Hotel investments: Issues & Perspectives 0866120882

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TEL STl^NTS Issues (jyjPerspecttvesi

Hotel industry experts share cutting-edge ideas for maximizing hotel

investment performance

Edited Lori E» Raleigh

by

& Rachel

J.

Roginsky

Digitized by the Internet Archive in

2014

https://archive.org/details/hotelinvestmentsOOrale

HOTEL INVESTMENTS Issues

&

Perspectives

Educational Institute Books UNIFORM SYSTEM OF ACCOUNTS AND EXPENSE DICTIONARY FOR SMALL HOTELS, MOTELS, AND

MANAGING HOSPITALITY ENGINEERING

MOTOR HOTELS

Michael H. Redlin/David

Fourth Edition

UNDERSTANDING HOSPFTALFTY ACCOUNTING I

SYSTEMS

RESORT DEVELOPMENT AND MANAGEMENT

Second Edition

Second Edition Chuck Y. Gee

Raymond Cote

M. Stipanuk

UNDERSTANDING HOSPFTALFTY ACCOUNTING II

PLANNING AND CONTROL FOR FOOD AND BEVERAGE OPERATIONS

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Raymond

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MANAGING QUALITY SERVICES

STRATEGIC MARKETING PLANNING IN THE HOSPITALITY INDUSTRY: A BOOK OF READINGS

MANAGING CONVENTIONS AND GROUP

Edited by Robert

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TRAINING FOR THE HOSPITALITY INDUSTRY Second Edition Lewis C. Forrest,

BUSINESS Leonard H. Hoyle/David C. Dorf/Tliomas

j.

A.

Joties

HOSPITALITY SALES AND ADVERTISING Second Edition James R. Abbey

]r.

UNDERSTANDING HOSPITALITY LAW Second Edition jack

Shriver

}.

MANAGING HUMAN RESOURCES IN THE HOSPITALITY INDUSTRY

P. jefferies

David WJieelhouse

SUPERVISION IN THE HOSPITALITY INDUSTRY Second Edition Raphael R. Kavanaugli/jack D. Ninemeier

ENERGY AND WATER RESOURCE MANAGEMENT Second Edition Robert E. Aidbach

MANAGING HOUSEKEEPING OPERATIONS Margaret M. Kappa/Aleta Nitschkc Patricia

B.

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CONVENTION SALES: A BOOK OF READINGS Margaret Shaw

DIMENSIONS OF TOURISM

MANAGEMENT OF FOOD AND BEVERAGE

Joseph D. Fridgen

OPERATIONS

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Second Edition jack D. Ninemeier

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MANAGING FRONT OFFICE OPERATIONS

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Tliird Edition

Lendal H. Kotschevar/Mary

Michael

L.

Kasavana/Richard M. Brooks

AN INTRODUCTION

L.

Tankc

STRATEGIC HOTEL/MOTEL MARKETING

POWERHOUSE CONFERENCES: ELIMINATING AUDIENCE BOREDOM

Revised Edition

Coleman Lee Finkel

Christopher W.

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Hart/David A. Troy

ETHICS IN HOSPITALITY MANAGEMENT: A

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OF READINGS

OPERATIONS

Edited by Steplien

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HOSPITALITY FACILFTIES

THE LODGING AND FOOD SERVICE INDUSTRY

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MANAGEMENT & the Security Committee ofAH&MA INDUSTRY MANAGERIAL HOSPITALITY ACCOUNTING C. Ellis,

Hall

MANAGEMENT AND

MANAGING HOSPFFALm HUMAN RESOURCES

SECURITY AND LOSS PREVENTION Raymond

S.J.

BOOK

jr.,

Robert H. Woods

FINANCIAL MANAGEMENT FOR THE HOSPITALITY INDUSTRY William

P.

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Schmidgall

HOSPITALITY INDUSTRY FINANCIAL

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ACCOUNTING

PURCHASING FOR HOSPITALITY OPERATIONS

INTERNATIONAL HOTELS: DEVELOPMENT AND

Raymond Wdliam

Raymond

B. Virts

S.

Schmidgall/james W. Damitio

MANAGEMENT

THE ART AND SCIENCE OF HOSPITALITY

Chuck

MANAGEMENT

QUALITY SANITATION MANAGEMENT

Jerome

j.

Vallen/james R. Abbey

MANAGING COMPUTERS IN THE HOSPITALITY INDUSTRY Second Edition Michael L. Kasavana/john

Ronald

Y.

