Value and Performance Barometers

The value of shares of public hotel companies and publicly traded hotel real estate, or Real Estate Investment Trusts, are essentially valued �by the market� on a regular on-going basis. And it is estimated that public investment currently accounts for approximately 20 percent of the hotel inventory in the U.S., with C-Corporations accounting for approximately 55 percent of this total and REIT�s  the balance of approximately 45 percent.

In contrast, however, information on private (versus publicly traded) hotel �values� and investment performance, which it is estimated currently accounts for approximately 80 percent of hotel inventory, is extremely limited and based primarily on research and/or transaction data available. 

What is �Value� ?

Not an easy question to answer when it comes to valuing hotels, in particular in today�s economic environment! 

When we think of the term �value� of a hotel we traditionally think of �appraised or market� value. It is important to keep in mind, however, that there are different approaches to appraisal value i.e. the replacement cost, comparable sales and the capitalization of income or discounted cash flow approach to value.

And in today�s environment, these different approaches can potentially yield very different �values� depending upon the particular situation and certain key assumptions.

In addition to �appraised� value, there are also the concepts of  �Highest and Best Use� Value �, �NAV or Net Asset Value�, �Assessed Value�,  �Investment Value� and �Liquidation value� that potentially need to be understood and reconciled as well!

Why do hotel �values� fluctuate?

Hotel values can fluctuate due to many factors including the following:

• Changes in the net income generated from the hotel
• changes in the value of underlying real estate
• changes in investment  risk versus return expectations (cap rates /discount factors) and/or
• changes in the availability/cost of capital.

Today�s transactions market

While there are potential �sellers� and clearly also potential �buyers� for hotels, during these past several months there have been very few transactions. And this is due primarily to a significant gap between what buyers are willing to pay for a hotel and what sellers are willing to sell a hotel for, or often referred to as  �ask� versus �bid� terms.

Back to the Future?- Not necessarily!

Many are asking why the reluctance of sellers to sell and what is different about today versus 10 years ago when many hotels ended up selling at deeply discounted prices.

There are two circumstances in particular which have changed dramatically which are influencing today�s buy and sell decisions. One is the ability of the industry to absorb cash flow shortfalls and the other is alternative investment performance.
 

Why the disconnect in thinking ?
 
As noted above, changes in the terms and availability of debt capital can impact the value of a hotel. And changes in cap rates also impact hotel values. In today�s environment, however, it is differences in thinking between buyers and sellers about the net income stream (and where it is headed!) for a hotel that appears to account for much of the disconnect in ask vs bid terms and expectations.

• From the sellers perspective�During recent months many potential sellers have absorbed significant financial shortfalls from the fallout of the events of September 11th and the economy. Having already incurred this income loss they are thinking why sell at a substantial �value� discount if I can rebuild the income stream for the hotel.

• And buyers� in light of recent events are understandably reluctant to pay for or give �value� credit for projected or forecasted improvement in the cash flow performance of a hotel.

Where are hotel values headed? Hotels that can demonstrate that they can rebuild business will be able to restore value, hotels expected to face on-going challenges rebuilding business will most likely experience declines or erosion in value.

It is important to keep in mind that individual hotel performance can vary dramatically from the industry as a whole. And as evidenced by recent events even seemingly similar hotels have been impacted very differently depending upon a particular hotels management, location, accessibility and business mix.

Some hotels, in particular ones that have a diversified business mix and that have been able to tap into and maximize opportunities that have emerged from changing demand patters (i.e. changing fly vs drive, domestic vs international, and/or price value demand patterns etc.) have been able to rebuild business already. 

The ability for other hotels, i.e. destination hotels in markets highly dependent upon air lift capacity, hotels in markets that are experiencing major declines in city wide base business, hotels that are dependent upon capturing demand and have limited ability to �induce� or generate demand etc.to rebuild business will be much more challenging.

More recently and increasingly going forward, we can anticipate that hotel buyers and lenders will place much greater emphasis on the evaluation and underwriting  of the underlying business mix/demand generators for a particular hotel in their investment  and lending decisions.
 
Evaluating and Managing Hotel Investment Risk

With hotels as with any investment there is a trade off between investment risk versus return performance expectations. Historically, hotels have been viewed as being at the higher end of the risk spectrum. And recent events have exacerbated this perception!

Which begs the question�are there additional opportunities for better identifying and managing hotel investment risk?

Yes! As noted above, we can anticipate that a better understanding and a more in depth underwriting of the business mix and demand generators for a hotel will be a critical part of managing hotel investment risk. 

Additionally, as recent events have brought keen attention to, operating leverage can work for and against a hotel. Evaluating the cost structure of operating a hotel and in particular understanding the impact of changes in margin performance and operating leverage or the ratio of fixed versus variable costs on the overall investment performance of a hotel can also be expected to play an increasing role in managing hotel investment risk.

Enhancing Hotel investment returns in a challenging market

As an industry we have experienced a substantial decline in profitability�from a record $22.5 B in 2000 to an estimate of approximately $17B in 2002, (which it has been argued could have been much worse i.e. possibly $13.7 B without major cost cutting), representing a decline of nearly 25% during this timeframe.

Are there additional opportunities for potentially improving investment / financial performance (and in turn the value ) of hotels?

On the revenue side there appears to be opportunity in managing yield from the bottom up. Up until recently many hotels have been focusing primarily on managing high yield business. For many hotels, in today�s challenging environment in particular, managing the business mix and yield from the �bottom up� represents a significant untapped opportunity to improve performance.

From an expense perspective, it is important to keep in mind that the cost of generating rooms revenue can vary dramatically from 1-2% of revenue for a piece of repeat business to well over 20% of revenue for business generated in response to an ad, involving a travel agent and offering triple mileage points!

A better understanding and  management of distribution costs represents a substantial opportunity for many hotels to potentially improve financial performance.

About the Author: Ms Raleigh, Executive Director, ISHC is the co-editor and author of �Hotel Investments: Issues & Perspectives� and has written numerous articles on Hotel Investments, Asset Management and Franchise and Brand Affiliation. She is past president of the Hotel Asset Managers Association and is also a member of ULI and the Association of Financial Management Educators.