Part III Being There
4.4 Valuing Hotel Assets
multiple. That is, a hotel transferred for $12 million and generating $6 million of revenues has been sold at a multiple of two times revenues.
Also related to this is the averagegross room revenue multiplier(GRRM)—a method commonly used for valuing economy hotels but that is less often applied in the valuation of upscale properties. Those are normally valued on the cap rate calculations as described in the next paragraphs. GRRMs across all location categories have tended to range from 2.5 times to 3.6 times.
A sum-of-the-parts approach would typically take each of a company’s major operating lines—usually owned properties, leased properties, managed and fran- chised fees, and timeshares—and apply a target multiple (which depends on interest rates and recent overall stock market multiples) to the EBITDA of each operating line. A summation of those values less long-term debt plus cash would provide an equity value as in Table4.6.
Most often, however, hotel real estate would use the cap rate (income capital- ization) approach. Here, a property’s income stream (cash flow excluding mainte- nance reserves) over a specified period is projected into the future and an appropriate capitalization rate (multiple) is then applied to this forecasted income stream. The cap rate represents the market’s sentiment of the moment, the cost of debt, the required return on equity, and the upside returns that buyers hope to achieve. This widely accepted real estate benchmark is calculated as a hotel’s net operating income (NOI) divided by its value or sale price. Although the annual NOI used in the calculation will be projected a year forward, the more verifiable trailing-12-months data will, especially for risk-averse lenders, always be a decisive factor.
The appropriate capitalization rate—in all cases tied indirectly to interest rate conditions in the economy as a whole—may be derived from a number of sources including capitalization rates for similar recent property transactions. Generally,
market value¼ðaverage annual income streamÞ=ðoverall capitalization rateÞ;
Table 4.6 Sum-of-the-parts approach
EBITDA Target multiple Enterprise value
Owned properties $700 9.0 $6,300
Leased properties 50 7.0 350
Managed and franchised fees 500 12.0 6,000
Other (incl. timeshare) 90 9.0 810
Total 1,340 10.0 13,460
Less projected long-term debt 4,460
Plus cash 540
Equity value 5,000
Divided by fully-diluted shares outstanding 1,250
Projected price per share: $4.00
but this formula greatly oversimplifies the situation. A more sophisticated formula that takes into account the amount of debt to total financing would be:
overall capitalization rate¼PdMCþ ð1PdÞ Re,
wherePdis the percentage of debt financing to total financing,MCis the mortgage constant, 1Pdis the equity financing percentage (because the sum of debt and equity is always 100 %), andReis the annual required return on the equity portion.
The mortgage constant term stands for the capitalization rate for debt, which is the ratio of annual debt service to the original loan principal. It is a function of the interest rate, term of loan, and frequency of loan payments. For example, on $1 million of debt, an annual mortgage payment of $100,000 that includes the cost of interest and return of principal would result in a mortgage constant of 10 %.
A hotel loan for 70 % of value, an annual interest rate of 10 %, a mortgage constant of 0.10, and a required equity return of 15 % would result in the following capitalization rate (CR):
Capitalization rate¼100 ð0:70:1Þ þ100 ð0:30:15Þ ¼11:5%
This capitalization rate may then be used to find the property’s capitalized value by dividing an estimate of average annual income by the capitalization rate (i.e., the market value equation). The property’s net operating income stream over itseconomic life—often defined as property-level EBITDA less recurring capital expenditures—
may also be discounted using the capitalization rate (CR) as a discount factor.
Discount Factor¼1=ð1þCRÞn
wherenis the year number of the income stream being discounted. The sum of the discounted yearly income streams—then provides the property’s valuation esti- mate, an example of which (assuming no salvage value after 5 years) is shown in Table4.7.
As can be seen, if the net income stream is that of a hotel operating company, then the implied present value would further require that cash, construction-in- progress, and receivables and deposits be added and long-term debt be subtracted from the sum of the discounted annual streams to arrive at an implied net asset value (NAV). This would then naturally be divided by the number of rooms (and perhaps other features such as land size) to provide an estimate of NAV per room (or per acre or hectare).
As such, NAV is the theoretical measure of what would be left over after all tangible assets were to be sold and all liabilities were to be paid. As a surrogate for liquidation value, it provides a more accurate current-market measure than balance sheet book value which has typically been distorted—possibly over many years or decades of tax law changes and owners—by application of various historical cost estimates and depreciation methods.
178 4 Hotels
Even so, however, derivation of NAV may often be based on arguable assump- tions and judgments related to untrustworthy pricing data for comparable properties and to inaccurate estimates of transaction costs and tax consequences. Asset valuation procedures will also generally be unable to directly capture in the discount factors applied to projected cash flows all of the intangible elements and encumbrances that might affect transfer prices.49One such important feature would be the initial cap rate-spread to treasury securities (which tends to narrow in boom times and widen in recessions).50 And for specific property types, room revenue multipliers would also be significant valuation factors given that Luxury properties might, for instance, trade for 5.6 times, Upscale about 4.1 times, and Economy 3.7 times.