F.

Gee

Cichy

HOTEL INVESTMENTS: ISSUES & PERSPECTIVES Edited by Lori E. Raleigh and Rachel

j.

Cahill

].

Rogiusky

HOTEL INVESTMENTS Issues

&

Perspectives

Edited by Lori E. Raleigh

Rachel

J.

Roginsky,

ISHC

EDUCATIONAL INSTITUTE of the

American Hotel & Motel Association

Disclaimer This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. From the Declaration of Principles jointly adopted by the American Bar Association and a Committee of Publishers

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and Associations

The authors or author

of each chapter are solely responsible for

its

content. All views expressed herein are

and do not necessarily reflect the views of the Educational Institute of the American Motel Association (the Institute) or the American Hotel & Motel Association (AH&MA).

solely those of the authors

Hotel

&

Nothing contained

an endorsement, or a recommendation of disclaim any liability with respect to the use of any information, procedure, or product, or reliance thereon by any member of the hospitality industry. the Institute or

in this publication shall constitute a standard,

AH&MA.

The

Institute

©Copyright 1995 By the EDUCATIONAL INSTITUTE

and

AH&MA

of the

AMERICAN HOTEL & MOTEL ASSOCIATION 1407 South Harrison Road Box 1240

P.O.

East Lansing, Michigan 48826

The Educational Institute of the American Hotel & Motel Association is a nonprofit educational foundation. All rights

reserved.

publication

may be

No

part of this

reproduced, stored

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a retrieval system, or transmitted, in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without prior permission of the

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publisher.

Printed in tlie United States of America 1 2 3 4 5 6 7 8 9 10 99 98 97 96 95 Library of Congress Cataloging-in-Publication Data Hotel investments: issues and perspectives/edited by Lori E. Raleigh, Rachel J. Roginsky. cm. p.

ISBN 0-86612-088-2

—

Hotels Finance. Roginsky, Rachel J.

1. II.

2.

TX911.3.F5H68 1994 647.94'0681— dc20 Editors:

Jim Purvis George Glazer Marj Harless

Timothy

J.

Eaton

Hotel

management.

I.

Raleigh, Lori E.

94-39455 CIP

Table of Contents Preface

vii

James

J. Eyster, Ph.D., Hospitality Valuation Services Professor, Cornell University

Acknowledgments 1

An

xiii

Industry Perspective

1

Geller, Chairman, Geller & Company, and Randell A. Smith, President, Smith Travel Research

Laurence

2

Hotel Investment and Risk Analysis

23

Allen J. Ostroff, Senior Vice President, and Allen Toman, Vice President Hotel Investments,

—

The Prudential Realty Group

3

Underwriting the Investment

55

—

Lewis C. Miller, Vice President Corporate Real Estate and Asset Management, Holiday Inn Worldwide

4

Evaluating Operating Performance from an Investment Perspective

95

Richard M. Kelleher, President and CEO, and

—

Stephen D. Fletcher, Senior Vice President Technical Services and Project Management, Doubletree Hotels Corporation

5

Asset

Management

109

Issues

David T. Johnstone, Executive Vice President, and Jeffrey A. Duni, Vice President Investment Advisory Services Division. Sage Hospitality Resources, Inc.

—

6

Evaluating Franchise and Chain Affiliation

Programs

135

Lori E. Raleigh, Principal, The Travers Group

7

Developing Effective Marketing Strategies Peter C. Yesawich, Ph.D., President and CEO, Robinson, Yesawich & Pepperdine, Inc.

153

vi

Contents

8

A

Critical Analysis of Hotel

Rachel

J.

Impact Issues

175

Roginsky, ISHC, Principal,

Pinnacle Advisory Group

9

Valuation: Regulation Versus Reality

191

Daniel C. Hanrahan II, MAI. Principal. Pinnacle Advisory Group

10

Taking the Gamble Out of Hotel Investment

203

Strategy Robert

J. Crawford, Jr., President. Hospitality Resolutions, Inc.

11

217

Hotel Asset Disposition Jeffrey S. Wilder, President, The Wilder Group. Inc.

12

237

Investment Analysis Tools

—

Bjorn Hanson, Ph.D., Managing Director Lodging and Gaining Investment Banking, Kidder Peabody

Educational Institute Board of Trustees

269

Preface By James

j.

