3 Approaches to Hotel Valuations
Like all Commercial Real Estates (CRE) transactions it is an operating company with a real estate component, and a lot more, that it is being transacted, not just a piece of real estate. The real estate is a key aspect, it is very likely the reason for the transaction, but just as important, or even more so, is the operating results and cash flow the operation is expected to generate. It is an illiquid asset with lots of conflicting information and multiple approaches to estimate its true value that must be reconciled, determining the “Market Value” vs “Investment Value” is critical.
There are three approaches in valuing hotels: The Income Capitalization, Sales Comparison, and Cost Approach.
Let´s start with the Income Capitalization Approach, based on the “present worth of future benefits”, or “Net Present Value of Discounted Cash Flows”. The forecast of income and expense along with the anticipated proceeds from a future sale.
The forecast of income and expense is expressed in nominal or inflation-adjusted dollars for three years to generate a “stabilized year”, intended to reflect the anticipated operating results of the property over its remaining economic life. Of the three valuation approaches this generally provides the clearest and most straight forward conclusions for hotels.
The problem is that this approach does not take into account major market shifts, such as a significant increase in room availability, now even more complicated by the Airbnb phenomenon, new attractions or major companies moving into or out of the area, to name but a few. When the future is expected to be very much like the past this works out, otherwise this is just a starting point.
The Sales Comparison Approach could also be described as the “perfect market” concept, meaning the market incorporates and reflects all variables into the price. The problem is not all properties are created equal, and sometimes in illiquid markets there are few if any comparable, leading to the seller and the buyer having wildly different expectations. In residential transactions this is the default, and sometimes only approach, as you can easily buy the next house, but in CRE, where two hotels right next to each other can have wildly different operating numbers due to location, room size, décor, and even the expertise of the General Manager, this becomes a good reference to be used to the seller or buyers advantage as it may be.
The Cost Approach is ideal in the case of new properties, but as it grows older and begins to deteriorate and depreciate it becomes increasingly difficult to quantify accurately, but most importantly, the revenue generating reality takes precedence; and for “trophy properties” where special events have taken place, it is impossible to calculate. If you want to buy the Waldorf Astoria or The Plaza, there is only one.
Ideally you want to use all three approaches as a reference in the negotiation process, with the highest as an anchor, if you´re the seller, or the lowest if you’re the buyer. A combination such as using historic data to calculate the projected net present value of future earnings combined with a major Performance Improvement Plan (PIP) and the expected increase in RevPAR allows for a very credible argument for a much higher valuation.
Another scenario could be an operating property with enough land to add revenue generating facilities, such as additional rooms or conference space.
When the potential buyer is an operating company it will most likely identify revenue enhancing opportunities attributable to its own expertise and build this into the pricing dynamics.
Also, when the potential buyer is a REIT or a PEREIF it will be able to justify a higher CAP, as the markets provide a diversification premium that can be pass on as part of the acquisition price. Given that we are in a seller’s market and aggressive buyers are having a hard time finding revenue generating properties, there is an inherent bias toward justifying higher prices, and these combination of valuation approaches provide the ammunition. It is in both parties benefit to find these arguments.