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Hotel Capitalization Rates Drop
by: David J. Sangree, MAI, CPA, ISHC 
February 2003

The Winter 2003 USRC Hotel Investment Survey of 27 hotel investors indicates that discount rates and capitalization rates for both limited service and full service hotels have decreased since our Winter 2002 survey. The author has completed this hotel investment survey annually since 1995. The drop in both types of rates is due to increased confidence in the hotel market even though declines in occupancy and average daily rates in most markets have weakened hotels’ net operating incomes. In addition, interest rates fell during 2002 allowing for a drop in the debt component of capitalization and discount rates. Full-service hotels achieved a larger decrease in rates as compared to limited service hotels. This larger decrease brings full-service hotel rates back to a level similar to our 2001 survey. The decreases have occurred as the risk associated with hotel investments has returned closer to normal levels following the impact from the terrorist attacks of September 11, 2001 on last year’s survey. In 2002, many markets have recorded declines in occupancy levels and average daily rates as compared to the previous year due to the weakening economy. 

Capitalization Rates 

Our 2003 survey indicates that investors require higher capitalization rates for limited-service hotels as compared to full-service hotels due to the higher barriers to entry in the full-service market. The direct capitalization rate for full-service hotels of 10.7% is 90 basis points lower than the average for the 2002 survey but the same as the 2001 survey average. The average direct capitalization rate for limited service hotels of 11.8% is 40 basis points lower than last year’s survey. The capitalization rate has two components: equity and debt. As interest rates have continued to fall during 2002, the overall equity capitalization rates have remained steady.

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USRC Hotel Investment Survey
Winter 2003 Limited Service
Winter 2003 Full - Service 
Winter 2002 Limited Service
Winter 2002 Full – Service
 Direct Capitalization Rate
Average 
11.8%
10.7%
12.2%
11.6%
Range 
9.5% - 14.0%
8.0% - 14.0%
9.0% - 16.0%
9.0% - 15.0%
 Terminal Capitalization Rate
Average 
12.2%
11.1%
12.2%
11.6%
Range 
10.0% - 15.0%
8.0% - 14.0%
9.0% - 15.0%
10.0 - 15.5%
 Discount Rate
Average 
14.4%
13.6%
14.9%
14.6%
Range 
12.0% - 20.0%
11.0% - 15.5%
12.0% - 20.0%
9.0% - 20.0%
Selling Expense
Average 
3.7%
2.8%
3.1%
2.3%
Range 
1.0% - 6.0%
1.0% - 6.0%
2.0% - 6.0%
1.0% - 4.0%
Management Fee Expense
Average 
4.1%
3.3%
3.7%
3.4%
Range 
3.0% - 6.0%
2.0% - 5.0%
2.5% - 5.0%
2.5% - 5.0%
ADR Growth 
Average 
2.4%
2.5%
2.6%
1.4%
Range 
-2.0% - 7.0%
0.0% - 8.0%
-5.0% - 3.0%
-5.0% - 5.0%
 Expense Growth
Average 
2.8%
2.7%
2.6%
2.6%
Range 
1.0% - 5.0%
1.0% - 4.0%
0.0% - 5.0%
1.0% - 5.0%
 Holding Period
Average 
7.0
8.1
7.6
7.6
Range 
3 – 10 years
3 – 40 years
3 - 10 years
3 - 12 years
 Marketing Period
Average 
8.6
9.5
7.4
8.3
Range 
3 – 12 months
3 – 24 months
3 - 12 months
4 - 12 months
Reserve for Replacement
Average 
4.1%
4.2%
4.1%
4.7%
Range 
3.0% - 6.0%
3.0% - 6.0%
2.0% - 7.0%
3.0% - 7.0%
 Rooms Revenue Multiplier
Average 
2.6
2.4
3.0
2.5
Range 
1.5 - 3.5
1.5 - 3.0
2.0 - 3.5
1.9 - 3.5
 Source: US Realty Consultants, Inc. 

Hotels have higher capitalization rates than other forms of real estate due to increased risk associated with hotel ownership because of the changing occupancy levels of hotels, particularly during an economic recession. The range of capitalization rates for each category was wide and depended upon the quality of product and its location. Upper-end, luxury, full-service hotels in locations with strong barriers to entry had capitalization rates of 9% to 11%. Terminal capitalization rates for both categories were slightly higher than the direct capitalization rates as these are utilized five to ten years in the future. 

Discount Rates Higher for Limited Service Hotels

Discount rates for limited-service hotels averaged 14.4% and for full-service hotels averaged 13.6%. Discount rates for full-service hotels showed a 100 basis point decrease over last year’s survey, but a figure similar to our 2001 survey. The range is wide for discount rates with respondents indicating from 11% to 20%. The average holding period for users utilizing a discounted cash flow analysis for both limited service and full-service hotels ranged from 7.0 years to 8.1 years.

ADR Growth Limited

The investors surveyed indicated that they project that ADR growth rates to be lower than operating expense growth rates for both categories of hotels. Some investors project ADR growth rates to be negative in 2002 although the overall average was 2.5% for full-service hotels and 2.4% for limited service hotels. The expense growth rates were higher than the ADR growth rates as well as slightly higher than last year’s survey. The selling expense ranged from 1% to 6% for both categories of hotels. The average selling expense was lower for full-service hotels as these transactions are typically for higher amounts, and brokers are willing to reduce their commission percentage. 