Eyster,

Ph.D.

James

J. Eyster, Ph.D., is the Hospitality Valuation Services Professor of Hotel Administration at Cornell University where he teaches, conducts research and industry seminars, and consults in the areas of hospitality financial management, real estate finance, management contracts, and operational analysis. He also conducts executive education seminars throughout the United States. Europe, and the Pacific. He is the author q/" Financing the Lodging Industry: Players and Techniques of the Eighties (1982). The Negotiation and Administration of

Hotel

and Restaurant Management Contracts

(1988).

and numerous

a member of the American Hotel & Motel Association's Industry Real Estate Financing Advisory Council (IREFAC) and has served as a panel moderator for New York University's Hospitality Industry Investment Conference and for the UCLA-PKF Real Estate Industry articles.

He

is

Conference.

THE PAST FIVE YEARS, the hotcl industry has undergone its most sweeping transition in recent history. Viewed in retrospect, the severe downturn, displacement, and gradual restructuring were inevitable given the sustained economic growth, unbridled optimism, and rapid expansion of the 1980s. A myriad of factors created this situation: a tax environment that focused on tax shelters, not on project economics; a flood of equity and debt funds from relatively vuisophisticated individual and institutional Investors seeking highly touted above-average re-

DURING

turns; players in the process (developers, operators, lenders, brokers, and consultants) whose returns were disproportionately up-front and fee-based; high inflation rates that permitted, at least early on, sharp room rate increases and fed feasibility-study illusions of ever -increasing cash flows and robust equity reversions; separation of the ownership and management functions that created a division between revenue generation and return on equity objectives; creation and proliferation of market-segmented products by hotel chains competing for increased market share; and a flood of foreign capital crossing borders in search of diversity, high returns, prestige, and safe havens. The hotel and real estate industry bust of the early 1990s and the restructuring that is now taking place have created a watershed as well as significant challenges and opportimities for those who

vii

viii

Hotel Investments

develop, finance, asset-manage, and operate hotels. Today our industry is experiencing downsizing, restructuring, and consolidation of most players (owners, lenders, and operators) and the rapid emergence of others; increased competition among operators and

chain brands

for

market share and new markets; continued

proliferation of market-segmented products: repositioning and refinancing of most properties; capital shortages in most markets and the emergence of capital in others; more conservative project analysis and underwriting; the positive and negative impacts of lower inflation; shorter project life cycles; increased asset management and owner involvement in operations; and rapid technological

advances. This text presents the key hotel investment issues now confronting the industry and how conventional wisdom, as well as maverick opinion, is analyzing, influencing, and dealing with them. How we as an industry deal with these issues will significantly affect

us

all.

When

I was asked several months ago to review the chapters submitted by the contributing authors, I knew I would be informed, challenged, and entertained. The authors are an eclectic group of accomplished movers and shakers in the industry. Each has valuable and perceptive insight. Each has strong, well-founded opinions, and some of these opinions conflict with one another. But what emerges from the weave of their knowledge and insight is a cutting-edge perspective of the industry's central problems, challenges, and, I suspect, solutions. It is for these reasons that all professionals playing integral parts in the hotel investment and management industry investor /owners, lenders, corporate and regional management of hotel operating companies, property general managers, brokers, and consultants will find this book of extreme value. In Chapter 1, "An Industry Perspective," Laurence Geller and Randy Smith present an insightful and critical view of the industry's systematic attempt to grow and develop through "product" or "concept" theory, using relatively sophisticated product development and market research in some areas with extremely successful results (several domestic chains within the United States) and in others with extremely poor results (most U.S. and foreign chains venturing offshore and all airline-hotel efforts). Industry' segmentation by management, price, region, and type is discussed and current segment trends are identified. I found most interesting the chapter's discussion of the key trends to be takeiT into account when considering investment in the lodging industry. These include governmental stimulation and protection policies: radical changes in the channels of distribution made possible by technologN'; the growing importance of brand and product integrity; the impact of newly formed trading blocs; the evolution of the industry into several clearly defined interdependent segments, each dominated by two or three mega-vendors; and the key roles of finance and technologv' for

—

—

achieving growth, market share, global positioning, and profits.