Other intangibles might further include the following:
prospective local, regional, national, and international economic conditions prospective costs of fuel and of travel in general relative to incomes current visitor demographic and income profiles and forecasted changes prospective amount of new local competition to be built
price elasticities (i.e., the prospective ability to raise room and food prices without driving customers away)
potential for adding rooms or other facilities and attractions such as on-premise health clubs and food courts
Table 4.7 Property income streams discounted using overall capitalization rate, an example
Year 1 2 3 4 5
Income stream (NOI) $1 million $1 million
$1 million
$1 million
$1 million
Discount factor @ 13 % 0.8850 0.7831 0.6931 0.6133 0.5428
Discounted income stream $885,000 $783,100 $693,100 $613,300 $542,800
Total $3,517,300
Plus:
Cash 1,500,000
Construction-in-progress 2,000,000 Receivables and deposits 1,500,000
Minus:
Long-term debt 3,000,000
Implied net asset value (NAV)
5,517,300
49Encumbrances are often the most important in determining the going concern value. A potential complication, for example, arises when ownership interest is encumbered by intangible non-cancelable and long term agreements that may be owned by different entities than those owning the real and personal property. All other things being equal, buyers will typically pay a higher price for hotel assets that are unencumbered.
50This spread is usually calculated against 10-year Treasury bonds for which the average yield spread from 1990 to 2004 was 490 basis points (bps) and from 2001 to 2004 630 bps. The Real Estate Research Corporation tracks this data. See also Titman et al. (2005).
potential need for renovations and upgrades potential alternative uses of the land
degree of recognition as a brand name or as a “trophy” property management agreement terms and potential encumbrances
prospects for new local roads, transport hubs, or airport facilities or convention centers to be built
availability of government subsidies or tax breaks local political and environmental conditions
The weakness of all approaches, though, is that the farther out the income stream projections are made, the more unreliable and unrealistic they are apt to become. An alternative may thus be to instead forecast a property’s likely sale price at the end of an investment period (rather than over its economic life) and to then discount to present value the anticipated sale price at the end of the investment period. This amount would then be combined with the sum of the discounted present values of the interim cash flows and would provide an estimate of a property’s total present value.
An illustration of a method that uses a single, stabilized estimate of net income rather than a projected net income stream over time is shown in Table4.8.
For hotel real estate companies that arepubliclyheld, the sum of the estimated asset valuations divided by the number of shares outstanding provides an estimate of value per share. For hotel management companies, valuation is also related to the strength of the brand, future unit additions, length of management and franchise agreements, and expansion opportunities. And for franchises, valuation requires Table 4.8 Stabilized income assumption method illustrated
Stabilized income assumption: $11.00 mm
Mortgage terms
Interest rate 8.00 %
Mortgage constanta 9.00 %
Amortization years 20
Loan-to-value ratio 50 %
Equity dividend pre tax 10 %
Rate of return WACC
Debt (mortgage) 50 %9.00 %¼0.045
Equity 50 %10.00 %¼0.05 %
Overall capitalization rate 0.095
Capitalized value 110.095¼115.789
Equity dividend 50 %10.00 %¼115.79 5.79
Annual debt service 50 %9.00 %¼115.79 5.21
$11.00 mm
aMortgage constant combines the returnoncapital (interest rate) and the returnofcapital through a sinking fund
Based on deRoos and Rushmore (2002, p. 78)
180 4 Hotels
estimates of the average life of contracts in the system, the probability of contract renewal, and the discount rate.
The estimated valuations as described might most frequently and practically be applied to privately negotiated transactions (including both portfolios of multiple properties and single assets). In any specific market, many factors will influence the buy-versus-build decision, but the most important would likely be the costs of acquiring existing properties as compared to the costs to acquire land and build new. Other things being equal, if it costs less to build (per room, say) than to buy existing properties, then there would likely be more new construction and vice versa. All of this is, of course, further affected by interest rates and by the cyclically varying ability and willingness of banks to underwrite commercial loans for either purpose. The easy financing environment that inflated the global housing-industry bubble into 2007 also created a similar peak (Fig.4.11) in the total value of hotel transactions (~$30 billion in the US) at around the same time.
A comprehensive valuation process should thus consider the three methods outlined: capitalization rates on operating income, transfer prices for comparable properties, and estimated replacement costs per room. Shares of public companies will generally become attractive for purchase (or a company for takeover) if and when market prices are significantly under (by at least 20 %) the estimated asset value per share.51
No matter which valuation methods are used, however, as has often been said with regard to real estate and hotels, it all boils down to location, location, and location.
150
Global Americas EMEA Asia Pacific
100
50
$ Billions
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015F
Fig. 4.11 Global hotel transaction volumes by region, 1998 to 2015E (excluding casino and land site sales).Source: Jones Lang LaSalleHotel Investment Outlook, 2015, reprinted with permission
51The same approach to public versus private market value comparisons and the use of valuation ratios as described for airlines (Sect.2.5) may also be applied.