Research Study on Financial Analysis of Hotel Investments

Description
The financial analysis that supports hotel real estate decision-making requires a nuanced understanding of what drives the major participants.

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SHA561: Financial Analysis of Hotel Investments
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MODULE OVERVIEW
Module 1: The Hotel Owner-Operator-Lender Partnership
Successfully putting together a hotel real estate investment is a complicated undertaking. The financial analysis that
supports hotel real estate decision-making requires a nuanced understanding of what drives the major participants. In this
module, consider the interests and motivations of the owners of hotel properties, the independent and branded operators
who manage hotels, and the financial institutions that lend to hotel owners. Consider also the different methods by which
hotel owners seek to meet their goals.
When you have completed this module, you will be able to:
Differentiate the interests and motivations of the major actors in hotel real estate investments: owners, operators,
and lenders
Explain the interests and motivations of different types of owners, and assess how they influence hotel real estate
investments
Describe different investment strategies prevalent in the hotel industry and apply them to varying ownership
interests
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TOPIC OVERVIEW
Topic 1.1: Partnering Owners, Operators, and Lenders
Hotel investments involve a number of partners, each with different interests, goals, and expectations. In this topic, meet
the major players in hotel investments, the owners, operators, and lenders who must be brought together in any
successful hotel investment.
When you have completed this topic, you will be able to:
Differentiate the interests and motivations of the major actors in hotel real estate investment: owners, operators,
and lenders
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Click to listen to Professor deRoos
talk in more detail about the needs of
each partner.
Putting Together Hotel Real Estate Investments
Fundamentally, this is a course about how you put together a hotel real estate investment. To introduce some of the
issues, we'll begin with a very basic deal. You have an opportunity to purchase a $30 million hotel. As the owners, you
don't need to have the $30 million available. You have the $10 million of equity you will need, and you can reasonably
expect to borrow $20 million from lenders. This gives you the necessary $30 million.
Your next step is to determine if the annual returns justify that $10 million
investment. To do this you need to make sure that the lenders receive an
adequate return on their $20 million investment; otherwise they will not lend
you the money. You need to demonstrate that the operators, or managers,
will receive a return adequate to their brand and to their management
expertise. The operators may have many other opportunities in the market
and may not consider your investment the best one.
You have a process: putting together the necessary $30 million in capital for the hotel investment. And you have the major
partners: the owners, the lenders, and the operators. The owners drive this process. They need to understand the ways
the other parties make money, and they need to ensure that at some level each party is achieving at least their minimum
returns. Once the owners know that all partners can realize their desired returns, the owners can proceed.
Transcript: Putting Together Hotel Real Estate Investments
Let's take a look at the operators, also known as the manager of the hotel. Operators are interested in two things: is this
deal consistent with the standards or identity of the brand? And, are the fees sufficient? Managers' fees are generally
some function of total revenues (called the base fee) plus some function of the gross operating profit (called the incentive
fee). Consider an opportunity in which the operator expects fees that are 3% of revenues plus 10% of gross operating
profit. The first thing that the operator wants to know before signing a contract is whether the market is strong. A strong
market drives high revenues, and high revenues drive high fees. The second question that operators need to answer is
whether this hotel matches their style of operations. Can the operator drive strong gross operating profits from the
revenues, thus driving a strong incentive fee? Once the operator becomes convinced that the market is strong and that
the hotel is compatible, they are likely to do the deal. The owners help the operators understand the market and the
property, facilitating the operators' decision making.
Now let's take a look at the lenders. The lenders' fundamental story is that they expect to get paid before the owner, but
after all of the operating obligations of the property get paid. They get paid their debt service, which is taken from cash
flow from operations. The lenders bake their underwriting criteria into the interest rate, including the strength of market,
strength of hotel within the market, strength of the brand, and then strength of the borrowers. Since the lenders always get
paid before owners get paid, they are willing to take a lower return than the owners. But in the end, cash flow from
operations needs to be some multiple of the annual debt service or the lender is not interested in participating in the deal.
Thus lenders closely scrutinize both historical and prospective cash flows to determine their comfort level. Owners play a
significant role by assisting the lenders in this evaluation.
Finally, to the owners. How do the owners get paid? Well, the general story is that the owners get paid after everybody
else gets paid; they get the cash flow after debt service. To realize their desired return, the owners need to understand the
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required returns for the other two parties. The owners may think that in isolation, we just want to achieve say a 12% return
on our $10 million investment. The owners can't make this statement unless they understand that that 12% is achievable
AFTER everyone else gets paid.
Seasoned owners know that everyone has an eye on the same things: the strength of the market and the relative
strengths the other participants bring to the deal. They make sure that the lenders and managers are treated as partners,
they work hard to help them understand the deal, and help them to "get to yes."
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Lodging Investment Participants and Advisors
Hotel real estate investments involve a range of different participants. In addition to the primary participants-the owner, the
operator, and the lender-most include a range of specialists who facilitate the investment. Unlike the owner, operator, and
lender, the involvement of these specialists is usually limited to the transaction (purchase and construction) of the hotel.
Let's look more deeply at the three major partners before considering the roles of the transaction specialists.
contribute the equity to a hotel investment. There are many different types of hotel real estate owners, including: Owners
usually individual owners or small firms Entrepreneurs:
including real estate corporations, real estate investment trusts (REITs), real estate Institutional investors:
investment funds, insurance companies, and pension funds
when the hotel operator or manager also owns the property Owner-operators:
often governmental bodies such as national tourism organizations Governments:
or lenders who have been forced to take ownership of the property due to the failure of Owners-in-foreclosure:
the owner to meet obligations
As we will see, different types of owners have different goals for their hotel investments.
provide the majority of the capital needed to finance a real estate transaction. These lenders typically include Lenders
commercial banks, conduit lenders, investment banks, credit companies, and insurance companies. Hotel real estate
loans are generally of two types. The first are long-term loans established at a fixed rate of interest. Lenders are willing to
take the interest-rate risk associated with a fixed rate over a lengthy term. In exchange, they extract significant penalties
for terminating the loan. For borrowers with a short-term need for funds, lenders provide short-term loans with a floating
rate of interest. In this case, the borrower has the flexibility to terminate the loan in a short time, but must take the
interest-rate risk.
The debt capital provided by commercial lenders is often insufficient to finance the investment. In these instances, gap, or
mezzanine, financing is employed to bridge the gap between the equity and debt capital contributions. Suppliers of "mezz"
financing are paid after the primary lender has been paid, but before the owner. For absorbing this added risk, they extract
a better rate. Suppliers of mezzanine financing typically include credit companies, specialty lenders, operating or franchise
companies, and often governments (frequently through a range of tax incentives).
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The third major participant in most hotel real estate transactions is the . Some hotels are owner-operated, but Operator
most are operated either by a chain operating company or an independent operating company.
Operators provide the brand and the managerial expertise needed to successfully run the hotel.
In addition to the three major participants, a number of transaction participate in the successful execution of Specialists
the investment. These include:
, who facilitate the sale of the property (sales brokerages) and the financing of the investment (investment or Brokers
mortgage bankers). Sales brokers add value by knowing who might be a likely buyer. Investment and mortgage bankers
add value by knowing who has the money to lend.
perform the market analysis of the proposed property and estimate its value to help potential Consultants or appraisers
lenders better understand the level of risk.
help "paper" the deal, by facilitating the many necessary transactions, including land purchase, Legal service providers
management contracts, loan documents, and construction contracts.
help achieve the owner's vision for the property, designing a physical structure consistent with Architects and designers
the owner's concept.
Finally, often play a substantial role in hotel real estate investments. In many parts of the world, Governments
government agencies, especially tourism ministries, facilitate development and redevelopment of hotels. In addition, local,
state or provincial, and national governments exercise a regulatory role in ensuring coherent and consistent development
policy.
Putting together a successful hotel real estate transaction involves a large number of actors. The three primary
participants, however, are always the owner, the operator, and the lender. Let's take a closer look at their interests.
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The Partnership: Owner, Operator, and Lender
Most hotel real estate projects involve a three-way partnership among owners, operators, and lenders. Each of these
partners has different interests and different investment goals. Let's look at each participant and their interests.
One of the primary interests of an owner is returns. These can come in the form of income returns (operating Owners:
cash flow) or appreciation returns (an increase in the value of the hotel). Both forms of returns matter to every owner,
though one type will probably matter more, depending on the investment goals of the owner. After returns, owners are
interested in owning a competitive hotel. They want a quality hotel product, located in an appropriate market, managed by
an appropriate operator, with an appropriate brand.
Additionally, owners are interested in influence over the management and operation of the hotel. They desire the influence
necessary to execute their strategic vision for the property. Owners also want the flexibility necessary to sell or refinance
when they so choose. Owners need this flexibility to harvest gains in appreciation. Finally, owners may own hotels for a
range of nonfinancial reasons. For many owners, owning a hotel brings more prestige than other investments or other real
estate. It is important to recognize the full range of motivations to truly understand owner behaviors.
The primary interest of the branded operator lies in market presence and market share This is true for Operators:
five-star hotels needing a property in every "gateway" city, and for budget chains needing a property in each market where
they have customers. Operators need a presence wherever their customers are likely to look for lodging. Independent
operators are primarily motivated by earning compensation for their management expertise.
To achieve their objectives, operators are also interested in operating a quality hotel, one consistent with the standards of
the brand, and one likely to provide substantial fees to the operator. Good managers or operators get paid for driving
revenues (basic fees) and for running efficient hotels (incentive fees). Operators also look for the maximum possible level
of discretion in managing the hotel in order to implement their strategic vision (to keep the hotel consistent with the brand
and operator standards). Operators also want long-term stability, which can be achieved by signing a long-term contract
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that inhibits the owner's ability to terminate the contract at will or via a sale. Finally, operators are interested in the financial
ability and willingness of the owner to fund renovations when needed and to supply working capital if circumstances call
for it.
The major objective of the lender is to be rewarded for the risk of lending by achieving an adequate overall Lenders:
risk-adjusted return on investment. Lenders manage risk by "underwriting" two critical items. First, the lender must be sure
that cash flows are significantly higher than debt service. Second, the lender must be sure that the value of the property is
significantly greater than the loan amount. Lenders are also looking for a quality, competitive hotel, managed by a
first-class operator, as a means to manage risk. Lenders seek influence over their investment to execute their own
strategic vision and to protect their investment. Finally, lenders are looking for the flexibility to foreclose or reschedule the
loan in difficult times.
Owners, operators, and lenders must all prioritize their interests between these often competing objectives. Real estate
investments must be structured to arrive at a reasonable accommodation of the interests of all three participants. The trick
is to identify the places where the interests of owners, operators, and lenders may overlap. Arriving at such a position is
the art of hotel investment.
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TOPIC OVERVIEW
Topic 1.2: Different Owners Have Different Reasons to Invest
The owner typically drives the investment process. Different types of owners have different investment strategies. These
differing strategies play a crucial role in determining the shape of specific hotel investments. In this topic, consider the
different motivations of different owners and apply that knowledge to specific real-world situations.
When you have completed this topic, you will be able to:
Explain the interests and motivations of different types of owners, and assess how they influence hotel real estate
investments
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Different Reasons Have Different Investors
An illustrated presentation appears below, along with a text transcript. Use these resources to enhance your
understanding of the reasons an owner invests in hotel real estate.
Transcript: Different Reasons Have Different Investors
Different reasons to invest find their home with different owners. It seems counterintuitive, but the essence of the problem
for hotel investors is to take the reasons or objectives they have for investing and map these onto an ownership structure
that works for that set of reasons. We are going to look at what these reasons might be and use some stories that
illustrate how different ownership structures might work.
We'll start with looking at returns as a reason for investing. Real estate returns have two fundamental components to
them. There is the cash flow from operations and the change in the value of the property over time. Together these two
are called "holding period return." Long-term, the cash flow from operations averages between 6% and 10% per year, and
long-term appreciation returns approximate inflation, which in this country have been between 2% and 4% per year.
Appreciation returns are much more volatile than cash flows; the best years in lodging have appreciation returns in excess
of 10%, and the worst years have seen value losses in excess of 10%.
Beyond returns, there are other financial reasons for investing in hotels. The three we'll talk about here are taxes, inflation,
and fees. Tax reasons for investing come from the depreciation deduction in real estate. Hotels have significant
depreciation deductions because of the large amounts of personal property that are owned along with the real estate. The
depreciation is a noncash expense, meaning it reduces your taxable income but doesn't reduce your cash flows.
Inflation is the next financial reason. Long-term, one of the most remarkable characteristics of real estate is that it is a
wonderful inflation hedge. In the long run, the value of properties tends to appreciate with inflation, which provides a great
hedging benefit.
And the last financial reason to own would be the fees. There are three important sets of fees that come out of ownership
of real estate. The first are development fees, which are fees an owner would earn for sourcing a deal and then managing
the deal from conception through beneficial occupancy. The second set of fees are property management fees, which are
also known as management fees, for operating the property efficiently. Owner operators are able to capture these fees; if
the owner hires a third party operator those fees would go to that third party. And lastly, we have asset management fees,
which come from managing the investment on behalf of other owners.
There are also many reasons to invest in hotel real estate that are not directly financial. We will start with hotels as part of
a real estate diversification story. Real estate is fundamentally uncorrelated with returns to stocks and bonds. Including
some real estate in your portfolio brings significant risk reduction to the portfolio, while the other assets, the stocks and
bonds, provide the engine for the returns. Real estate diversifies an investment portfolio; hotel real estate diversifies the
real estate component of the portfolio.
Another reason people invest in real estate is to protect the capital they've invested. Real estate is such a "lumpy" asset
that it provides remarkable opportunities to invest large quantities of money in a very short period of time. This differs from
other financial assets. If one were to want to invest a large quantity in a stock or a bond, you'd move the market, raising
prices. That doesn't generally happen with real estate markets, where such large investments are unremarkable. A related
reason to invest is control. Again, unlike stocks and bonds, real estate owners have absolute control over the day-to-day
operations of their real estate, or at least they have control over decisions that have an impact on the operations on a
day-to-day basis. Stocks and bonds clearly don't provide this level of control.
And the last thing is the game itself. Just like day traders who get wound up in trading the market, that same kind of
energy and adrenaline drives a lot of real estate trading in a much larger fashion. The poster child for a real estate deal
junky is Donald Trump.
Now let's take a look at a few examples of how the structure of the investment changes with the reasons that people want
to invest. We'll start with the example of a branded operator. Consider an operator with a world-class brand looking for a
presence in a very rapidly growing important market-say, Shanghai. Their overriding objectives would be, first, to secure a
great site so they get market share for their brand, and second, to secure a great hotel that produces a long-term fee
stream. The operator may not be able to find the best deal in the market by working with developers. They may see that
the best way for them to enter the market is to acquire an existing hotel, rebrand it with their brand, and look to the long
run to sell their hotel to another owner subject to a long-term management agreement. The operators' primary reasons to
invest are fees and control. They conclude that the best way to get control is through acquiring the property themselves
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and then, long-term, finding an investor consistent with the operator's long-term goal of having market share in that
market.