Preface

ix

Chapter 2, "Hotel Investment and Risk Analysis," Allen and Allen Toman focus on hotel investment as a business and its associated risks. They state that the key to successfully investing in the hotel industry is to understand and, where possible, reduce the uncertainty of future cash flow. After discussing the differences between a hotel's market value and investment value, they focus on methods of cash flow forecasting; the identification, measurement, and analysis of risk; and structuring and quantifying subjective assessments of risk. They identify the key risks for hotels as market demand, labor costs, operating In

Ostroff

and management and franchise affiliations. Lew Miller's Chapter 3, "Underwriting the Investment," is the most critical and perceptive treatment on feasibility studies have costs, capital expenditures, legal requirements,

I

yet read. Miller explores in depth the feasibility process, its techniques and its shortcomings, for the purpose of better controlling the process of developing a study. His views are strong but wellfounded. He provides a detailed request-for -proposal that serves as the basis for communication between the development team and the consultant performing the study. He carefully stipulates the necessary data for site evaluation, economic area analysis, and market analysis (with a particular emphasis on demand -based surveys), and describes the rigor necessary in the operating and financial projection to include the test for reasonableness and an exit strategy for the investment. He is critical of today's valuation methodologies, as are a number of the contributing authors, and offers suggestions on how individual investors can tailor their

methodologies to reflect expected uneven cash flows, holding and/ or reinvestment policies, and perception of risk. Miller concludes this chapter with a comparative summary of a five-year and a tenyear investment analysis. In Chapter 4, Rick Kelleher and Steve Fletcher outline the key components in evaluating a hotel's past, present, and future operating performance with emphasis on identifying revenue, operating expense, and capital expenditure efficiencies, inefficiencies, and areas for significant improvement. An operating performance analymarket assessment (includingbrandsis involves two components ing, relative quality and price positioning, and the efficiency with which those factors combine to yield relative market share) and the performance assessment, which measures the efficiency of the operational, structural, and physical dynamics of the hotel as they relate to management's ability to drive operating margins, productivity, and cash to the bottom line. They offer excellent advice on how to measure market demand and demand fluctuations, present and future competition, operating performance within the market, and how close the property is to optimal operating and financial performance. These data also reveal whether the existing management team or afflliation is effective and whether a change in management companies or hotel afflliation might significantly enhance the bot-

—

tom

line.

X

Hotel Investments

In Chapter 5, "Asset Management Issues," Dave Johnstone Jeff Duni describe how asset management is employed to strengthen and safeguard the hotel investment. They critically evaluate the asset manager's role in developing a strategic asset

and

management plan based on ownership investment criteria, research, and analyses of (1) the market. (2) the management company's performance, (3) the hotel's physical plant, (4) the hotel's affiliation, (5) the hotel's performance, and (6) strategic plan options. In addition, they focus on how an asset manager effectively selects the hotel management company and then monitors the operator's effectiveness and contract compliance through effective owner meetings, annual operating budget review and approval processes, and capital expenditure analyses. They stress the role of open and candid communication in establishing a true working relationship among the hotel owner, the asset manager, the management company, and the property's executive staff. In Chapter 6, Lori Raleigh underscores the need for o\VTiership to evaluate franchise and chain affiliation programs and recommends methodologies to evaluate the five potential affiliation alternatives: a standard franchise agreement, a management contract relationship, a combined franchise and management relationship, a license agreement, and a strategic marketing affiliation or alliance. She stresses that the decision should be based on the specific marketing and promotion needs and objectives of the particular hotel and outlines a methodology to determine these objectives and needs. In developing her cost-benefit analyses, she focuses on the myriad of fees and costs associated with these affiliations. She stresses the need to identify existing or potential conflicts of interest and instances where an affiliation can be potentially erosive rather than valuable. In some cases, she argues that a hotel can be more profitable operating as an independent than with an affiliation. Focusing on the future, she predicts that contracts will include franchise /affiliation fees more closely aligned to benefits received and based on a la carte or unbundled services, stricter franchisor default and conflict-of-interest provisions, shorter terms, and more flexible termination pro\^sions for franchisees. Peter Yesawich. in Chapter 7, notes that the practice of hotel marketing has become increasingly sophisticated in recent years and describes in detail the components of effective marketing strategies for individual hotels: market research methodologies, program planning, program implementation, and program measurement. He focuses on how to define a hotel's potential customer groups and how to market to them using origin markets defined by media coverage. Peter states that program planning must involve establishing performance objectives, selecting an appropriate strategy,', drafting a

comprehensive action plan, and preparing an appropriate budget. He is critical of most operators' efforts to develop defined marketing focus and realistic performance objectives. Only by choosing the appropriate differentiation and /or segmentation options, he argues.

