Chapter 11 Introduction

1. Chapter 11Introduction • This chapter will describe the process of hotel valuation. • Furthermore, this chapter will discuss: • Users and preparers of market studies and appraisals • Agency relationships • Cost approach to value • Sales approach to value • Income capitalization approach

2. What is an Appraisal and Why are They Done? • An appraisal is an opinion of value at a certain point in time. • Reasons for an appraisal to be completed • Interest in potential selling price by the owners • For the lender—purchase or refinancing • Tax assessment purposes • Liquidation value

3. Parties Involved in the Appraisal Process • Lenders • Banks, insurance companies, pension funds • Buyer or developer • Usually pays for the appraisal • Seller

4. Agency Problems in the Appraisal Process • 1980’s – appraisals commissioned by buyer/developer • Many appraisals were biased. • Barbers were state licensed; appraisers were not. • Significant savings and loans problems attributed to faulty appraisals. • This led to FIRREA in 1989. • Changed how appraisals were commissioned and completed; led to state regulation of appraisers

5. Appraiser Education • Although not the only designation, most commercial real estate appraisers are “MAI” • Member, Appraisal Institute • Required coursework, hours of practical experience, a full commercial appraisal and a comprehensive examination • More info available at: www.appraisalinstitute.org

6. Hotel Appraisal Process • Purpose of the appraisal • Why is this appraisal being completed? • Who is it for? • What is the appraisal problem? • Value being appraised • Most appraisals are completed using market value, but not all.

7. Real Estate and Real Estate Interests • Real estate is the land, building, and everything permanently attached to it. • Equipment is personal property and valued separately. • Real property includes real estate plus ownership benefits. • Fee simple interest—ownership interest with the most rights • Most hotel appraisals involve a fee simple interest • Other interests • Landlord—leased fee • Tenant—leasehold

8. Data Collection • Extremely important part of the process • The quality of the appraisal is directly related to the quality of data obtained. • Most of it is secondary data • Easier to obtain now • Be careful with sources of data—you are ultimately responsible! • What data are relevant? Anything that impacts size, timing or risk of cash flows.

9. Market Area Information • In general, start wide and narrow the focus. • Regional • Metro area or city • Look for information directly related to hotel room demand. • Employment • Office space/industrial space • Convention activity • Universities/College • Tourism stats

10. Submarket Analysis • One of the most important features of a good hotel appraisal • Hotels are more competitive than other types of real estate • Must hunt for demand every night • A proper assessment of the competition is absolutely essential • Establishes market demand • Establishes market “price” or ADR $

11. Submarket Analysis • What makes a hotel competitive to your property? • Location • Demand base accommodated • Rate • Amenities • Competitive hotels must be interviewed • Occupancy and rate information is sensitive but is the most important information to obtain

12. Market Demand • It is important to know which demand segments are in the market • Example: corporate individual • Different demand segments pay different rates and stay at different times of the week and year • Most common segments are corporate individual, corporate/association group, tourist, and government/military • Ideally, appraiser presents a historical analysis of changes in demand by segment (along with changes in historical hotel room supply as well)

13. Historical Market Analysis • Five years is preferred; three years is acceptable • Which segments increased or decreased? • Has there been historical growth in total demand, occupancy and Revpar? • The appraiser should not only know if demand has changed, but why it changed

14. Market Penetration and the “Fair Share” Concept • If a hotel represents 10% of the hotel supply in the market, then all else being equal, it should get 10% of the demand; this is its “fair share.” • If it is accommodating more than this amount, it is “outpenetrating the market” and is at a competitive advantage. • The historical analysis should include a market penetration analysis to show the hotels that are doing the best. • The property interviews will help the appraiser understand why certain hotels are doing better than others.

15. Neighborhood Analysis • A neighborhood can be defined as an area with complementary land uses that influence the hotel. • Neighborhoods have a life cycle. • Growth • Stability • Decline • Revitalization

16. Neighborhood Analysis, cont’d • Is there development activity around the subject hotel? • What type of amenities are available for hotel guests? • Have there been any hotel sales in the subject neighborhood? • This gives the appraiser an idea about trends in hotel values.