A second example might be a large landowner. Consider a landowner that owns many hectares outside of Bangalore, a
market that is growing extremely quickly. Their overriding objective is to be paid the best possible price for their land. If
they sell the land undeveloped to a developer, the developer will want to get paid for developing the improvements. In
order for the landowner to get paid a better price for the land, they may have to develop the property and sell the land plus
building. The owner decides the best way to achieve their reasons for ownership is to develop a building on the land,
operate it efficiently for a number of years, and then have the option of deciding how to harvest the building and the land
value. The owner has a number of reasons to invest. Control: the owner wants to keep control of the property until it will
bring the greatest returns. Fees: the landowner will get fees from development. Appreciation: they would achieve
appreciation of the asset once it's built, a key part of achieving the overriding goal of attaining the best possible price for
the land. Again, the structure of the investment matches the owners' reasons to invest.
The last example is a partnership. So now let's take a look at a very different structure, a type of joint venture. Joint
ventures are not a dominant form but I'm going to use this to illustrate how sometimes the reasons for investing can create
a structure that allows both parties to meet their objectives. Consider an institution that needs a large amount of office
space in an urban core. They have identified a site that is quite expensive and know that if they could partner with another
user, the cost of that site would be spread over two uses. So they partner with a hotel developer who is looking for a site in
that same urban core.
The hotel developer's objective is to be able to secure a site at a very reasonable price, develop the hotel, obtain the
operating cash flows, depreciation of the asset, and all of the financial and other objectives we talked about previously.
Well, what about the office-building developer? What do they get by partnering with the hotel developer? First, they get the
amenities that come from the hotel development-say, the restaurant, coffee shop, health club, business center, spa. In
addition, they are now able to develop some infrastructure jointly, such as a parking garage, and much less expensively,
than if it were developed separately. Both the office-developer, which is the institution, and the hotel developer have huge
incentives to make the project work in a way that benefits both partners. Again, the structure of the investment changes
with the reasons that the investors have for investing.
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Different Types of Owners
Companies invest in and own hotel real estate for varying reasons. Let's
meet three different hotel ownership interests, and consider how they will
evaluate potential hotel investments.
works for a private equity real estate fund. He is VP of John Dough
acquisitions for Black Hall Lodging, an based in New York. equity firm
Black Hall invests in hotels on its own and also partners with
foundations, endowments, insurance companies, sovereign funds, and
pension funds. Black Hall typically buys assets that they deem mispriced
in the market. They are very good at identifying acquisition targets,
making improvements to reposition the properties in the market,
operating the hotels via third-party management for a short period, and
then selling to realize their gains.
is VP of hotel investments for the Actuarial Insurance Sophie Smith
Group of Hartford (AIGH), a large . Sophie's life insurance company
firm attempts to put money to work earning consistent returns over a
long period by investing in stocks, bonds, and real estate. AIGH wants
high-quality, safe investments that yield consistent cash flows; real
estate, including hotels, meets some of their needs. Sophie invests in
hotels to provide a diversified real estate portfolio as an additional route
to smooth cash flows.
works for TarHeel Development, a in Alexandra Rodriguez developer
the North Carolina Research Triangle. She works to put two- and three-star products such as Comfy Suites, Sleep Right
Inns, and Courtway Hotels in both the growing suburban markets and the urban cores of Raleigh and Charlotte. TarHeel
identifies great locations in markets with growing demand for transient lodging. They buy land before its value is
recognized, develop the property, then either sell it or operate it under a franchise.
John, Sophie, and Alexandra are all considering an opportunity in the Charlotte area. An established three-star, branded,
300-room property, managed by International Hotel Company, is located in the urban core of Charlotte. The property has
ten years remaining on the management contract, but can be terminated by paying the operator a fee. The property is
scheduled for a full guestroom and public area renovation in one year. The property's location makes it an attractive target
for repositioning to a four-star hotel. There is also a lack of two-star properties in the Charlotte urban core. International
Hotel Company is keen, however, to keep the property and perhaps reposition the hotel to its four-star Regal Crowne
brand.
We will consider what factors determine how each potential owner evaluates the property.
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Matching Investment Projects with the Right Owners
A three-star branded hotel in Charlotte is available for acquisition from International Hotel Company. The hotel is in need
of renovation. How might John, Sophie, and Alexandra evaluate the property?
is very interested in repositioning the property from three-star to four-star status. The needed renovations are a plus, John
because folding the renovations into a repositioning story allows Black Hall to add value to their investment in the hotel.
Two key factors drive John's decision. First, he wants to secure a manager who is willing to operate under a
"termination-upon-sale" arrangement, because many potential buyers would wish to operate the hotel themselves.
Second, he must be convinced that there are buyers for the property once the repositioning effort is complete.
, interested in long-term cash flow, needs to know three things before committing: Sophie
Does the hotel bring a diversification benefit to other hotels in her portfolio?
Is Charlotte a strong hotel market in the long-term?
Is the manager capable of producing consistently high cash flows from a well-maintained asset?
She is deterred by the costs of the upcoming renovation, but might be induced to sign a long-term management contract if
International Hotel Company offers financial inducements.
is interested in the ability to terminate the manager and to manage the property under a franchise Alexandra
arrangement. Her plans call for redevelopment of the property. The 300-room three-star hotel would be transformed into
two hotels: a 150-room Life Hotel, International's lifestyle brand, and a 75-room Comfy Suites, International's midscale
extended-stay brand. Using cluster management would provide significant opportunities for operational efficiencies by
using one staff to run both properties. TarHeel would earn development fees from the redevelopment and would have two
new properties in the market that could be held for the long-term or sold for a profit.
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Who Acquires the Property?
Well, it may not be a single buyer. Situations may develop where John, Sophie, and Alexandra could all be involved in the
redevelopment of the property. Here are a couple of examples:
might enter into an agreement with in which John agrees to take the risk of repositioning the property, John Sophie
performing the renovations, and replacing management. Once the property has restabilized, Sophie agrees to purchase
the property from John at the prearranged price that reflects the anticipated cash flows. John's firm will make significant
returns if the repositioning effort succeeds. But John's firm takes significant risk, because Sophie's firm is not obligated to
purchase the property if it does not achieve the anticipated cash flows, and her firm is not responsible for cost overruns on
the repositioning effort.
might enter an agreement with firm to acquire and redevelop the property. John's firm supplies the Alexandra John's
majority of the capital needed to fund the acquisition and redevelopment effort. Alexandra's firm supplies a minority stake
and the development expertise to execute the redevelopment effort. John's firm makes a healthy return for supplying the
short-term bridge capital needed to redevelop the property. Alexandra's firm owns the project in the long-term, and has the
option to continue to operate the hotels or to sell them should more interesting opportunities come along.
The question of who will own the property does not have a simple or single answer. The ultimate answer depends on how
each potential owner evaluates the property. It also depends on how the operator and the lender evaluate the potential
owners.
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TOPIC OVERVIEW
Topic 1.3: How Equity Plays the Game
There are many different paths to wealth creation. In this topic, explore the four different investment strategies employed
by hotel owners. Note that owners may follow a single strategy or a combination of several.
When you have completed this topic, you will be able to:
Describe different investment strategies prevalent in the hotel industry and apply them to varying ownership
interests
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There are four basic approaches to
achieving high, risk-adjusted returns
through hotel real estate investment:
How Owners Play the Real Estate Game
Click the image to hear Professor deRoos introduce each of these
approaches.
Transcript: How Owners Play The Real Estate Game
We've seen that different types of owners have different investment
objectives. And we've seen how different reasons to invest produce different
investment structures. But what strategies do owners use to realize their
investment goals? How do they realize these investment goals?
In this topic, we are going to introduce four approaches for achieving high,
risk-adjusted returns in real estate portfolios. The approaches an owner
chooses by influenced heavily by the type of owner investing and the type of
property or investment available. Again, owners have different approaches,
but certain properties also lend themselves to certain strategies. So ask
yourself, as we explore these approaches, which ones John, Sophie, and
Alex are likely to pursue.
The approaches are, first, wealth creation. In this approach, value is created
through the development, redevelopment, and repositioning of properties.
The second strategy, very different from wealth creation, is a value-added
strategy. This is essentially a timing strategy in which one seeks to use
superior investing skills, selection, and timing to exploit market inefficiencies that might exist.
The third strategy is income enhancement. The income enhancement strategy is driven out of a desire to produce very
high cash flows relative to what others can produce from the same property. This is only possible by having superior
operating and marketing talent.
The fourth or last strategy is an incremental risk strategy. Here the investor chooses both investments and leverage
combinations, that's debt, that are much higher on the risk-return continuum and seeks to use other people's money in a
way that to produce high returns to equity. The basic story for lodging is that one seeks to use debt in excess of 80% of
the capital stack to achieve very high returns on the remaining less than 20% equity investment.
In the end, what you will see that there is absolutely no right or wrong strategy. What is right for one owner is wrong for
another owner and vice versa. A strategy that works for one property would not be appropriate for another property. The
strategy that a firm embraces depends on its needs. As we will see, each strategy produces very different cash flow and
appreciation profiles. Some strategies are consistent with long-term cash flows; while other strategies are consistent with
producing high appreciation returns.
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Wealth Creation
In real estate, almost all wealth creation arises from development and redevelopment. Wealth creation strategies are
driven primarily by market dynamics, particularly growth in population, employment, and income. Examples of favorable
market changes for each of the major real estate property types include:
Robust job growth in office-sector employment and changes in workplace technology create demand for new or
redeveloped space.
Changing demographics and increasing wealth create demand for new and different apartment space.
New retail formats drive demand for new or redeveloped space.
Expanding business activity and increased segmentation drive demand for new or redeveloped lodging facilities.
New development focuses on creating wealth by providing above-market-quality space to satisfy unmet demand.
Typically, redevelopment creates wealth by repositioning a property to, or above, the new and improved market quality.
The plan is to increase rents, decrease vacancy, or both, and hence improve cash flow. Graphically, the wealth creation
strategy looks like this:
There are some important issues to keep in mind when employing the wealth creation strategy.
During the development or redevelopment phase, you experience negative cash flow and illiquidity.
Timing plays a critical role in success. In the long-term, disposition decisions must be made while the property still
commands a quality premium to the market. In the short-term, the "exit" value is very sensitive to market conditions
at sale.
To succeed, you need high-quality acquisition talent, individuals skilled at finding opportunities or value that others
do not see.
Much of the total return is tied up in market value at exit, not ongoing cash flow.
Extended holding periods will depress total returns, so this is essentially a buy or build and flip strategy.
This strategy, therefore, appeals to owners such as Alexandra at TarHeel Development. Alex is good at identifying assets
misplaced in the market, repositioning them, realizing the gains brought with increased cash flow, and then selling before
the property is again below market standard.
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Value-Added Investing
Value-added investing refers to strategies that seek to achieve high returns from value appreciation instead of income or
cash flows. Investors exploit properties whose prices are discounted due to nonmarket risks such as event risk, liquidity
risk, or information inefficiencies.
Value-added investing consists of two distinct steps:
Finding and closing transactions that the investor feels are mispriced by the market.
Structuring deals to mitigate risk as effectively as possible.
The key is an active strategy to neutralize the embedded risks so that the achieved or realized risk is much lower than the
theoretical risk. The lowered risk is a direct result of management decisions made at the time of acquisition, stewardship,
and exit. The contributions to risk control can take many forms:
Legal skills
Asset-management skills
Relationship advantages
Market advantages, such as preferential access to profitable buy and sell opportunities
The strategy relies heavily on risk reduction, with the "exit" designed to seek buyers who pay a premium for low-risk deals.
Issues with the value-added strategy:
To succeed, you need a coherent set of risk reduction strategies. Trusting that time will diminish the risk is not
sufficient.
Timing plays a critical role in success. The "exit" value depends on finding buyers willing to pay a premium for low
risk.
You need high-quality acquisition talent, individuals skilled at recognizing value that others do not perceive.
Much of the total return is tied up in market value at exit, not in ongoing cash flow.
Extended holding periods depress total returns, so this is essentially a buy and flip strategy.
Here are some examples of how the value-added strategy might work:
An investor such as John might buy a hotel with "good bones" but with what John evaluates as an underperforming
brand. Buying a good hotel for a fair price, John might terminate the existing management contract, bring in a new
branded operator, invest funds to meet the new brand's standards, and then sell for a significant premium. By
rebranding, John has reduced the risk, making it a more stable property. John would be likely to sell the new,
low-risk property to an investor such as Sophie, who is interested in stable cash flows.
An investor might have to purchase a bundle of properties, including one current "loser." The investor can add
value by "fixing" the losing property (through a change in brand, management, or by repositioning or renovation).
The investor may then sell the properties individually, for a significantly higher sale price than the acquired portfolio.
The investors exploit their transaction skills and repositioning skills to add value.
An investor might assume a significant level of "event risk." Investors in post-Hurricane Katrina hotels in New
Orleans might be able to buy at very low prices, timing the recovery of the market. If done correctly, these investors
can then realize significant appreciation gains.
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Income Enhancement
The ability to actively participate in decisions at the property level is one of the distinguishing features of real estate, as
opposed to traditional equity or bond investing. The income enhancement strategy focuses on asset management and
property management skills to enhance cash flows. It is the dominant strategy for owner-operators of real estate.
Since the strategy is focused on income enhancement, it is seen as consistent with long-term holding periods. To
overstate the case, since the current owners are more efficient operators than "any other" operators, they produce a
higher cash flow than "any other" operators. Hence they have the highest valuation for the property, and hence they can
never sell it for what it is worth to them because "any other" potential investor has a lower valuation.
The key to a successful income enhancement strategy is to deliver on one or more of the following:
Lift revenue through rate increases or occupancy increases. The key is superior marketing skills and operational
efficiencies.
Economies of scale.
Strong asset or property management skills with excellent expense management.
Extending the "market life" of properties.
Issues with the Income Enhancement Strategy
It is easy to be trapped into thinking that you are a "better than average" operator. It is important to ask from time to
time if the property is worth more to someone else.
Strong asset and property management skills are needed. It is difficult to overestimate their importance.
In general, this strategy does not rely on superior transaction skills, only that properties be traded at the market
price. Typically, a rolling investment tactic is employed, structured to stabilize cash flows across a portfolio and
neutralize business cycle risk. In a large fund, purchase and sale proceed slowly, but continuously, as aging
properties are disposed of and new ones purchased to refresh the portfolio.