Preface

can a hotel hope

to develop the appropriate strategy. Action

xi

plans

must clearly identify chronologies of initiatives and assign responsibilities. Budgets must be task-oriented or zero-based, forcing management to commit itself to a detailed marketing plan well in advance of authorizing the expenditures that will support it. Peter's advice is critical for achieving adequate results in a fiercely competitive market where product differentiation is unclear and confusing to most guests. As hotel chains clamor for increased market share by flagging a myriad of identical and market- segmented properties, impact situations

and

conflicts occur as the result of conflicting goals inherent

Chapter 8, Rachel Roginsky analyzes the conflict between the franchisor's goal to expand its chain and the franchisee's goal to increase or maintain cash flow performance, which is facilitated by a lack of local competition. She defines impact, evaluates incremental impact studies, and discusses the flaws of current policies and impact study methodologies through an analysis of the components of an impact study. Noting that franchise companies deal in very different ways with impact issues, she argues that franchise companies should adopt equitable and consistent policies and procedures for analyzing impact issues in order to maintain reasonable franchisor /franchisee relationships and avoid legal battles, which could set severely limiting precedents. She suggests that the measurement of impact includes incremental changes not only in occupancy but also in room rate, other revenue, and operating expense levels for a period of three to five years, and that monitoring actual impact should be part of the process. Since quantifying impact will always be subjective, she states that various methods must be included to ensure reasonableness of the conclusions and to minimize analysis subjectivity. In Chapter 9, "Valuation: Regulation Versus Reality, Dan Hanrahan addresses several key controversial appraisal issues. He contends that few of the new population of appraisers created and legitimized to participate in federally related transactions possess the skills necessary to address hotel valuation problems. He argues that market value reflecting "as is" conditions does not adequately reflect an asset's value and that appraisers should forecast prospective values for an asset. Prospective values, based on potential operational and capital improvements, a change in the hotel's current affiliation, and /or a change in cvirrent management, give investors a better picture of an asset's potential value, he explains. He adds that the appraiser must reasonably describe the scope and character of proposed improvements, including probable timing and associated costs. Appraisals that contain a broader range of information and alternatives, he says, can greatly assist the in franchise relationships. In

"

community in making its investment decisions. Based on Kenny Rogers' "Know when to hold em, know when to fold em" principle. Bob Crawford, in Chapter 10, presents a unique and interesting approach to evaluating workout strategies

financial

for distressed properties.

Bob develops a

hotel value recovery grid

xii

Hotel Investments

that helps identify and evaluate property and market strengths. This information enables the selection of strategies appropriate for the hotel and its operating environment. The author describes four types of situations: strong hotels in strong markets, strong hotels in weak markets, weak hotels in strong markets, and weak hotels in weak markets. For each of these situations, he offers specific and realistic steps to achieve the desired results. His chapter offers a refreshingly clear framework for evaluating a property and developing a logical action plan. In Chapter II, "Hotel Asset Disposition," Jeff Wilder outlines the process of selling a hotel property. He describes how to assess the value of what one has for sale to include the benefit or detriment of an existing franchise or management contract, as well as alternative methods of selling the property hiring a broker, selling it yourself, auctioning. Being a broker, he naturally recommends using one. He describes clearly the processes of selecting among the tjrpes of listing agreements, developing an effective relationship between seller and broker, establishing an offering price and terms, preparing the property offering brochure, disseminating information to the marketplace, providing status reports, and the offering process used by brokers. Wliat is particularly helpful is his advice on firming up offers, the purchase contract, due diligence periods, financing contingencies, franchise responsibilities, the period between contract and closing, and the closing process. The text concludes with a chapter by Bjorn Hanson that presents the key profit, asset, liquidity, and capitalization ratios used to evaluate a hotel's operational and financial performance. I believe you will find this collection of insights and opinions food for thought and action.

—

Acknowledgments

We

EXTEND OUR UTMOST GRATITUDE to all of the Contributing authors. True professionals, they generously offered their time, talents, and expertise without remuneration in support of this project and cavise. Royalties from the book are being donated to a scholarship fund to support the advancement of education in

—

the hospitality industry. We owe thanks also to our families patience and support of this project.