Management Fee Expense Range

Management fee expenses averaged 4.1% of total hotel revenues for limited-service hotels and 3.3% for full-service hotels. Management fees are typically higher on a percentage basis for limited service hotels due to the disparity in total revenues versus full-service hotels.

Marketing Period Remaining Stable despite Change in Economy

The marketing period was 9.5 months for full-service hotels and 8.6 months for limited-service hotels. The investors indicated that the marketing periods have increased since last year’s survey which is reflected by the decline in the number of sale transactions in 2002 and 2003 to date. The reserve for replacement as a percentage of total revenue for limited service hotels was 4.1% while for full-service hotels was 4.2%. The higher rate for full-service hotels is due to the larger size of building and increased amount of amenities as compared to limited service properties. The room revenue multiplier was typically used by limited-service hotel buyers and averaged 2.6 with a range of 1.5 to 3.5 times room revenue. Only a few of the investors utilized a room revenue multiplier for full-service hotels and this averaged 2.4 with a range of 1.5 to 3.0. This was highly dependent upon the type of property. 

Hotel Interest Rates Decrease
 

DEBT PARAMETERS
 
Winter 2003
Winter 2002
 INTEREST RATE 
 Average 
6.9%
8.2%
 Range 
3.0% - 9.0%
6.0% – 10.0%
TERM (YEARS) 
 Average 
11.6
9.5
 Range 
3 - 25
3 - 25
AMORTIZATION PERIOD (YEARS) 
 Average 
22
22.3
 Range 
5 - 30
15 - 25
DEBT COVERAGE RATIO 
 Average 
1.45
1.45
 Range 
0.5 - 2.3
1.25 - 1.75
LOAN TO VALUE 
 Average 
67%
65%
 Range 
50% - 80%
50% - 80%
 Source: US Realty Consultants, Inc.

The average interest rate of 6.9% for the Winter 2003 survey decreased from 8.2% as illustrated in Winter 2002 survey. The range of rates from 3% to 9% was lower than in last year’s survey and is due to the continued decline in the prime rate from 4.75% on January 1, 2002 to 4.25% on December 1, 2002. The average term was 11.6 years which is 2.1 years higher than our 2002 survey. The years amortized was 22 years with the range from 5-30 years which was similar to the previous year’s range. The debt coverage ratio averaged 1.45 with a range from 0.5 to 2.3. The loan-to-value ratio was 67% with a range from 50% to 80%. Investors indicate that financing is still difficult for most new development projects around the nation. 

Major Concerns 

The possible war in Iraq, continued economic recession, ADR decreases, and higher oil prices are the major concerns of the investors in the survey. The impact on travel and tourism from the possible war in Iraq is a major uncertainty in the hospitality marketplace. If the war does not occur or if it is short-term, there should be limited impact; however, if the war occurs and it extends into a longer time frame, there could be a negative impact on the hospitality industry. The economic recession is reducing net operating incomes at most hotels, which has translated into declines in value for hotels as investors typically look most closely at the trailing 12 months of performance. Potential further ADR decreases are a concern of some respondents due to rate cutting from usage of Internet portals as well as increased competition. The higher oil prices were a concern mentioned by some investors as this would result in higher utility and energy costs at hotels as well as have an impact on travel overall. 

Respondents to the survey include:
 

Boykin Lodging Company
Cendant
Coldwell Banker
Commonwealth Hotels
Concord Hospitality
David L. Babson and Company
Forest City
GMAC
The Great Lakes Companies
Hardin Capital
Hotel Partners
Hotel Source
Hunter Realty Associates
Kinseth Hospitality
LaQuinta Inns, Inc.
LaSalle Partners
Marcus Hotels 
Molinaro Koger
Morris, Smith & Fehy
Rockbridge Capital
Salomon Brothers Realty
Schahet Hotels
Six Continents Hotels
Tharoldson
Wells Fargo
White Lodging Services

David J. Sangree, MAI, CPA, ISHC is President of Hotel & Leisure Advisors, a national hospitality consulting firm specializing in appraisals, feasibility studies, and impact analysis for hotels, resorts, waterparks, and other leisure real estate. When this article was published, David Sangree was Director of Hospitality Consulting with US Realty Consultants and a Principal in the Cleveland office. 

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Contact:

David J. Sangree, MAI, CPA, ISHC
Hotel & Leisure Advisors
14805 Detroit Avenue, Suite 420
Cleveland, OH 44107-3921
216-228-7000 Phone    216-228-7320 Fax
dsangree@hladvisors.com
www.hladvisors.com

US Realty Consultants
216-221-9191 Phone     216-221-9097 Fax 
www.usrc.com
 

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Also See: Hotel Capitalization Rates Drop Further / May 2005
Cleveland’s Lodging Market: A Slow Climb Back / David J. Sangree & Joseph Pierce/ February 2005
Indoor Waterpark Resorts Continue Impressive Growth in ‘05; a Viable Segment of the Travel / David J. Sangree / January 2005
Indoor Waterpark Resorts Expand Nationwide / David J. Sangree / April 2004
Cleveland Lodging Market at Bottom with Improvement Predicted / US Realty Consultants, Inc. / January 2004
Hotel Capitalization Rates Drop Again / David J. Sangree, MAI, CPA, ISHC / April 2004
Appraisal and Financing of Indoor Waterpark Resorts / David J. Sangree / October 2003
Hotel Capitalization Rates Drop / David J. Sangree, MAI, CPA, ISHC / February 2003


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