Total return is driven by income, not appreciation. Although some of the increased income can be capitalized into
the property price, the market may not view the enhanced income as transferable to new owners.
This strategy produces high "cash-on-cash" returns relative to the wealth creation and value-added strategies.
Income enhancement is a strategy likely to appeal to investors such as insurance companies that are interested in
long-term, dependable cash flows. Sophie at AIGH would place income enhancement at the foundation of her investment
strategy.
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Incremental Risk
Using terminology from modern portfolio theory, this strategy is focused on making property investments have a high
'beta'. That is, relative to a 'market' portfolio of real estate, this strategy seeks to embrace risk in a systematic fashion, and
be rewarded for taking the additional risk. The two traditional means of embracing risk are:
Invest in riskier property types such as hotels, raw land development, or speculative office projects
Add debt to increase equity returns
Investors having special relationships with lenders often implement this strategy. In many cases, not only does the special
relationship result in lower interest rates, it can also result in higher loan-to-value ratios.
This strategy is often implemented in concert with the value-added strategy, which seeks to reduce the risk of individual
properties, or portfolios of properties. The combination might work as follows:
An investor purchases an asset that is misplaced in the market. The investor takes actions that reduce the risk and
the risk reduction boosts the value of the investment. That is the value-added strategy.
The investor continues to hold the asset, and borrows against the new, improved value. The investor harvests
some of the equity investment and makes a nice return by continuing to hold the asset. That is the incremental risk
strategy.
With lenders and capital providers in the business of evaluating risk and pricing leverage accordingly, the combination
provides a mechanism for owners to participate in potentially extraordinary returns to equity capital.
Issues with the Incremental Risk Strategy
It is the intrinsic nature of the investments (the riskiness of the lodging) that provides the mechanisms for excess
returns, not any special skill on the part of the manager. This is both a good and a bad thing.
Performance measurement must explicitly allow for the increased risk of investments, some sort of risk-adjusted
return metric is needed.
Owners need to have an appetite for increased risk.
This strategy would appeal to John at Black Hall. Due to his firm's strong relationship with lenders (debt capital), and the
large number of real estate investments in Black Hall's portfolio, John would have the necessary appetite for additional
risk. The appeal of strong returns would lead John to embrace this incremental risk approach.
Summary
This 'taxonomy' of wealth creation strategies is meant to stimulate your thinking about the linkage between individual
property investing and portfolio management. The four strategies represent different approaches, tradeoffs, risks, and
styles of ownership. Clearly, investors in the real world employ more than one of these approaches to achieve their goals.
Different properties, or different investment possibilities, lend themselves to one approach or another. The perspectives
contained in each approach should assist you in assessing a given firm's approach to the market.
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Module 1 Wrap-Up
In this module, you have met the major participants in hotel investments. The art of hotel investment lies in thoroughly
understanding the interests and motivations of hotel owners, operators, and lenders. These interests help determine the
shape of hotel investments. A successful investment must find common ground among the major participants; it must
cater to their respective needs. You have also explored a range of different investment models that hotel owners follow in
pursuit of their interests. These strategies also influence the contours of hotel investments.
Having completed this module, you should be able to:
Differentiate the interests and motivations of the major actors in hotel real estate investments: owners, operators,
and lenders
Explain the interests and motivations of different types of owners, and assess how they influence hotel real estate
investments
Describe different investment strategies prevalent in the hotel industry and apply them to varying ownership
interests
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MODULE OVERVIEW
Module 2: Evaluating the Deal: How Owners, Operators, and Lenders Evaluate Proposed Projects
Evaluating a potential hotel investment requires a thorough understanding of the financial implications of the deal.
Producing accurate estimates of the returns for owners, operators, and lenders is a crucial first step in assessing the
viability of a specific investment. In this module, learn to estimate the returns for each of the participants, and learn to use
a range of methodologies to estimate hotel value.
When you have completed this module, you will be able to:
Estimate the return on investment by calculating the net present value and the internal rate of return
Estimate the owner's return on equity by calculating the net present value and the internal rate of return
Explain how operators and lenders evaluate their investments in an owner's project
Combine the investment evaluations of the owner, operator, and lender
Explain three approaches used to estimate the market value of a hotel
Apply various methodologies to produce estimates of value
Reconcile the approaches to produce a final estimate of market value
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TOPIC OVERVIEW
Topic 2.1: Evaluating the Project
Owners, operators, and lenders must be able to accurately estimate their returns before they can decide whether to
proceed on a prospective investment. Owners drive the process. They must estimate their own returns and determine
whether the returns for the operator and lender are sufficient to entice them into the deal. In this topic you estimate returns
for each of the partners.
When you have completed this topic, you will be able to:
Estimate the return on investment by calculating the net present value and the internal rate of return
Estimate the owner's return on equity by calculating the net present value and the internal rate of return
Explain how operators and lenders evaluate their investments in an owner's project
Combine the investment evaluations of the owner, operator, and lender
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Managing the Acquisition
An illustrated presentation appears below, along with a text transcript. Use these resources to enhance your
understanding of the hotel acquisition process.
Transcript: Managing The Acquisition
There are usually four phases to an acquisition. First comes the vision, or ideas, phase, where the owner decides what the
project will involve. Second is a feasibility phase, where you determine that the project is economically, politically, and
physically possible. Third, a commitment phase, where the owner obtains the commitments necessary to make the project
successful. And finally, a closing phase, where the owner perfects the needed commitments. We briefly examine each in
turn.
The acquisition process starts with a vision. The developer has to have a vision for why they are acquiring a property and
what they want to achieve in the end. Where are we today, and where do we want to go? Is this a repositioning story? A
redevelopment story? What are the potential outcomes of the project? Developing this vision involves a study of the
competitive market, the relevant macroeconomic factors, and the and goals of the owner. objectives
The next phase is feasibility. The outcome of the feasibility phase is a "go" or "no go" decision on the process. There are
three legs to the feasibility "stool". The first leg is financial feasibility, the major focus of this course. The big question here:
are the financial benefits greater than the costs anticipated for acquisition? Will this project meet the financial needs of the
owner? The second leg of the stool is political feasibility. The big question here: can I get the entitlements to do what I
wish to do? Can I make the changes that I would like to make to the property? Can I successfully bargain with political
entities and with the public? The third leg of the stool is physical feasibility. The big question here: will the site itself
support the improvements that I would like to make? Again, each of these feasibility questions needs to be answered
positively before a project is allowed to proceed.
Assume now that we have answered yes, the project is financially feasible, it's politically feasible, and it's physically
feasible, so now we seek our commitments. Again, this can be visualized as a three-legged stool, where feasibility is
turned into firm commitments. Financial feasibility must become commitments from lenders and from partners to fund the
project. Political feasibility evolves into firm commitments from public officials to issue those approvals necessary to
complete the project. Physical feasibility becomes a commitment from an operator to manage the project.
Once the commitments are obtained there is a closing phase. This is simply the phase where you perfect all of the
commitments. Borrow the money, you sign the management contract, you get the approvals, the title changes hands from
the seller to the buyer, and then you take beneficial occupancy.
Done rigorously, the process allows ample opportunity to test assumptions and most importantly, to not commit huge
amounts of funds without being very certain that the commitment would result in positive outcomes for all stakeholders. At
each stage it is possible to proceed or to pull the plug on the project and return to the vision phase or look for a different
opportunity.
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Finance Definitions
A key element of evaluating a hotel investment is determining the financial returns. Here we define a number of important
finance terms we will use as we investigate how to estimate investment returns.
the time value of money
the idea that a dollar received today is worth more than a dollar received in the future. To accept a dollar in the future
rather than today, investors need to be rewarded for:
allowing others to use their funds (the real rate of return)
inflation
risk (both default and volatility)
compound interest rate
the annual rate of return a specific sum of money earns when invested over a number of periods. This rate incorporates
the three broad categories of rewards identified above (real rate of return, inflation, risk).
discount rate (or discount factor)
the inverse of the compound interest rate.
hurdle rate
the minimum rate of return an investor is willing to accept in order to invest his or her money. The hurdle rate is also
known as the opportunity cost or the required rate of return.
present value
the value today of one inflow or a series of inflows expected in the future, assuming the inflows have earned a stipulated
compounded rate of return.
future value
the value that a specific sum of money invested today will have at a future time, assuming that the money earns a
stipulated return that compounds on an annual basis.
net present value (NPV)
the sum of the discounted cash inflows less the sum of the discounted cash outflows, all discounted at the hurdle rate.
the NPV's relationship to the project's actual return
if the NPV is positive, the actual return is greater than the required return.
if the NPV is zero, the actual return is equal to the required return.
if the NPV is negative, the actual return is less than the required return.
internal rate of return (IRR)
a project's implied rate of return; it is the discount rate (rate of return) that produces an NPV of zero.
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Measuring Returns
An illustrated presentation appears below, along with a text transcript. Use these resources to enhance your
understanding of how investment and equity returns are estimated.
Transcript: Measuring Returns
To make informed business decisions, you must be able to estimate a return on your investment. There are a number of
ways to go about this. In this section, we'll look at two models, a return on investment model and a return on equity model.
The return on investment model is appropriate when we want to assess the returns for the entire investment, debt and
equity both included. The same technique can be used to estimate the value of a hotel property. For the return on
investment model, the discount rate is the weighted-average cost of capital that includes both debt and equity. Here the
discount rate or hurdle rate is the minimum required rate of return. In the corporate setting this hurdle rate represents the
firm's risk adjusted cost of capital. Projects must earn this minimum rate or they destroy value for the firm. In a valuation
setting, the hurdle rate is that rate that represents the average return for investors in analogous properties. Again, it is the
minimum return needed to induce investors to invest in the property.
Now let's take a look at a time line, which lays out symbolically how the cash flows happen. An arrow down is money out
of your pocket into the deal. Arrows up are money out of the deal into your pocket. In our simplified model, at time zero,
we buy the hotel using both debt and equity capital. The property then produces cash flows on an annual basis, that's
cash flow before debt service shown as the arrows up for years one, two, through the end of the holding period. At the end
of the holding period we sell the property. The investment analysis proceeds by assuming that the property will be sold at
the end of the holding period, usually ten years, regardless of whether you intend to do that or not. This is a device to
monetize all of the future flows into one flow. The sale price is estimated to be what we could sell the property to the
market for. We deduct from the sale price the selling expenses and any other fees or cost associated with unwinding the
deal, which might include a management contract buyout, or franchise buyout, or other costs.
We have a set of positive cash flows from year one through the end of the holding period. We discount these cash flows
using the hurdle rate for each year starting in one and continuing through the end of the timeline, we then add those
values to the total investment in year zero. This sum is called the net present value of the project. Later in the course we
will do this using an example with specific numbers. Decision rules: if the net present value is greater than or equal to
zero, invest. If it is less than zero, do not invest. Alternatively, we can calculate the internal rate of return, which is that
discount rate that makes the net present value equal to zero. Here the decision rule is to compare the internal rate of
return to the hurdle rate. If the IRR is greater than or equal to the hurdle rate, we invest. If not, don't invest.
Now we turn to the return on equity story. Here we are looking at specific financing arrangements for a specific investor.
An equity investor's primary concern is the return on the equity investment. So, we don't look at the flows to the entire
property, rather, we look at the flows to equity. At the beginning of the investment, you invest your equity, which is
generally the total project cost minus the debt capital you have borrowed. You obtain the cash flows after debt service for
each year on the timeline. Cash flow after debt service is the cash flow from operations in the previous example less the
obligation to the mortgage lender, which is their debt service. At the end of the holding period, the equity investor receives
the equity reversion. This starts in the same place as the return-on-investment model: we sell the property, we have the
selling expenses, we have all of the cost to unwind the position like the management contract buyout or franchise buyout.
In addition, we have to pay off our lender, which is the outstanding mortgage balance and any fees that may be
associated with paying off the balance at the end of the loan. What's left is the equity reversion to the equity investor.
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Calculating the Net Present Value now proceeds just as it did before. The discount rate is a before tax equity hurdle rate, it
is the required return to equity higher then the discount rate in the return-on-investment model seen previously. We take
the cash flows, discount them at the equity hurdle rate, calculate the NPV, calculate the IRR, then apply our decision rule.
So let's peel the onion back on the return-on-equity model and take a look at it in more detail. What we will be looking at is
really three distinct phases. There is a development and acquisitions phase, which lasts two to three years, an operations
phase, which we will model as a ten-year holding period, and a sale or disposition phase at the end of the operating
period.
Let's begin with the development. The development proceeds over a two to three years period. From the moment you
purchase the land until the day the hotel opens you incur a large number of expenses. These include a range of turnkey
costs, including the cost of land, cost of land improvements such as utilities and infrastructure, cost of roads, parking lots,
the building itself, and the furniture fixtures and equipment, also known as FF&E. These are all the "hard" things that
people can see. In addition, there are other significant pre-opening expenses, these include advertising, payroll, and
organizational expenses for creating the legal structures. There are fees for a wide variety of consultants, most notably
architectural fees, design fees, and consulting fees. Finally, there is a developer fee. The developer gets paid a fee to
source the deal and manage the entire development process. Even after the hotel opens it produces negative cash flows
for somewhere between several months and several years, depending on the property. During this period the developer
has to "feed the deal." Once the property stabilizes, the property starts producing positive cash flows from operations.
Once the hotel is open, we obtain cash flows from operations. The calculation is actually quite straightforward
conceptually. We have our revenues, from revenues we deduct operating expenses, we deduct the fixed expenses such
as property taxes and insurance, we deduct the annual debt service owed to the lender, and we also deduct the income
taxes that are owed to the state and federal governments. The income tax calculation is a non-trivial calculation. For now
let's just say one needs to do a tax calculation in order to determine after-tax cash flows to equity. The after-tax cash flow
equity is the net result of what is leftover after deducting all of these expenses from the property's revenues.
At the end of the holding period we are now in the sale and disposition phase. The equity reversion, or more properly
after-tax equity reversion, is calculated as follows. We sell the property. Property sale is generally some multiple of the
cash flow from operations in the year after the last operating year. That multiple is determined by using the inverse of the
capitalization rate. In general, hotel capitalization rates are in the range of 7 to 12%. Inverted, this gives multiples of 8 to
14 times cash flows. So we sell our property. Let's use an example of 8.33% capitalization rate which is a 12 times
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multiple. We sell our property for 12 times its expected cash flow from operations next year. From that we deduct selling
expenses, which would be fees from the brokers and the lawyers necessary to facilitate the transaction. We pay the
remaining mortgage balance to our lender. We pay any pre-payment penalties, yield maintenance fees, or other fees
owed to the lender at the end of the holding period. There may be a franchise buyout or management contract buyout
owed or other fees associated with unwinding the deal. Finally, we have to pay the government capital gains taxes based
on the difference between the book value of the property and the actual sale price.