And we

offer

our deepest sympathy

—

and colleagues to the family of

Ling, a dedicated industry professional, special friend,

for their

David W.

and sup-

porter of this project who was a passenger on the ill-fated USAlrPittsburgh flight earlier this year.

—Lori E. Raleigh Rachel

J.

Roginsky

xiii

=

1

An

Industry Perspective

By Laurence Celler and Randell A. Smith

Laurence Geller is Chairman and founder of Geller & Company, a Chicago-based international real estate and financial advisory firm specializing in lodging, tourism, leisure, gaming, and related industries. With more than 30 years of experience in hospitality real estate development and hotel operations. Mr. Geller has been ChieJ Operating Officer and Executive Vice President of Hyatt Development Corporation: a

managing partner of Safari Management Inc.: a founding partner of Berins & Company: a Senior Vice President in charge of development and franchising for Holiday Inns. Inc.; and responsible for development activities for Grand Metropolitan Hotels in the United Kingdom. Currently serving his third term as Chairman of the American Hotel & Motel Association's (AH&MA's) Industry Real Estate Financing Advisory Council (IREFAC). he is a past Vice Chairman of the Commercial Council of the Urban Land Institute. He is a graduate of Ealing (U.K.) Hotel School, a Fellow of AH&MA's Educational Institute, and a Fellow of the Hotel and Catering Institutional Management Association in the United Kingdom. is President and cofounder of Smith Travel Research, a leading authority on current trends in occupancy, room rate, and supply / demand data for the lodging industry. Mr Smith has over 18 years of experience in lodging industry research. Prior to starting Smith Travel Research, he was Director of Research for Laventhol & Horwath. He is a charter member of

Randell A. Smith

the International Society of Hospitality

Consultants and a former men^ber of its Board of Directors. He is a member of the American Hotel & Motel Association's (AH&MA's) Industry Real Estate Financing Advisory Council (IREFAC). and is also a member of AH&MA's Market. Financial, and Investment Analysis Corrmiittee Advisory Panel.

A View

of the Past

industry in Europe was at a relatively

THE LATE 1800s. the lodgiiif^ INsophisticated state of development. provided by resorts and urban hotels

The

hif^h quality of services

made them

the centers of social

1

2

Hotel Investments

The United States lodging community was viewed as the "poor relation" who merely tried to mimic the taste and style of the "Old World." However, by the early 1900s, the sheer pressure of demand, largely caused by the growth of the railroads, began to force the U.S. lodging community to take on the aspects of a real industry. Early hotels in the United States catered almost entirely to destination travelers. Travelers fell into two major well-defined groups: those seeking rest or relaxation who headed for the resort areas at the seashore or in the mountains, and those on business who visited the urban centers where their clients and customers were located. Travel was uncomfortable, and a length of stay of several nights was common. Since the workweek was normally six days, the heavy mid-week demand and low weekend occupancy experienced by hotels today were unknown in the early 1900s. World War 1 left Europe in a malaise. The economies of Europe were crippled and there was a festering uneasiness caused by what was deemed to be an unsatisfactory series of peace treaties. In the United States, however. World War I brought about massive societal change. By the mid- 1920s, half of the U.S. population lived in cities and the doors of immigration were wide open. The systematic introduction of the automobile, coupled with improv^ements to the road system, forced a different approach to commercial and lodging growth in the United States as compared to that in Europe. Early travel by automobile led to the development of auto camps, the forerunners of today's motels. At first, auto camps were simply open fields where drivers could park their vehicles and spend the night, frequently in tents. Wliile the first use of the term "motel" is attributed to a California facility built in 1925, the first "motel" was actually built in 1913, near Douglas, Arizona, when city workers erected six wooden structures on a vacant lot that had been used as an auto camp. Auto camps and early motels held great attraction to motorists because they offered relatively clean and safe places to sleep. The easy parking, low prices, and informal atmosphere were ideal substitutes for the more formal atmosphere and ser\aces provided by hotels. By the mid- 1920s, there were several thousand auto camps scattered around the country. At this time, entry barriers to the competitive lodging field were low. The initial investment was low. Cheap land was readily available on the outskirts of the cities for the relatively inexpensive single-story frame structures. Their growth continued from the early 1920s until the second World War (even during the Depression they continued to be built). Following World War 11, the development of the Interstate Highway System gave the necessary impetus to the growth of the modern lodging industry. As travel by automobile became easy and relatively inexpensive, millions of vacationers traveled along the new highway system. The increase in demand for accommodations led to the wide-scale development of properties catering to motorists. Legend has it that Kemmons Wilson, a builder in Memphis. Tennessee, started the motel industry by developing Holiday Inns activity.