17. Site Analysis • Site analysis is critical for hotels because much of the demand is “drive-by.” • Legal address/description is not a mailing address. • What is the zoning of the subject? • Tax assessment • Flood plain/flood zone

18. Site Analysis • Is the site desirable from a guest standpoint? • Visibility • Accessibility • Parking • Close to major roads • Close to demand generators • These factors affect desirability of hotel to investors as well.

19. Description of the Improvements • Description comes from a variety of sources such as a physical inspection, the property engineer, and building plans • Description of the major systems • Electrical • Heating • Air conditioning • Plumbing • Fire safety • Description of room interior and public space • Note any deferred maintenance.

20. Highest and Best Use • What type of development makes the most sense? • Physically possible • Legally permissible • Economically feasible • Maximally productive • This is done as if the land were vacant and as improved.

21. Approaches to Value • Cost approach • Sales comparison approach • Income capitalization approach • Which one is best for an income-producing property? • The appraiser must value the property in a manner similar to market investors.

22. Cost Approach • We must first calculate value of land. • Cost of improvements new • Replacement cost vs. reproduction cost • Value of furniture, fixtures, and equipment • Subtract three types of depreciation. • Physical, functional, and economic • Better used with new properties and non-income producing properties

23. Sales Comparison Approach • The underlying idea with this approach is that properties providing the same utility should sell for the same price. • Find similar hotels that have sold and make adjustments. • Superior properties are adjusted downward; inferior properties are adjusted upward. • Difficult to make accurate adjustments

24. Income Capitalization Approach • The market value of an income-producing property is the present value of its benefits. • We utilize the historical market analysis to make market projections for supply and demand. • Forecast demand by segment • Forecast future competitive room supply • A critical point is the future occupancy for the entire competitive market. • This will lead to projecting the occupancy for the subject.

25. Market Penetration Analysis • We examine each segment of demand for the subject hotel and try to estimate penetration rates by segment. • A rate of 100 percent is the standard; more than this and the hotel has an advantage. • It is not uncommon for convention hotels to have a penetration rate of well above 100 percent in the group demand segment. • The captured demand from each segment is added together to find total accommodated demand for the hotel.

26. Average Daily Rate (ADR) • The ADR should be market-based (in other words, the existing ADR may not be the ADR the hotel should be achieving). • Historical growth should be examined. • Rack rates/discounting at competitive hotels to see the achieved average rate. • Projections of future growth in terms of discounting/premiums and inflation

27. Preparation of Financial Estimates • Analysis of historical operating statements • % of revenues • Amount per occupied room • Amount per available room • Use of financial statements from comparable hotels • Revenues and expenses are to be market-oriented; assume the hotel is managed efficiently (not necessarily with current management).

28. Other Financial Considerations • Need to include reserve for replacement • Historical ranges (3 to 5 percent of revenue) have been too low. • Expenses need to be adjusted properly. • Inflation/increase considerations • Fixed portion vs. variable portion • Bottom number is referred to as “NOI” —net operating income.

29. Direct Capitalization • Need to use stabilized NOI in current value currency. • Stabilized NOI is divided by a capitalization rate. • Two main sources for these rates • Extract from comparable sales • Band of investment • A weighted average of return on debt and return on equity

30. Direct Capitalization • Many investors do not buy hotels based upon one year of income. • Appraisers must use the method used by investors. • Be careful when extracting rates from sales. • Did the comparable sale extract a reserve for replacement? • Band of investment requires knowledge of current mortgage terms and expected equity returns.

31. Yield Capitalization • Projected NOI for hotels is discounted at the equity yield rate. • 5 to 10 years is common for NOI projection. • Equity yield rate is holding period return for the equity investor. • Usually obtained from investor surveys • Final year NOI should include proceeds from a sale. • Sales price is next year’s NOI divided by a terminal capitalization rate. • A broker’s fee must also be deducted.

32. Other Approaches • ADR rule of thumb • Take ADR, multiply by $1,000 to obtain value per room. • Rooms revenue multipliers • Find comparable sales and divide sales price by rooms revenue. • Combines income capitalization approach and sales comparison approach

33. Final Reconciliation • Appraiser will examine the values from the approaches completed. • Appraiser must make a judgment about which approach is best. • A major consideration is the quality of data obtained. • Appraiser can give most consideration to one approach or another. • Final value is not an average of the approaches used.