So what have we done, why do we spend so much time creating these very precise estimates of cash flows? These cash
flow estimates are the foundation for investment decisions. We use the cash flow estimates to calculate the net present
value and the internal rates of return that are expected from a hotel investment on an after-tax basis so the investor has
some calibration to support the investment decision. If the net present value from discounting those cash flows at the
required rate of return is positive, there is support for the decision to invest in the property. Similarly if the internal rate of
return on these cash flows is greater than the required rate of return on an after-tax basis the investment decision is
supported. Of course other information goes into a final decision, but without a positive outcome on the financial analysis,
it is very difficult for an investor to proceed without having some other non-financial motives for investment.
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How Do Operators and Lenders Evaluate the Project?
You've now explored how owners evaluate possible hotel investments. But how do operators and lenders evaluate
potential investments?
While lenders are primarily driven by yield, operators have both financial and non-financial reasons for investing. Before
deciding to move forward with a potential opportunity, they need to know the answers to a series of questions that will help
them assess how the investments meets their fee-related criteria and their nonfee-related criteria.
Click to hear Prof. deRoos talk more about these criteria and how operators and lenders go about evaluating prospective
investments.
Transcript: How Do Operators and Lenders Evaluate the Project?
Operators and lenders use different criteria to evaluate a prospective hotel investment.
Operators have two sets of criteria by which they evaluate a prospective assignment. The financial criteria are dominated
by their interest earning management fees from a hotel, and in earning those fees over a very long time. Additionally,
operators have non-fee oriented evaluation criteria. What operators want to know is: is the hotel consistent with the brand,
with brand quality, and with the long-term growth of the brand? Is the owner likely to support the brand? Specifically, is the
owner willing and able to fund cash shortfalls and capital expenditures? How long is the owner committed to this particular
hotel? All other things being equal, an operator looks for an owner who is committed to the project for a very long time.
A committed owner, consistent with the brand standards, results in a series of management fee flows that allow operators
a healthy return on their time and investment in the property. Operators calculate net present value, they don't calculate
internal rates of return; as we'll see, the internal rate of return is not a good measure of the operator's returns. The
financial metric that operators are most interested in is the net present value per room.
Lenders, on the other hand, are yield-driven beasts. They look at the return on investment measured as the internal rate of
return on this investment relative to the internal rate of return on other possible investments. The metric they use is the
risk-adjusted rate of return. Lenders use a process called "underwriting" to make their decision. They underwrite three
basic items as they evaluate a proposed project: first, what is the quality of the borrower? Second, what is the quality of
the market? And third, what is the quality of the project within the market? Positive answers to these three questions
provide the lender with confidence that the cash flows will exceed the annual debt service. A quality borrower in a quality
market assures the lender that when bad things happen there will be some flexibility on how the loan might be
restructured. Finally, a quality borrower gives the lender some influence on the operation and will recognize the lenders'
interest in the property.
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The Operator and the Lender
We've seen the ways owners calculate returns. Operators and lenders use their own calculations to evaluate a
prospective investment. We'll consider each in turn.
Operators
For operators, the evaluation is purely fee-driven. It is driven by the net present value (NPV) of the property, not by yields.
The operator wants to know if this is the right hotel compared with other potential projects. Do the fees from the
management contract provide proper compensation for the operator's services? If it is a branded operator, does the brand
fit with the project? If it is an independent operator, the brand is moot. It is all about execution. Given that the operators
cannot participate in every hotel opportunity, they must determine if this is the best deal.
The operator must first determine the hurdle rate. Large firms know the hurdle rate in advance. It is the weighted cost of
capital plus a risk premium for the deal (though this risk premium may not be included for certain low-risk deals). An
independent operator is unlikely to know the cost of capital. They generally set a fairly high discount rate. They decide
they will need to earn a certain amount of return per year to compensate for the execution risk.
Look at the diagram below:
We determine the NPV of the property by taking the management fees, deducting costs, and then discounting for each
year at the operator's hurdle rate. The fees include pre-opening fees paid to the operator and pre-opening expenses paid
by the operator. They include the management fees received by the operator each year (including base and incentive
fees) less the operator's overheard costs. Finally, they include the contract termination fee paid to the operator at
disposition. All these fees are discounted at the hurdle rate and the resulting sum is the NPV. A positive NPV suggests a
management contract that will provide the operator with a suitable return. The operator would be interested in this deal.
Lenders
For lenders, the calculation is quite different. Lenders like hotels because they get a yield premium due to the added risk.
Hotels are the riskiest of the major real estate options (which include office, multifamily, retail, and hotel) with the highest
rate of default. Because of this, hotels have the highest returns to lenders, as the lender bakes the default risk into the
loan. Hotel owners looking for loans must recognize that they are competing against other real estate opportunities, not
just other hotels.
For lenders, the key is clearing the hurdle rate. Lenders are not concerned with NPV. Instead, they focus on the internal
rate of return (IRR). Here is a good illustration of how lenders go about evaluating potential investments:
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Lenders determine the yield they can expect to realize on the loan. The major cash flow out for the lender is obviously the
mortgage principle, but it also includes evaluation and administration expenses incurred before the loan is issued. The
lender obtains annual debt service, including any interest kicker, over the course of the holding period. Administrative
expenses are subtracted from this debt service. The lender calculates the IRR for each of these annual flows. If the IRR
calculation results in a yield larger than the lender's hurdle rate, the lender is likely to find the loan attractive.
An owner interested in successfully negotiating a hotel investment must be able to estimate the returns for each of the
major partners.
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The Hungerford Hotel
Now that we've examined how owners, operators, and lenders evaluate projects to determine if they will receive their
desired returns, let's look at how this works out in a real-world situation. Here we introduce an investment possibility facing
Alexandra Rodriguez and her firm, TarHeel Development. We use this example throughout the rest of the course both to
illustrate the concepts we are considering, and to keep ourselves rooted in a realistic example. We begin with some
necessary background and context.
Case Background
On a chilly March day, Alexandra Rodriguez sits in her office at TarHeel Development (THD) reviewing the proposed
Hungerford Hotel in Grandville, a growing southeastern city in North Carolina's Research Triangle. Recently, THD has
concentrated on developing Hungerford Hotels, a 200-unit chain similar in concept to Hilton Garden Inns and Courtyard by
Marriott. THD has just successfully opened three Hungerford Hotels in the Southeast. They operate the hotels under a
franchise license from Hungerford, a US-based hotel company. The proposed project is THD's first Hungerford in the
Research Triangle region.
TarHeel Development
THD is a family-owned business started about 40 years ago by "Gus" Chung, a Chinese immigrant. Gus Chung started
the business with a small roadside motel and the firm grew with friendly service and a "hands-on" management approach.
The firm has grown from two small independent motels to a portfolio of 15 branded hotels plus other real estate holdings.
What was a small owner-operator of independent small hotels is now a respected regional developer and owner of
branded select service hotels.
Ms. Rodriguez has worked at THD for 10 years. Her primary role has been that of vice president of development,
responsible for finding new development sites and building the appropriate hotel on the site.
The Investment and Financing Decision
THD has submitted a loan application for the project to the local commercial bank (LCB). The following summary data has
been developed:
THD's development department has estimated the cost to develop as $24,000,000. The construction costs have been
verified by a general contractor, and the furniture, fixtures, and equipment (FF&E) costs are based on those of a similar
hotel that opened recently. The bank's appraiser prepared a forecast of hotel operations, and used that to generate an
estimate of market value of . Rodriguez feels that the Grandville economy is much stronger than indicated in $25,100,000
the market study and appraisal report. She is convinced that property performance will be stronger than the bank's
appraisal pro forma indicates. However, LCB insists on using the appraisal report's estimate of market value in their
evaluation. The bank's conservative approach is evident in the size of the loan they are willing to extend, which is 75% of
, not 75% of the appraised value. the costs of development
Last week, Rodriguez submitted her loan application to the local commercial bank. The bank responded favorably,
indicating that the project would be considered for a loan, given the success of THD's two recently completed projects.
The senior loan officer provided a term sheet with the following loan terms:
Development cost $24,000,000
Loan size $18,000,000, based on a 75% loan-to-cost ratio
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Interest rate on mortgage 6.75%
Amortization term 25-year term, monthly payments
THD has a long relationship with the LCB and feels that continuing to "shop" the loan would not be productive. Both
Chung and Rodriguez believe in the Hungerford concept and feel that a new hotel in Grandville would be a great success,
especially in light of the firm's recent experience with the brand. To support the investment decision, Rodriguez must
calculate the returns on the investment, using the current loan terms from LCB. To do so, she will need to answer several
key questions:
What is the net present value (NPV) of the overall investment decision, not considering borrowing?
What is the NPV of the equity investment decision, after taxes?
What is the NPV of the management contract, as THD pays its management subsidiary a management fee to
manage the property?
What is the lender's yield on the mortgage loan?
Mr. Chung would like to have the answers to these questions within a week, as he is anxious to make a decision about the
project.
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Estimating Returns: The Case of the Hungerford Hotel
An illustrated presentation appears below, along with a text transcript. This presentation introduces a spreadsheet to
assist in your financial analysis. You will use this spreadsheet later in the course. Use these resources to enhance your
understanding of estimating returns.
Transcript: Estimating Returns: The Case Of The Hungerford Hotel
Alexandra Rodriguez is faced with the investor's classic feasibility dilemma. You need to answer the question: is value
greater than cost? Alexandra will need to answer some key questions: what is the NPV of the overall investment? What is
the NPV of the equity investment decision? What is the NPV of the management contract? What is the lender's IRR or
yield? Ultimately, Alex will want to know if the NPV of the investment is greater than zero, and if the IRR is greater than
the hurdle rate. To answer these questions requires a thorough analysis using the best information available at the current
time.
Let's take a look at the investment assumptions. Here we have the assumptions we need to answer the valuation
questions and the question of the net present value of the overall investment decision. These include the holding period of
ten years, the capitalization rate used at the end of the holding period, the selling expenses at the end of the holding
period, and the desired overall property discount rate or hurdle rate. We also have the desired equity after-tax discount
rate or hurdle rate. The lending parameters and the tax environment that follow will be used to estimate the cash flows to
equity. Lastly, there is a set of assumptions on the valuation of the management contract. These include the net margin on
the management fees and the management fee multiple at the end of the holding period.
We're now looking at a five-year projection of revenues and expenses. The projection uses the standard Uniform System
of Accounts for the Lodging Industry. Note the organization. There is summary at the top of each year: number of rooms,
occupancy, average rate, and rooms occupied. Then sections for overall revenues and the departmental expenses related
directly to the revenue production. These are followed by the undistributed operating expenses and fixed charges, which
are overheads carried by the business. The five-year projection of revenues and expenses is appropriate in this case as
the property stabilizes in year four. There is no need to project all ten years. Note that the stabilization is defined here as
the occupancy stabilizing at 71% in the fourth year. The property becomes more efficient as it stabilizes.
You can note the efficiency increase by looking at the operating margin, which improves from 25.3% in year one to 28.1%
in year four.
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Now we look at cash flows over the holding period. Recall our assumption of a ten-year holding period. We take the pro
forma projections for years one through five, then project cash flows for the remainder of the holding period. In addition,
we need to project equity cash flows for the entire ten-year holding period. Now let's focus on the equity cash flow
projections over the holding period. Note the use of the separate tax calculation and cash calculation. First the tax
calculation. Starting with cash flow from operations, we make a series of additions and deductions to determine ordinary
taxable income. Taxable income is multiplied by the tax rate, which then equals the income taxes.
Now the cash calculation. It's very straightforward. Cash flow to equity is equal to the cash flow from operations less the
annual debt service and income taxes.
We continue developing the cash flows from the investment. We are now concerned with the reversions at the end of the
ten-year holding period. First we have the sale of the hotel. In section A of the simulated sale, we estimate the net sale
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proceeds.
Here, we should step back and look at the $32 million net sale proceeds and relate that to the $24 million investment. We
think the hotel will be worth $8 million more when we sell it at the end of the tenth year than it was worth when we built it.
The remaining sections of the simulated sale relate to estimating the after-tax cash flow to equity.
We deduct the remaining mortgage balance at the end of the holding period, adjust for depreciation and the resulting
capital gains taxes, to arrive at an after-tax equity cash flow from sale.
Again, let's step back for a moment. Note that the $6 million equity investment has an estimated "pay day" of almost $15
million. All of the $8 million increase in property value goes to equity. Lastly, this slide shows the reversionary value of the
management contract, is roughly $2 million.
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So now we're ready to put it all together and we will answer Alex's key questions. Question one. What is the net present
value of the overall investment decision, not considering borrowing? Here, we have the $24 million investment in year
zero, cash flow from operations over the holding period, and the net sale proceeds in year ten. [1] These are summed
each year, discounted at the hurdle rate of 11%, and then the sum of the discounted cash flows is exactly equal to the
overall property net present value. In addition, we calculate the internal rate of return of the investment using Excel's IRR
function. So, the decision: the net present value is positive by $1.36 million. The IRR of 11.86% is greater than the hurdle
rate of 11%. Decision: do the deal.
On to Alex's second question, which is the most important question she wants to answer. What is the net present value of
the equity investment decision after taxes? Here we have the $6 million investment in year zero, we have after-tax cash
flows to equity over the holding period, and we have the after-tax equity cash flow from sale in year ten. Using the same
methodologies as before, the annual cash flows are discounted, but now they are discounted at the equity after-tax hurdle
rate of 14%. The sum of the equity cash flows is exactly equal to the equity net present value. In addition, the internal rate
of return is calculated using Excel's IRR function. So to our decision. The net present value is positive at $869,000. The
internal rate of return is 15.96%, which is greater than the equity hurdle rate of 14%. Again, the analysis indicates that we
should do the deal. The net present value of $869,000 means that $869,000 of wealth is created after obtaining a 14%
equity yield.
Now we know that the investment works for Alex. However, she needs to understand the value of the proposed
Hungerford to both the operator and the lender. Her next question: what is the value of the management contract? Here
we have the annual net management contract flows over the holding period, and the end of holding period value of the
management contract. These are summed each year, discounted at the managers' assumed hurdle rate of 12%, and then
summed to obtain the net present value and the net present value per room. The calculation shows that the management
contract is worth $1.9 million or approximately $9,400 per room. She knows that operators like to achieve a minimum
value in the range of $8 to $10 thousand per room, so she is confident that the manager will be interested.
Alex finishes the evaluation by looking at the lender's returns from participating in the project. The question she wants to
answer here is: what is the lender's yield? Here we have the lender's initial loan of $18 million in year zero. The lender
obtains the annual debt service and the interest kicker over the holding period and obtains the remaining mortgage
balance in year ten. These are summed each year, and then she calculates the internal rate of return of these annual
flows using Excel's IRR function. The internal rate of return calculation indicates that the loan yields 7.21%. Recall that this
is a loan with an interest rate of 6.75% plus the interest kicker, and so, including the interest kicker, it improves the yield
significantly for the lender. Alex is confident that the lender will find this attractive given the risks.
