difficult asset to appraise. As such, investors and lenders should rely on appraisers with a deep understanding of this asset class before ordering a hotel appraisal.”
Written by Sarah Hood