So now what do we know? Well, we know that the proposed Hungerford has a good return on investment. The net present
value is positive. We know that the proposed Hungerford has a good return on equity. The net present value of equity is
positive. Over $850,000 in wealth is created over and above the equity hurdle rate of 14%. We know that the operator
achieves a good contract and we know that the lender will obtain a good yield. Alex is now in a great position to move
forward, knowing that the investment is likely to meet the needs of the three key partners.
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TOPIC OVERVIEW
Topic 2.2: Overview of Hotel Market Valuations
To make informed decisions about a prospective or an existing hotel investment, all parties need to have accurate
estimates of the value of the hotel property. There are a range of different methods used to produce these estimates, each
with different strengths and weaknesses. In this topic we consider these different approaches and produce estimates of
value.
When you have completed this topic, you will be able to:
Explain three approaches used to estimate the market value of a hotel
Apply various methodologies to produce estimates of value
Reconcile the approaches to produce a final estimate of market value
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What's it Worth?
In this section we look at a classic real estate problem: determining the value of a property without selling it. What is a
property worth? Or what's the value of property? And why would anybody be interested in the value of the property if
you're not going to sell it?
Now that we've explored the reasons to perform a market valuation, we need to consider how to go about valuing a hotel
property. Click to hear Professor deRoos explain the different options.
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Transcript: What's it Worth?
So now I know that I need to value properties. How do I derive my valuation? Again, we are in an environment where we
don't have information on what the price is, because we haven't sold the property. Appraisers rely on three traditional
methods to produce an estimate of market value: a market comparison approach, a cost approach, and an income
approach.
Let's start with the market comparison approach. My property has to be worth the same amount of money that a similar
property recently sold for. Method proceeds by collecting data on what similar properties have sold for, adjusting them for
differences amongst the properties, to produce a value estimate.
Using the cost approach, my property should be worth what it costs to build, less the depreciation that's accumulated.
Certainly my property can't be worth much more than what I could spend to build it new, including a developer's profit. So
the cost approach provides a upper bound on value.
The third approach, the income approach, is the present value of all of the future income streams or cash flows that I
expect to achieve over some holding period. This can be done a number of different ways, as we shall see.
Appraisers and investors use all three sets of information to inform a market value estimate. Appraisers are required to do
this as a part of the uniform standards of professional appraisal practice (known as the USPAP). They use all three
approaches, because each approach carries different and important information that is used to inform the market value
estimate.
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Market Comparison and Cost Approaches
Here we look at two of the three main approaches used to estimate the market value of a hotel property. First we consider
the market comparison approach, where the property should be worth what an identical property just sold for. Next, we
consider the cost approach, where the property is worth the cost to construct a replacement, less depreciation.
Let's begin with the market comparison approach. The market comparison approach is useful if there are a number of
analogous properties for comparison. Taken step-by-step, a market comparison is conducted as follows:
Research the market to find recently sold, similar properties and determine accurate data such as price, room
count, amenities and condition of the property, and conditions of sale from each.
Reject comparable properties that may not be good value indicators for the subject property. This is usually due to
non-arms length transactions (related party or seller financing) or partial interests that are sold.
Compare the physical characteristics, location, time of sale, condition of the property, and financing of the
comparable properties with those of the subject property.
Where the subject property and the comparable properties differ, adjust the comparable's selling prices according
to the market reaction to those differences.
From this analysis, estimate a final value for the subject property.
The strength of the market comparison approach is based on the availability of data from similar properties sold recently.
The approach does have distinct limitations. First, its use is limited by any rapid or extreme changes in market conditions
that affect price. Second, no two properties are ever truly comparable, a problem that gets worse with unusual or unique
properties and with higher-quality properties.
Let's turn to the cost approach. The cost approach is especially useful for properties built according to chain standards
and for relatively new properties. Again, let's take a step-by-step look at this approach:
Estimate the new cost to reproduce or replace the structure and other improvements, not including the land value.
A reproduction refers to a complete replica. A replacement refers to a building of similar utility or usefulness
applying currently used materials and building techniques. The replacement cost is most often estimated.
Estimate the loss in property value (depreciation). This may be done using a straight-line method based on the
property's age as a percentage of its useful life, or a breakdown method that takes into consideration physical
deterioration, functional obsolescence, and economic obsolescence.
Deduct total depreciation from the estimated new cost.
Estimate the value of the land as if it were vacant, typically using the market comparison approach.
Add the land value to the depreciated value of the structure and improvements for a total value estimate.
Even in circumstances when the cost approach is most applicable, it still has limitations. Cost estimates may be
inaccurate, and depreciation estimates are highly subjective.
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Income Approaches: Capitalization Rate Approach
We use income approaches to value a hotel property based on the present value of the future cash flows we expect the
property to generate. These flows can be valued in a number of different ways. We examine the most common
approaches.
Let's begin with valuing the flows using the . First we'll look at the model, then at an example capitalization rate approach
(Note: the colors in the model are keyed so that you can follow the terms through the example.). In the model, the value is
equal to the stabilized net income divided by the capitalization rate.
Stabilized Net Income (CFFO)
Model: Value =
Capitalization Rate
The stabilized net income, or cash flow from operations (CFFO), is derived from a forecast of revenues and expenses,
with the cash flows estimated using the appraiser's estimate of long-term equilibrium. Let's look at how the capitalization
rate is calculated.
Calculation: Capitalization Rate
( Leverage times ) Rate
Mortgage (Loan-to-value ratio x Mortgage Constant)
Plus Equity (Equity-to-value ratio x Equity Dividend Rate)
You take the loan-to-value ratio (LTV ratio) and multiply it by the mortgage constant, then take the equity-to-value ratio
(ETV ratio) and multiply it by the equity dividend rate. Summing these two numbers gives you your value estimate. Let's
see how this looks in a real world example:
Mortgage Finance Terms:
Mortgage Interest Rate: 7.00
Mortgage Amortization: 25 years
Mortgage Constant: 0.0848214
Loan-to-Value Ratio 65%
Equity Dividend Rate (before tax) 13%
Capitalization Rate Calculation:
Leverage Rate
Weighted
Average
Mortgage 65% x 0.084814 = 0.055129
Equity 35% x 0.130000 = 0.045500
Overall Capitalization Rate = 0.100629
The stabilized net income is divided by the capitalization rate to calculate the capitalized value:
$4,000,000 divided by 0.100629 = $39,750,061
The model produces a very precise answer, estimating the value down to the dollar. Remember, however, that this is an
estimate. The capitalized value of the property is $40 million.
What are the strengths and limitations of the capitalization rate approach? First, the model is analytically compact. It
doesn't require a lot of forecasting or analytical work, a clear plus. Second, the information needed is very supportable.
The only difficulty is finding data for the equity dividend rate. Finally, it is very useful for stable properties in stable markets.
On the limitation side of the ledger, the model doesn't recognize changes in the market or the asset. If future cash flows
are different than those in the past, estimates of the stabilized year are notoriously difficult. Also, it is not a yield-driven
model, it is a dividend model, and investors are driven by yields. Finally, keep in mind that it does not consider cash flows
over the holding period and sale at end; it is just a single-year model.
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Income Approaches: Ten-Year DCF and Multipliers
Ten-Year DCF
Now let's turn to a second income approach to valuing the flows, a ten-year discounted cash flow (DCF). To perform a
ten-year DCF, you basically make the same calculations as when estimating equity returns by determining NPV. You sum
each year's cash flows during the holding period. You add in the sale proceeds (sale price less selling expenses). The
sale price is estimated by dividing the CFFO for the 11th year by the terminal capitalization rate. Cash flows and sale
proceeds are all discounted by an overall discount rate. The totals are then summed to arrive at the total valuation.
Let's look at this through an example. For this example, we'll assume an 11% overall discount rate, a hotel capitalization
rate in year ten of 8.3%, and 4% selling expenses. We have cash flows from operations in years one through eleven. We
need to calculate the net sale proceeds. This can be calculated as sale price (CFFO for 11th year divided by terminal cap
rate) less selling expenses.
Value Estimate Using a Ten-Year DCF
Assumptions
Overall Discount Rate 11.0%
Hotel Capitalization
Rate in Year 10
8.3%
Selling Expenses 4.0%
Year
Cash Flow
From Operations
1 $ 5,966,000
2 $ 5,966,000
3 $ 5,496,000
4 $ 4,754,000
5 $ 5,243,000
6 $ 6,264,000
7 $ 6,840,000
8 $ 6,746,000
9 $ 6,645,000
10 $ 6,774,000
11 $ 6,904,000
Reversion Calculation- Hotel
Estimated Hotel CFFO in the 11th Year Divided by the Cap Rate
Estimated Year 11 CFFO $6,904,000
Capitalization Rate 8.3%
Expected Sale Price $82,848,000
Less: Selling Expenses $3,313,920
Net Sale Proceeds $79,534,080
Valuation
Year Cash Flow
Discount
Factor
Discounted
Cash Flow
1 $ 5,966,000 0.900901 $ 5,374,775
2 $ 5,966,000 0.811622 $ 4,843,763
3 $ 5,496,000 0.731191 $ 4,018,628
4 $ 4,754,000 0.658731 $ 3,131,607
5 $ 5,243,000 0.593451 $ 3,111,465
6 $ 6,264,000 0.534641 $ 3,348,990
7 $ 6,840,000 0.481658 $ 3,294,544
8 $ 6,746,000 0.433926 $ 2,927,268
9 $ 6,645,000 0.390925 $ 2,597,695
10 $ 86,308,080 0.352184 $ 30,396,366
Value of the Hotel $ 63,045,101
To arrive at the valuation, multiply each year's cash flows by the discount factor to arrive at the discounted cash flow for
each year (one through ten) of the holding period. The discount factor is calculated as one divided by the discount rate
raised to the nth power, where n is the year of the cash flow. For example, the discount factor of 0.811622 for year 2 is
calculated as 1/(1.11) ^2. The value of the hotel is the sum of each year's DCF plus the DCF from the net sale proceeds.
In this example, the value is $63 million.
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What are the strengths and limitations of the ten-year DCF? The ten-year DCF is an accurate, supportable model that
explicitly considers flows over a holding period. It can also explicitly account for a cycle, unlike the snapshot approach of
the cap rate model. On the other hand, the ten-year DCF requires a forecast of cash flows and is only as good as those
forecasts. Also, although the cap rate today is observable, the cap rate in future (terminal cap rate) is more difficult to
forecast. Changes in the cap rate over the ten-year term would change the value of the property.
Room Rate Multiples
In addition to the capitalization rate approach and the ten-year DCF, we will consider two multiplier models. Both are very
quick, rule-of-thumb models. First, the room rate multiple. You simply take the average room rate and multiply it by $1,000
to get the value of each room (or key). Then take the value per room and multiply by the number of rooms to arrive at your
valuation. Let's take the simplest example, a 200-room hotel with an average room rate of $100:
Average room rate ($100) x $1,000 = $100,000 value per room
$100,000 per room x 200 rooms = $20,000,000 value for hotel
What are the strengths and limitations of the room rate multiplier? On the plus side, it is a simple, quick, and easy method
that provides a solid, rule-of-thumb estimation of a hotel's value. It is essentially a room revenue multiplier, setting the
value of the hotel at 3.5-4.5 times the annual room revenue. On the other hand, any rule-of-thumb estimate is a blunt
instrument, unable to gauge value with any rigor or precision. More specifically, this method poses a dilemma: what ADR
do you use? Last year? This year? A stabilized year? In practice, most people in the industry use the current year, which
can pose serious problems if this year is anomalous in any way.
Coke-Can Multiplier
On a lighter note, let's look at a fun method we might call the Coke-can multiplier. Basically, this is the price charged for a
soda multiplied by $100,000 = the value of the room. Think about it: at your average Red Roof Inn, sodas are available at
a vending machine for about a dollar. As you move up the star chain, the soda becomes pricier. At a Hyatt you may pay
$3 for a soda from the in-room mini-bar. At the Four Seasons you pay $5 for the soda from room service.
Obviously, you should use this technique sparingly. Some properties seriously "misprice" soda in relation to property
value!
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Illustrating Valuations: The Case of the Hungerford Hotel
Alexandra needs to have reliable estimates of value to facilitate her decision on the Hungerford. See how each of our
approaches to estimating value arrives at a valuation.
Transcript: Illustrating Valuations: The Case Of The Hungerford Hotel
We've just finished exploring the three approaches to estimating market value. Now we're going to take a look at how they
would apply in practice, using the example of the Hungerford. So how do they work in the real world? How do they inform
real estate investment decision-making? The appraiser is charged with going to the market and finding the information
necessary to support the three different approaches to value. As we explore these three approaches, note how market
data is used in each approach to help form the market value opinion.
First approach: the market-comparison approach. The appraiser has found three recent sales of properties very similar to
the Hungerford. Asset A is a Hungerford Hotel in a different market, a market with generally lower room rates. It's a
150-room property, which sold for $17 million three months ago. The sale price per room is $113,333. Property A is in a
good location, is four years old, and is a good-quality hotel. Based on the age, location, quality, and the difference in
market room rates, the appraiser feels that this sale needs to be adjusted up by 10%, making its indicated value $124,600
per room.
Asset B is in the same market as the Hungerford. It's a new property, only one year old, of excellent quality. The property
is in an excellent location. It's got a great brand. In fact, the appraiser thinks the brand is slightly better than the
Hungerford brand. It sold for $34 million one year ago when it was first built. The sale price per room is $136,000. The
appraiser feels that this property needs to be adjusted down by 5% to make it equivalent to the Hungerford, indicating a
value of $129,200 per room. This downward adjustment is based on Property B's superior location, superior brand, and
superior quality. The age of the property-it's only one year old-does not require an adjustment.
The third sale was also in the same market as the Hungerford. It is an eight-year-old Brand C hotel that sold six months
ago fro $23 million or approximately $110,000 per room. Property C is an average-quality hotel. It is in a good location, but
not a great location, as opposed to the Hungerford. Brand C is not considered to be as good a brand as the Hungerford.
To make it comparable to the Hungerford, the appraiser adjusts it up 12%, so that the price per room gets adjusted up to
an indicated value of $122,000 per room. The appraiser feels that all three sales should be equally weighted; no sale
dominates the others. So the average indicated values is $125,511 per room. Times 200 rooms, gives an indicated value
of the Hungerford via the market-comparison approach of $25.1 million or approximately $25 million.
Next is the cost approach. The appraiser knows that the Hungerford will be a new hotel. Thus no adjustment for
depreciation will be necessary. The appraiser goes to the market, talks to professionals who have built similar buildings in
the recent past, and determines that the total cost to build the Hungerford is $24 million. Remarkably, this is exactly what
Alexandra estimates it will cost to build a Hungerford in this market. That's comprised of $4 million of land, a $14 million
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construction cost estimate, an FF&E estimate of $3 million, and then fees and preopening expenses of another $3 million.
Since the Hungerford is a brand new building, no depreciation is deducted from this estimate. So the value via the cost
approach is $24 million.
Now we move to the income approaches. Our first income approach is a capitalization rate model with one stabilized year.
In this approach, the appraiser again goes to the market and determines that the appropriate rates of return for the
investment would indicate a mortgage of 6.75% for 25 years. This results in a mortgage constant of 8.29%. He knows that
equity owners require an equity dividend rate (or cash-on-cash return) of 11% per year. He feels that the lender would
lend up to 75% of the capital, meaning that the equity would need to be 25% of the capital. The weighted-average return
becomes 8.968%, roughly a 9% overall capitalization rate. Stabilized net income for the Hungerford is the year four
income based on the stabilized occupancy of 71%. This is discounted for three years at the assumed inflation rate of 3%,
resulting in a stabilized net income of $2.225 million. This stabilized income of $2.225 million divided by the cap rate of
8.97% indicates a value of $24.8 million via the capitalization rate model.
In addition to the capitalization rate model, the appraiser also uses a 10-year overall discounted cash flow model. Cash
flows over a 10-year holding period are estimated along with a net sale price at the end of the holding period, the so-called
"reversionary value." These are summed and then discounted at an overall discount rate of 11%. The sum of the present
values, using this approach, is $25.4 million. Note that this is exactly the $25.4 million obtained by Alex in her estimate of
the overall value of the property. We have not changed either the cash flows or the discount factor for this approach. In the
real world, appraisers would test the cash flows and make sure that these were the cash flows that would be achieved by
a component operator. The appraiser would also test the discount rate, making sure that it was a market discount rate, not
the investor's discount rate.
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Now onto the room-rate multiplier. In addition to the capitalization rate model and the 10-year DCF, the appraiser uses the
room-rate multiplier and the Coke-can multiplier to estimate value. The room-rate multiplier is a thumb rule. Value per
room is exactly 1000 times the average daily rate in the first year of operation. The appraiser has already produced a
10-year projection of income and expense and next year's room rate is expected to be $97.85, indicating a value per room
of $97,850. This times 200 rooms is exactly $19.57 million. Note that this is significantly less than the other value
estimates, indicating that the room-rate multiplier, while an interesting thumb rule, is not an accurate estimator of the value
of a hotel.
And finally, on a less serious note, we can estimate value using the Coke-can multiplier. At the Hungerford, brand
standards specify that Coca-Cola is sold for $1.25 per can in the vending machines. The thumb rule is that the value per
room is exactly 100,000 times the cost of a Coke, indicating the value at the Hungerford of $125,000 per room. Multiplying
by 200 rooms indicates a value of $25 million. Note the remarkable accuracy of this approach, which is very much in line
with the other value estimates via the income approaches, the cost approach, and the market-comparison approach. The
accuracy of the Coke-can multiplier in this example should not be taken as an endorsement.
So, now the appraiser is faced with a problem of reconciling all of the different value indicators. Recall where we are: we
have-a value of $25.1 million via the market-comparison approach, a value of $24 million via the cost approach, and two
value indicators via the income approaches, one at $24.8 million for the cap rate model and one at $25.4 million via the
DCF model. The appraiser concludes that the preponderance of the evidence suggests that this hotel is worth
approximately $25 million. He gives equal weights to the market-comparison and income approaches, and much less
weight to the cost approach, because he knows that for a well-located property, properly built, the value in use will be
greater than the cost to construct.
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Module 2 Wrap-Up
In this module, you have produced accurate estimates of returns for each of the participants in a hotel investment. You
have used a variety of methods to produce an estimate of value. These are both crucial steps in evaluating potential
investments.
Having completed this module, you should be able to:
Estimate the return on investment by calculating the net present value and the internal rate of return.
Estimate the owner's return on equity by calculating the net present value and the internal rate of return
Explain how operators and lenders evaluate their investments in an owner's project
Combine the investment evaluations of the owner, operator, and lender
Explain three approaches used to estimate the market value of a hotel
Apply various methodologies to produce estimates of value
Reconcile the approaches to produce a final estimate of market value
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MODULE OVERVIEW
Module 3: Structuring the Deal: Current Equity and Debt Financing Structures
In this module you examine the loan-sizing process and explore the different options for financing projects. You engage in
a loan analysis and sizing exercise. You apply what you have learned to arrive at an investment recommendation.
When you have completed this module, you will be able to:
Explain the major options for financing hotel real estate projects and connect them to the relevant owners
Forecast the size of a loan for a given project using the lender's underwriting criteria
Analyze a prospective loan from the borrower's perspective
Make and defend an investment and financing recommendation
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TOPIC OVERVIEW
Topic 3.1: Hotel Financing Cycle: Equity Financing
A wide range of options are available for equity financing. Different types of owners assemble the necessary capital,
including the necessary equity, in different ways. In this topic, explore the various ways of assembling the equity
component of the capital stack.
When you have completed this topic, you will be able to:
Explain the major options for financing hotel real estate projects and connect them to the relevant owners
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How Do You Raise the Money?
Real estate investments require large amounts of capital. How do hotel owners raise the funds
necessary to finance their investments? Examine the capital stack diagram, comprised of the equity the
owner contributes, the debt capital the owner borrows, and any mezzanine funds the owner must
borrow to bridge the gap between debt and equity. Here we look at how three different investors might
implement their unique approach to stacking their capital.
We start with Sophie. Recall Sophie works for an insurance company. Her
fundamental driving goal is a desire to put large amounts of her capital to
work as equity. She uses debt strategically to boost equity yield slightly,
especially if small amounts of debt, say 25 to 50% of the capital stack, add
little risk to her equity position. Because she's not capital-constrained-she has
plenty of funds to put to work-she has no use for mezzanine funds. The real
question that determines how much equity she contributes is the
risk-adjusted return.
Now let's contrast Sophie with John. John works for a real estate investment fund. Like
Sophie, John's fundamental driving goal is to put a significant amount of equity to work, but
unlike Sophie, John wants to achieve a significantly higher desired equity yield than
Sophie's. John uses large amounts of debt capital to significantly boost the equity yield to
his deals. He is seen as a low-risk borrower, so banks are generally willing to extend high
loan-to-value (LTV) loans to John. It's not unusual for John to achieve debt levels in
excess of 75%, sometimes approaching 80%, meaning he has to put 20 to 25% equity in
the deals. This means that over the long-term John has to do many more deals than
Sophie to achieve his desired equity returns, because he puts less amounts of his capital
in each deal.
Lastly, we will take a look at Alexandra. Recall that Alex is a developer. She is fundamentally
a wealth creator and she is usually severely capital-constrained. She is full of creative ideas
and wonderful sites to be developed or redeveloped, but she is short of capital. Alex needs
to find capital partners willing to support her vision of development. Her fundamental driving
goal is to use her limited equity to develop and redevelop property by taking on these
partners. She is seen as a relatively risky borrower. So banks are generally unwilling to
extend high-LTV loans. In general, it would be difficult for Alex to borrow more than 65% of
her funds from a traditional first mortgage lender. Alex wants to put in somewhere between
10 and 15% of the capital stack. Thus, Alex has a gap problem. She puts in 15% of the
capital as equity, the first mortgage lender puts in 65% as debt. The result is a 20% gap. The
solution is to use mezzanine funds to bring her borrowed funds from 60 to 80% (or more) of
the total capital. The mezzanine money is expensive, but it is the grease that gets her deal
done. In the sections that follow, we will take a look inside these stacks. According to real
estate folklore: first you do the deal, then you raise the money. The first money you raise is
always equity. So we will start with equity financing before moving on to debt capital.
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Equity Financing: Real Estate Equity Funds
Let's begin our look inside possible hotel investment capital stacks by considering private equity funds. A private equity
fund is a collective investment mechanism where large amounts of equity capital can be united, usually under the direction
of a fund sponsor. The best way to explain how this works is to take an example.
John Dough, our vice president of acquisitions at Black Hall Lodging, works for a firm that has put together a private equity
fund to drive greater returns. The firm makes a proposal to potential equity capital contributors. John's firm proposes to
raise $1 billion for hotel investment. At this stage, Black Hall has no specific plans to invest in any particular property;
however it does have a strategy to purchase underperforming properties, and it has a track record of achieving 30%
annual equity returns. To raise the $1 billion, John approaches potential investors such as high-net-worth individuals,
sovereign funds, pension funds, insurance companies (in fact, John might approach Sophie at AIGH), and other real
estate investors. Those investors who agree to participate are trusting in Black Hall's record of achieved returns. They
place their contribution in a blind pool (they do not know what it is they are buying), generally handing over control of their
money for a three- to seven-year period (the fund has the ability to redeem 4%-5% of the invested equity each year, but
generally the investor's money is committed).
Once the fund is assembled, John begins to acquire hotel assets. He adds debt as needed, stretching the equity
contribution as far as he can. It would not be unusual for John to turn his $1 billion in funds into $4 or $5 billion in real
estate assets.
What does each of the partners in the private equity fund provide and what does each partner achieve?
The fund sponsor, Black Hall, primarily provides expertise. It is John's job to source and acquire the properties for the
fund. Black Hall also provides seed money and administrative expertise for the fund. In exchange, Black Hall receives:
Fees. These include acquisition, administrative, and management fees. For example, Black Hall may typically
receive a fee of 0.5% to 1% of the value of the owned assets for asset management.
A percentage of profits and losses
A percentage of cash flow from operations (after preferred returns are paid to the fund investors)
A percentage of the net proceeds from refinancing
A percentage of tax benefits
What about the fund investors? Obviously, their contribution is cash, paid either as a lump sum or a staged pay-in. What
do they receive?
A percentage of profits and losses
A preferred cash return ("preferred" means that these investors obtain a return prior to Black Hall obtaining their
cash return)
A percentage of cash flow from operations (after the preferred cash return)
A percentage of net proceeds from refinancing
A percentage of net proceeds from sale
A percentage of tax benefits
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Equity Financing: Joint-Venture Agreement
Private equity funds are for the major players in real estate investment, the "big boys" with large amounts of capital for
investment. What about the small developer who does not have the track record or the available capital, but has a great
investment possibility and does not want to go to a fund? For these developers, a joint venture is often the preferable
route.
In this arrangement, the equity portion of the capital stack is assembled through an agreement between two partners.
Usually these consist of a sponsor or developer, who provides the expertise, and a money partner, who provides the
majority of the equity capital. In the case of an acquisition, the agreement is usually between a sponsor and a money
partner. In the case of a new property, the agreement is usually between a developer and a money partner.
Alexandra, at TarHeel Development, would be a likely candidate for a joint-venture agreement. Chronically
capital-constrained, she does have development expertise and a strong sense of the market in the Research Triangle. A
joint venture with a money partner might help Alex raise the equity component of her capital stack. Sophie and AIGH
might be a likely money partner for this joint venture.
Alex, via TarHeel, would develop the deal, in exchange for the long-term fees associated with the project. Sophie agrees
to form a joint venture and contribute a substantial amount of equity capital, conditional on Alex receiving a certificate of
occupancy. Alex can then take the joint-venture commitment to the lending community for the necessary debt capital. She
can receive a permanent loan commitment, again conditional on achieving the certificate of occupancy. Alex can then take
the joint-venture agreement commitment and the permanent loan commitment to construction lenders to secure funding
during the development or acquisition process. Neither Sophie nor the bank wants to commit money until the hotel can be
occupied.
In this particular joint venture, Sophie, as the money partner, would be the majority owner. Thus, even though Alex
provides much of the development expertise, Sophie's money wins her a voice in design, standards, or anything other
area where she seeks a measure of input or control.
A successful joint venture requires the negotiation of certain key provisions. The agreement must establish the
percentage of ownership for each partner. Additionally, the partners must agree on what contribution constitutes
the basis for this percentage. It may be made up of cash, land, other assets, services provided, other value brought
to the project, or some combination of these.
The agreement must specify the roles and voting rights for each partner during each phase of ownership:
development or acquisition, operation, and disposition.
The agreement must specify the funding requirements. These include the amounts, the methods and terms of
funding, and the fund release schedule. Provisions for additional funding, including cost overruns and
greater-than-anticipated negative cash flow from operations, must be specified. The agreement should specify
adjustments in the joint-venture ownership percentages if any partner fails to meet its funding obligations.
The agreement must specify provisions for termination of any contract or agreement between the joint venture and
any partner, and for termination of the joint-venture agreement.
A joint-venture agreement may be a sound method for a developer such as Alex to raise the necessary equity capital for
an investment. It can also be a lucrative means for Sophie to put her capital to work achieving the stable returns she
desires.
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Equity Financing: Real Estate Investment Trusts
Like private equity funds, Real Estate Investment Trusts (REITs) are large pools of equity capital for hotel investment.
Unlike private equity funds, however, REITs are publicly traded . Because of this the real estate in the trust has much
1
more liquidity than a private fund, that is, one can sell the shares at any time.
REITs are a common exit strategy for owners of hotel portfolios. The portfolio owner takes a set of assets, and sells them
to the public through a REIT initial public offering. REIT share holders achieve a very liquid form of real estate, providing
returns without the day-to-day burden of managing the asset or assets. Their payout structure (REITs are required to
distribute at least 90% of their taxable income in the form of dividends) and lower risk profile make them attractive to many
public investors, especially pension funds.
REITs are typically put together by a sponsor, much like a mutual funds sponsor. REITs in the United States are exempt
from corporate income taxes provided they conform to the following rules:
75% of the assets in the REIT must be real estate (either whole assets, shares of other REITs, or mortgages)
75% of the revenues of the REIT must come from real estate
90% of the REIT's taxable income must be paid out in the form of dividends-they can retain only 10% of the taxable
income for growth.
A key metric in evaluating REITs is the ratio of the Enterprise Value to the Net Asset Value (NAV). Enterprise value is the
total value of the company's shares plus the value of the company's debt. NAV is an estimate of the market value of the
firm, defined as the sum of the values of the individual properties in the firm. Generally calculated by a Wall Street analyst,
NAV is compared to the firm's enterprise. If the enterprise value is greater than NAV, the firm trades at a premium to its
market value. If the enterprise value is less than NAV, the firm trades at a discount to its market value. This relationship
plays a key role in arbitrage decisions made to realize gains in taking private real estate public, or in taking REITs apart
and converting assets back into private real estate.
REITs Around the World
Though the number of REITs has decreased in the United States in recent years, REIT structures are increasingly
common around the world. There are many more such structures available now than there were even a few years ago.
The REIT model has been historically underdeveloped in Europe, but it is growing in the UK, Germany, and France.
Though family ownership networks still predominate in Asia, REITs are beginning to emerge there as well; Japan,
Singapore and Australia all have well developed REIT (or property share) markets.
Issues Considerations for REITs
Interest Rate Sensitivity: Since REITs have high dividends, they are often purchased for their dividend yield. If
interest rates go up, and REIT dividends are unchanged (as a percentage of the REIT stock value), the REIT stock
price will decline until the REIT dividend is in equilibrium with interest rates. For example, suppose T-Bills have a
5% dividend and REITs have (on average) a dividend rate of 7%. If T-Bill rates increase to 6%, the REIT dividend
rate will need to increase to 8% to have the same 2% spread. If REITs do not increase the cash payout to achieve
the 8% dividend rate, the REIT price will decline to achieve an 8% dividend rate.
Correlation between Stocks and Real Estate: one of the benefits of real estate in an investment portfolio is the lack
of correlation between stocks and hotels. For REITs, however, this benefit is diminished. The correlation between
REITs and the major stock indexes is strong, and has strengthened over time.
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Rolling REIT Correlations. REIT Cafe. http://www.reitcafe.com
Dividend Payout Ratio and Performance: The dividend payout ratio is the ratio of dividends paid to funds from
operations (FFO); it is essentially that percentage of that is paid to share holders (note that REITs are cash flow
required to pay at least 90% of their as dividends). Generally, REITs with low payout ratios taxable income
perform better than those with high payout ratios as the firms can use these internally generated funds for growth.
REIT payout ratios have averaged about 75% over the past 10 years.
Growth Strategies: REITs generally grow in two ways:
Organically: by using good asset management skills to obtain greater cash flows from the same asset base
Via Acquisitions: by using debt to acquire properties, then 'taking out' the debt via a 'follow on' offering of
stock. This is a riskier method than the first method.
How do REITs connect to the ownership interests we have considered in this course? Both John and Alex would consider
selling properties to a REIT at the end of their holding periods. REITs need stable, cash-flowing assets. In fact, some
REITs have agreements with developers to purchase assets after stabilization at a fixed capitalization rate.
Sophie would be interested in being a REIT shareholder. Remember, in addition to wanting to put large amounts of capital
to work over long periods of time, Sophie's insurance company has a need for liquid assets. Sophie would be attracted to
the liquidity REITs provide.

1
There are a few non-listed REITs, whose shares are not traded on a public exchange. They represent a very small
portion of REIT market capitalization.
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TOPIC OVERVIEW
Topic 3.2: Hotel Financing Cycle: Debt Financing
Assembling the requisite debt capital for a hotel investment invariably means negotiating a mortgage with a lender. In this
topic, explore the loan negotiation process and learn how to negotiate and size a loan.
When you have completed this topic, you will be able to:
Forecast the size of a loan for a given project using the lender's underwriting criteria
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What Do Lenders and Borrowers Want?
An illustrated presentation appears below, along with a text transcript. Use these resources to enhance your
understanding of the goals of both lenders and borrowers in the loan negotiation process.
Transcript: What Do Lenders and Borrowers Want?
What do lenders and borrowers want? Let's start with lenders. What do lenders want? A good way to answer this question
is to look at their underwriting criteria. Lenders use two fundamental underwriting criteria to size loans. First, they want the
loan paid. Thus, they are very interested in the amount cash flow from operations exceeds the annual debt service. The
metric used to measure this factor is called the debt-coverage ratio. The debt-coverage ratio is defined as cash flow from
operations divided by the annual debt service. Think about this for a moment. A debt-coverage ratio of 1.5 means that
there is a $1.50 of cash flow for every $1 of annual debt service. Lenders specify the minimum debt-coverage ratio that
they will tolerate for different property types and for different risk levels.
The second fundamental underwriting criteria that is used to size a loan is called the loan-to-value ratio. This is used
because lenders want to be able to sell the property for at least the amount of the loan should the borrower default. The
loan-to-value ratio is defined as the loan amount divided by the market value of the property. Lenders specify the
maximum loan-to-value ratio they are willing to tolerate for different property types and for different risk levels. Again,
these two criteria are collectively known as the underwriting criteria. These two criteria, the debt coverage ratio and the
loan-to-value ratio, are the primary means lenders use to evaluate and to size a loan.
In addition to the debt-coverage ratio and the loan-to-value ratio lenders want a yield. They want the interest rate on hotel
loans to have a premium relative to other property types, because of the additional risks of hotels. Finally, lenders want
borrowers to have little or no ability to prepay the loan before the end of the loan term.
So, this gives you a feel for what lenders want. Now let's take a look at the borrower desires. What do borrowers want?
Well first and foremost, borrowers want a big loan. They want the maximum loan amount. They will negotiate very hard
with lenders over debt-coverage ratios and loan-to-value ratios to increase the size of their loans. Secondly, they want low
interest rates. They want a so-called low-cost loan. Note that maximum loan amount and low interest rates are definitely in
tension, because as the lender allows a loan to get bigger they will charge a higher interest rate due to the increased risk.
So, if borrowers want low interest rates they generally have to be satisfied with a smaller loan.
The third thing that borrowers want is maximum flexibility to refinance the property or to prepay the loan. Note that this is
in tension with one of the lender's desires, which is little or no ability for borrowers to prepay the loans. The fourth thing
that borrowers want is mechanisms that structures payments based on the property's ability to pay. One of the most
important manifestations of this is for new properties or newly acquired properties that need a few years to stabilize.
Finally, borrowers want limited recourse in case they default. Generally, this is structured as a so-called nonrecourse loan
in which the lenders only recourse is their ability to foreclose on the property and sell it. Limited recourse means the lender
has limited ability to go after the other assets of a borrower in default.
So we can clearly see that there is some common ground between the borrower's desires and the lender's desires, but we
can also see that there are many things in tension. What borrowers and lenders need to do is to be nimble and have very
clear objectives as they are negotiating their loans to obtain the best set of loan terms for them. This is not an impossible
task. Lenders and borrowers come to terms every day, but borrowers that don't have their eye on the ball and are not very
clear about their objectives tend to get suboptimal loans.
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Debt Financing
A wide variety of debt financing options are available for hotel mortgages. Explore the most important, beginning with
some basic debt financing terms.
principal
the amount of the loan.
term
the number of years the borrower gets to use the money.
amortization
the number of years upon which the payment is based.
balloon
the remaining mortgage balance when the term is less than the amortization.
interest rate
the annual rate of interest on the loan.
origination fee and points
fees charged at the beginning of the loan for the privilege of being able to borrow the money. The origination fee generally
covers the lender's cost. Points are fundamentally yield boosters. One point is a charge equal to 1% of the loan amount
paid to the lender at the time the loan is originated.
prepayment management
a set of devices used by lenders to prevent borrowers from prepaying the mortgage before the end of the term. These
include:
lockout: the borrower is contractually prevented from prepaying.
yield maintenance: the borrower pays a prepayment fee that provides the lender a stated yield over the loan term.
defeasance: the borrower provides the lender with securities that replicate the contract interest rate over the loan
term.
recourse loans
give lenders access to other borrower assets in addition to the real property if the borrower defaults.
contingent interest
also called a "participating loan"; gives the lender additional interest based on the operating results.
Hotel investments often involve more than one type of debt financing, as borrowers combine a preliminary mortgage for
the hotel construction with the permanent mortgage.
construction mortgage
this is often the first mortgage taken out in a real estate investment. It is a floating-rate, interest-only mortgage used to
finance the construction of a new hotel. Interest accrues and is added to the loan balance for the duration of the loan. The
construction loan balance (funds advanced plus accrued interest) is then "taken out" by the permanent mortgage.
permanent mortgages
: a mortgage in which the interest rate is fixed for the term. Generally terms are relatively long, fixed-rate mortgage
7 to 15 years typically, with 20- to 30-year amortization. This loan usually has a "balloon payment" at the end,
requiring the borrower to pay the remaining mortgage balance (the "balloon") when the loan term is less than the
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amortization.
: a mortgage in which the interest rate floats over an index for the term of the mortgage. floating-rate mortgage
The most common index is the London Interbank Offer Rate (LIBOR). These are generally short-term loans, for 2
to 5 years, with no amortization (they are so-called "interest only" loans). These loans generally have lower debt
coverage ratio (DCR) and higher loan-to-value (LTV) constraints than fixed-interest loans. Floating-rate loans often
come with extension options, allowing the borrower to extend the loan for one, two, or three additional years in
exchange for additional points (1/4 or 1/2 point per extension).
: a modified fixed-rate mortgage where there is a fixed rate of interest, generally lower than participating mortgage
an equivalent term fixed-rate mortgage, and in addition the lender participates in cash flows on the property. The
lender generally takes some percentage of the property revenues.
: a mortgage where the lender has the ability to convert the mortgage into equity at very convertible mortgage
specific points in time. In exchange for this right, the lender gives a lower interest rate. Convertible mortgages are
not common.
In addition to these basics, there are also several "flavors" of combination or extension mortgages. The most important
include:
: also known as a mini-perm loan, this combines the construction loan combined construction and term loan
(generally an interest-only, floating-rate mortgage) with a floating-rate mortgage for a short term after opening. This
allows the borrower to have the property stabilize after opening before refinancing into a larger fixed-rate mortgage.
The borrower has to go to the capital market twice (to secure a mini-perm and then refinance into a permanent
loan), not three times (secure a construction loan, which is "taken out" by a floating-rate mortgage, which is
subsequently taken out by a fixed-rate loan once the property stabilizes).
: similar to a construction and term loan, but used for acquisitions. If you acquire a property and bridge loan
reposition it, a bridge loan funds the cost of the acquisition plus needed renovations. This loan is a "bridge" to a
larger loan once the property stabilizes.
: not really a loan. You can think of a sale-leaseback as a 100% loan-to-value mortgage where you sale-leaseback
retain control of the property through the lease, and are able to achieve "mortgage proceeds" that are 100% of the
value of the property. It is often framed as an alternative form of financing.
: government-assisted loans in which tax increment financing (TIF) and payment in lieu of taxes (PILOT)
government agencies provide pieces of (or facilitate) the capital structure. These government programs are
generally secondary to the first lender, but they get paid before equity gets paid. They are funded through either a
tax holiday or some other mechanism that reduces property taxes earlier in a property's life.
: a device that many sellers use if they have a purchaser who may not be able to borrow in the seller financing
regular financing markets. In this case the seller may extend some financing to that buyer as a way to get the
property sold. Generally, seller financing is expensive money, but many sellers embrace the technique because the
worst thing that can happen is they get their property back in a foreclosure. It is also seen by sellers as a
mechanism to turn their risky equity capital into less-risky debt capital.
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Project Presentation for Lenders
Consider the borrower's position. The borrower knows what the lenders are looking for when they review a loan
application. First, the lenders would like a high rate of return. Second, they need to balance their loan portfolio. They have
coverage ratio targets (DCR) for any type of property and they have portfolio targets. The lenders want a certain amount
of real estate in the portfolio, and within real estate, they want a certain amount allocated to lodging. Third, the lenders
must evaluate whether or not they are interested in owning a hotel if the borrower should default. This last criterion
prevents some lenders from considering loans for hotel investments. They simply have no interest in owning a hotel via a
default.
Borrowers need to put together a formal loan application package that addresses these issues. This package is designed
to convince the lender of the benefits of this project, to "sell" the entire investment to the lender. The borrower also hopes
to achieve some influence over the underwriting of the loan. The loan application is the borrowers' opportunity to share
their vision of the project with the lenders. The package includes:
Documented market analysis and operating projections. In a perfect world these would be prepared by a third-party
consultant. In many cases the lender accepts these from the borrowers when they have a good relationship and the
borrowers have a demonstrated record of delivering on their promises.
Documented turn-key cost. This should explain what the turn-key costs are to build the property if it is new, or what
the total costs are of an acquisition.
A developer package. This includes a wealth of information about the developer or borrower and their background.
It includes:
Objectives for ownership
How the borrower's equity is structured
Who the borrower's partners are, if they have any
Who the borrower's major principals are, with background on each
Details of any partner commitments between the borrower and third parties, including copies of partnership
agreements
Background on financial assets and completed projects for the borrower in the past; a history or vita
Evidence that an operator has agreed to operate the project if a third-party operator is needed. Ideally, this would
include a copy of the management contract, a copy of the franchise agreement, or a copy of the lease.
Architectural renderings for a new project or glossy photos for an acquisition. This is a key element of selling the
project to the lender. Show the lenders a great set of images to help them envision the property and commit to the
project.
Evidence that the borrower has searched land use and title issues. This may entail evidence that the borrower can
obtain legal title to the land, evidence that the property can be used for the intended purposes, and evidence that
all necessary economic and environmental impact studies have been successfully completed.
Finally, the borrower is well advised to prepare a forecast of the lender's
cash flows. What is the lender likely to achieve by providing the debt
capital for this project? This should include projections for good and bad
times. For a straightforward, fixed-rate loan, this might not be necessary.
But for a participating loan, or a loan with conversion features, it is
advisable to help the lender understand what the returns will look like.
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Throughout this process it is very important that the borrower treat the lender as a business partner. Lenders have seen
many applications. If they spot any "puff" or dubious numbers, they will probably treat the entire application with suspicion.
By treating lenders as business partners, you can convince them that you will treat them fairly and honestly. This goes a
long way toward helping the borrower obtain a loan that meets their objectives.
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Sizing the Loan
An illustrated presentation appears below, along with a text transcript. Use these resources to enhance your
understanding of how to size a loan.
Transcript: Sizing The Loan
An important piece of the borrower's presentation to the lender involves the borrower's presentation of the future results
from operations. The borrower presents pro forma estimates of future revenues and expenses. Looking at the pro forma,
it's the bottom line, the cash flow from operations, that is most important. The borrower and the lender will enter into
negotiation over the numbers used to size the loan. As an example, consider the Hannah Hotel in San Francisco. The
borrower provides four years of cash flow estimates. The cash flow estimates increase over time, from $2.14 million in
year one to $2.94 million in year four, as the occupancy and rate of the hotel improve over time.
The lender responds to the borrower's four-year pro forma numbers with a set of numbers called the lender's underwriting.
The borrower understands these as the numbers the lender will use to underwrite or size the loan via the debt-coverage
ratio.
In this example, the lender's underwriting uses the borrower's year three numbers, with two important exceptions. The
lender uses a more conservative occupancy of 75% instead of the year three estimate of 77%. The revenues for the
lender's underwriting are 75% occupancy at a $125 average daily rate. In addition, the lender deducts franchise fees,
assuming that the property will be branded if they need to take the property back through foreclosure. The net result is that
the lender is underwriting $2.35 million of cash flow, as opposed to the year three numbers of the borrower, which show
$2.7 million of cash flow. As we'll see, this has a significant impact on the size of the loan the lender is willing to provide.
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Let's look at the lender's preliminary or "base case" loan that they are willing to originate. In the base case, the lender
uses an interest rate of 6%, an amortization term of 20 years, with monthly payments. The loan-to-value ratio that the
bank uses is 60%. This means that the loan can be no larger than 60% of the appraised value of the property. The lender
hires an appraiser, the appraiser goes to the market and prepares a market value estimate of $30 million. The loan size
via the loan-to-value ratio is 60% of the appraised value, thus $18 million. In addition, the lender imposes a debt-coverage
ratio of 1.6, meaning that the annual debt service will be no more than the cash flow from underwriting divided by 1.6.
Another way to say this: the cash flow used for underwriting needs to be 1.6 times the annual debt service. As we've just
seen, cash flow from underwriting was $2.35 million, which came from the negotiation between the borrower and the
lender. The loan sizes, using this cash flow, at $17.1 million.
The lender will always use a smaller loan. So, in this case, the debt-coverage ratio constrains the loan size. The borrower
will not be able to borrow $18 million; the maximum loan is $17.1 million. To show the impact of the underwriting criteria
have on the loan size, note the following: if the lender had used the year three pro forma cash flow of $2.7 million, the loan
would have sized via the debt-coverage ratio at $19.6 million, significantly more than $17.1. If this were the case,
however, the loan would now be constrained by the loan-to-value ratio of $18 million. The negotiation over cash flows has
a significant impact on the size of the loan.
Let's now look at the projected debt-coverage ratios on the cash flow used for underwriting. Note that the lender imposed
a debt-coverage ratio of 1.6 on the cash flow used for underwriting. Based on the borrower's projected cash flow from
operations, the debt-coverage ratios are projected to be 1.45 in year one, 1.65 in year two, 1.84 in year three, and 2 in
year four. This indicates a large cushion of safety for the borrower in this loan.
Now let's take a look at some optional loan terms. Suppose that the lender is willing to offer these optional loan terms in
order to obtain a higher yield on the loan. They will offer a longer amortization term in exchange for a higher interest
rate-specifically, the higher interest rate is 6.2% and the longer amortization term is 24 years. What this does is increase
the loan size, but as we will see, the loan is now constrained by the loan-to-value ratio. Let's take a look at how this works.
We have the same loan-to-value ratio, the same debt-coverage ratio, the same cash flow from underwriting, and the same
appraised value. What has changed is the interest rate and the amortization term. These two parameters combine to
increase the size of the loan via the debt-coverage ratio to $18.36 million. Now the size of the loan is constrained by the
loan-to-value ratio. The smaller of the two loans debt-coverage ratio, loan-to-value ratio is the $18 million loan sized via
the loan-to-value ratio.
So the borrower has a choice. Would the borrower be willing to pay 20 extra basis points (0.2%) for the loan in order to
increase it by $833,000, from $17.1 million to $18 million? This is a 5.2% increase in the loan size. It's also an $833,000
reduction in the amount of equity the borrower would have to provide to purchase the property. In general, the borrower's
answer would be yes. Borrowers would say yes to the small increase in loan cost because it is dominated by the large
increase in the borrower's funds. This has the effect of increasing the borrower's equity returns. You'll have an opportunity
to model this in the case study that concludes this course.
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The Lender's Response: The Term Sheet
The term sheet results from a negotiation between a borrower and a lender over the terms of a loan. It answers a simple
question for both parties: what did we agree to? It is a very useful means of ensuring that the borrower and lender are on
the same page.
Click to view the the term sheet for the Hungerford project. here
Click to download a print-friendly version of the term sheet. here
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Mortgage Worksheet
Download this . You can use this Excel file to see how changes in the mortgage interest mortgage calculation worksheet
rate, amortization term, payments per year, mortgage constant, LTV ratio, debt coverage ratio, appraised value, or cash
flows from operations change the loan size via the LTV or the DCR.
Just enter a new value for any of the blue cells to see the adjusted loan sizes. Remember, the smaller of the two ratios will
be the size of the loan.
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TOPIC OVERVIEW
Topic 3.3: Investment Construction and Analysis
You are now ready to apply what you have learned. In this module you undertake a course project in which you analyze a
prospective investment and consider different debt capital options.
When you have completed this topic, you will be able to:
Analyze a prospective loan from the borrower's perspective
Make and defend an investment and financing recommendation
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Case Study of the Hungerford Hotel
For the final course project, you analyze a prospective investment, estimating returns to the relevant partners and
determining if the investment is financially feasible. Download the following documents, which describe your assignment
and give you tools you will need. When you have made the required estimates, return to this page and answer the
questions below. You should then proceed to the discussion, where you are asked to make and defend a
recommendation.
Please download the following documents:
: Download and read the Hungerford case study. Description
: See the description of the case for an explanation. Pro Forma
: The workbook has a series of tabbed worksheets. To answer the questions, you need to The Excel workbook
enter the proper information in the blue cells in each worksheet.
When you have completed the workbook, answer the questions in the forms below. Then proceed to the discussion to
make and defend your recommendation
For this question, enter a dollar amount that is rounded to the nearest cent.
For this question, enter a dollar amount that is rounded to the nearest cent.
For this question, enter a dollar amount that is rounded to the nearest cent.
For this question, enter a percentage that is rounded to the nearest hundredth of a percent (for example, .08374 becomes
8.37%).
For this question, enter a percentage that is rounded to the nearest hundredth of a percent (for example, .08374 becomes
8.37%).
For this question, enter the capital letter only. For example, "E" would be an acceptable answer, but "e" or "E (undecided)"
would not be acceptable.
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Module 3 Wrap-Up
You have successfully completed this module. You should now be able to:
Explain the major options for financing hotel real estate projects and connect them to the relevant owners
Forecast the size of a loan for a given project using the lender's underwriting criteria
Analyze a prospective loan from the borrower's perspective
Make and defend an investment recommendation
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Course Wrap-Up
Upon reaching this page, you should have completed the following modules in the course:
The Hotel Owner-Operator-Lender Partnership
Evaluating the Deal: How Owners, Operators, and Lenders Evaluate Proposed Projects
Structuring the Deal: Current Equity and Debt Financing Structures
If you have completed these modules-congratulations! Let's review the course objectives. Having completed this course,
you should feel comfortable with your ability to do the following:
Explain the varied motivations of owners, operators, and lenders in pursuing real estate investments
Explain the different investment approaches taken by owners in the hotel industry
Estimate the return on investment and the return on equity for a prospective hotel investment
Estimate the value of a proposed hotel using a variety of methods
Analyze and evaluate investment projects from the perspective of owners, operators, and lenders
Structure hotel investments that meet the needs of all parties
Size a loan that meets the needs of different partners
Make informed decisions about the relative attractiveness of hotel investments
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Thank You and Farewell
Hi, this is Jan deRoos again. A primary goal in any hotel investment is to make money. By now, you should have a
better understanding of the role played by the three dominant actors in the hotel investment community: the owner, the
hotel operator and the lender. In order for any of these actors to truly achieve their objectives, they need to understand the
motivations and incentives of the other actors. Participants who have the insight to anticipate the needs of others generally
find success by creating an environment in which everyone wins. This doesn't mean giving up returns, it means crafting
deals which allow all parties to get to yes.
I hope you found this course to be a stimulating and informative introduction to the financial analysis of hotel investments.
In addition, I hope that you will continue with the next course in this certificate program.
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Stay Connected
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Glossary
average daily rate (ADR)
The average income per occupied room for a given time period.
amortization
The number of years upon which the payment is based.
after-tax equity cash flows (ATECF)
The net result of what is left over after deducting expenses from a property's revenues.
balloon
The remaining mortgage balance when the term is less than the amortization.
cash flow from operations (CFFO)
The stabilized net income of a property.
combined construction and term loan
Also known as a mini-perm loan, this combines the construction loan (generally an interest-only, floating-rate
mortgage) with a floating-rate mortgage for a short term after opening. This allows the borrower to have the
property stabilize after opening before refinancing into a larger fixed-rate mortgage. The borrower has to go
to the capital market twice (to secure a mini-perm and then refinance into a permanent loan), not three times
(secure a construction loan, which is "taken out" by a floating-rate mortgage, which is subsequently taken
out by a fixed-rate loan once the property stabilizes).
: Similar to a construction and term loan, but used for acquisitions. If you acquire a bridge loan
property and reposition it, a bridge loan funds the cost of the acquisition plus needed renovations.
This loan is a "bridge" to a larger loan once the property stabilizes.
: Not really a loan. You can think of a sale-leaseback as a 100% loan-to-value sale-leaseback
mortgage where you retain control of the property through the lease, and are able to achieve
"mortgage proceeds" that are 100% of the value of the property. It is often framed as an alternative
form of financing.
: Government-assisted loans tax increment financing (TIF) and payment in lieu of taxes (PILOT)
in which government agencies provide pieces of (or facilitate) the capital structure. These
government programs are generally secondary to the first lender, but they get paid before equity gets
paid. They are funded through either a tax holiday or some other mechanism that reduces property
taxes earlier in a property's life.
: A device that many sellers use if they have a purchaser who may not be able to seller financing
borrow in the regular financing markets. In this case the seller may extend some financing to that
buyer as a way to get the property sold. Generally, seller financing is expensive money, but many
sellers embrace the technique because the worst thing that can happen is they get their property
back in a foreclosure. It is also seen by sellers as a mechanism to turn their risky equity capital into
less-risky debt capital.
compound interest rate
The annual rate of return a specific sum of money earns when invested over a number of periods. This rate
incorporates three broad categories of rewards for investors (real rate of return, inflation, risk).
construction mortgage
This is often the first mortgage taken out in a real estate investment. It is a floating-rate, interest-only
mortgage used to finance the construction of a new hotel. Interest accrues and is added to the loan balance
for the duration of the loan. The construction loan balance (funds advanced plus accrued interest) is then
"taken out" by the permanent mortgage.
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contingent interest
Also called a "participating loan"; gives the lender additional interest based on the operating results.
Hotel investments often involve more than one type of debt financing, as borrowers combine a preliminary
mortgage for the hotel construction with the permanent mortgage.
discounted cash flow (DCF)
One of the valuation methods used to estimate the market value of a property.
discount rate (or discount factor)
The inverse of the compound interest rate.
furniture, fixtures and equipment (FF&E)
An expense incurred during the development phase.
future value
The value that a specific sum of money invested today will have at a future time, assuming that the money
earns a stipulated return that compounds on an annual basis.
hurdle rate
The minimum rate of return an investor is willing to accept in order to invest his or her money. The hurdle
rate is also known as the opportunity cost or the required rate of return.
interest rate
The annual rate of interest on the loan.
interest kicker
Additional interest paid on a loan that is contingent on the revenues or cash flows of the business being
financed. For lodging, it is most common for the interest kicker to be a percentage (0.5% to 2.0%) of total
revenues.
internal rate of return (IRR)
A project's implied rate of return; it is the discount rate (rate of return) that produces an NPV of zero.
loan-to-value (LTV)
The ratio of the outstanding debt on a property to its market value.
mezzanine funds
Financing that fills the gap between debt and equity.
net present value (NPV)
The sum of the discounted cash inflows less the sum of the discounted cash outflows, all discounted at the
hurdle rate.
the NPV's relationship to the project's actual return
If the NPV is positive, the actual return is greater than the required return.
if the NPV is zero, the actual return is equal to the required return.
If the NPV is negative, the actual return is less than the required return.
origination fee and points
Fees charged at the beginning of the loan for the privilege of being able to borrow the money. The
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origination fee generally covers the lender's cost. Points are fundamentally yield boosters. One point is a
charge equal to 1% of the loan amount paid to the lender at the time the loan is originated.
permanent mortgages
: A mortgage in which the interest rate is fixed for the term. Generally terms are fixed-rate mortgage
relatively long, 7 to 15 years typically, with 20- to 30-year amortization. This loan usually has a
"balloon payment" at the end, requiring the borrower to pay the remaining mortgage balance (the
"balloon") when the loan term is less than the amortization.
: A mortgage in which the interest rate floats over an index for the term of the floating-rate mortgage
mortgage. The most common index is the London Interbank Offer Rate (LIBOR). These are generally
short-term loans, for 2 to 5 years, with no amortization (they are so-called "interest only" loans).
These loans generally have lower debt coverage ratio (DCR) and higher loan-to-value (LTV)
constraints than fixed-interest loans. Floating-rate loans often come with extension options, allowing
the borrower to extend the loan for one, two, or three additional years in exchange for additional
points (1/4 or 1/2 point per extension).
: A modified fixed-rate mortgage where there is a fixed rate of interest, participating mortgage
generally lower than an equivalent term fixed-rate mortgage, and in addition the lender participates in
cash flows on the property. The lender generally takes some percentage of the property revenues.
: A mortgage where the lender has the ability to convert the mortgage into convertible mortgage
equity at very specific points in time. In exchange for this right, the lender gives a lower interest rate.
Convertible mortgages are not common.
prepayment management
A set of devices used by lenders to prevent borrowers from prepaying the mortgage before the end of the
term. These include:
: The borrower is contractually prevented from prepaying. lockout
: The borrower pays a prepayment fee that provides the lender a stated yield over yield maintenance
the loan term.
: The borrower provides the lender with securities that replicate the contract interest rate defeasance
over the loan term.
present value
The value today of one inflow or a series of inflows expected in the future, assuming the inflows have earned
a stipulated compounded rate of return.
principal
The amount of the loan.
recourse loans
Give lenders access to other borrower assets in addition to the real property if the borrower defaults.
thumb rule
A general or approximate principle or rule based on experience or practice, as opposed to a specific,
scientific calculation or estimate.
term
The number of years the borrower gets to use the money.
the time value of money
The idea that a dollar received today is worth more than a dollar received in the future. To accept a dollar in
the future rather than today, investors need to be rewarded for:
allowing others to use their funds (the real rate of return)
inflation
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risk (both default and volatility)
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Course Files
Some of the pages in this course include files for you to download. We've made all of the downloadable files available
here for your convenience.
Topic 3.2: Hotel Financing Cycle: Debt Financing
(48.3 KB pdf file) The Lender's Response: The Term Sheet
(23.5 KB .xls file) Mortgage Worksheet
(55.5 KB .xls file) Loan Sizing
Topic 3.3: Investment Construction and Analysis
, The Excel Workbook (65.5 KB .xls file) Case Study of the Hungerford Hotel
, Discription (29.9 KB pdf file) Case Study of the Hungerford Hotel
, Pro Forma (18.5 KB pdf file) Case Study of the Hungerford Hotel
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