An

Industry Perspective

3

across the country. While the legend is not totally correct, Wilson certainly started a systematic approach to development and pioneered the concept of franchising in the lodging industry. The result, which has dominated development of lodging facilities since then in various formats, has been the "product" or "concept" theory of a common name and common standards. By the early 1950s, it was clear that the United States was leading the rest of the world's lodging industries in size, organization, scope, technology, innovation, growth, and management. The faded elegance of European hotels indeed had its charm and sophistication and played a role in the shattered post-World War II European economies. However, lodging organizations formed in the United States with the concept of a common name and common standards had made their mark and were beginning to be recognized as the clear wave of the future. Influenced strictly by the very rapid increase in travel by automobile, the motel segment of the lodging industry expanded over five decades from a few wooden shacks to nearly 50,000 establishments with over 800,000 rooms by the early 1960s. By then, receipts from patrons had reached nearly $2 billion and, since most motels were independent and locally owned, a significant portion of that cimount remained in the communities in which the motels were located.

During the 1960s and 1970s, the rapid increase in seat capacon the "new" jet aircraft also changed the development of hotels by reducing the time needed to reach one's destination. As a result, the four -day "business week" became common and hotel operators began to turn to new marketing methods to fill vacant rooms on weekends. Somewhere along the line, the marketing concept that people travel for a variety of reasons, and that their needs differ depending on the purpose of the visit, finally began to form a basis for planned growth. Holiday Inn, in the mid-1970s, became the first organization to systematically use consvimer -oriented marketing techniques that encompassed relatively sophisticated product development and market research rather than the instinctive traditional hoteliers' view of how a guest should "want to behave. Other hotel companies soon copied these techniques with varying degrees of success. ity

"

Supply and

Demand

Patterns

According to an analysis of available sources, inckiding the Census of Business reports and other data issued by the U.S. Department of Commerce, there were over 1.7 million rooms in the lodging industry in 1949. By 1995, the total is expected to nearly double that amount and reach approximately 3.3 million rooms. Although the increase is significant, the average annual change is only 1.3% compounded. The demand for guestrooms increased at the same rate for the period, but, as shown in Exhibit I, the change by decade was not

"

4

Hotel Investments

Exhibit

1

Room

Supply,

Demand, and Employment

Average Annual Increase by Decade 1950S-1990S (through 1995 projected) Percent

5-r 4.3

4

3

2 1.7

0

1950s

Rm I

1960s Supply

1970s

Rm Demand

1980s

1990s

Employment

I

Source; Smith Travel Research.

consistent. For example, there was above-average growth in the 1950s in supply and the rate rose to over 2% in the 1980s, although it was low in the period 1959-1969. Part of the growth of the 1980s was caused by the increase in demand of the 1970s, but much of it was created by the ease of obtaining financing. Adequate the usual restrictions to entering site and a source of financing the lodging industry were readily available in the 1980s. The mid-1980s offered a glut of liquidity for the lodging industr\\ With the benefit of hindsight, it seems apparent that a "growth for growth's sake" attitude became the only apparent strategy. Leaders of the industry's corporate giants grandly rationalized growth with strategic buzzwords such as "product segmentation" the universal panacea to the problems of inadequate growth opportunities, otherwise known as oversupply! At the time, capital seemed endlessly available, so many adopted the notion of "let s use it and ra-

—

—

—

tionalize

it

later.

employment in the lodging industry stood at 464,000 people which amounted to approximately 27 employees per 100 rooms. As the size and complexity of the business increased, the 1988 average rose to 48 employees per 100 rooms. But, the average weekly hours of non-supervisory employees dropped from over 40 hours in the 1950s to only slightly over 30 hours in the 1980s. Exhibit 2 shows the average annual changes in room rate, annu£il labor hours, and productivity (room revenue In 1949, total

An Room

Exhibit 2

Rate,

Industry Perspective

5

Hours Worked, and Productivity

Average Annual Change by Decade 1950s-1990s (through 1995 projected)

Percent

10

7.7

5.5

6

4.7

4

1

2

0 (0.1)

(0.2)

-2-

1950s

Rm I

1960s

1970s

Annual Hours

Rate |

I

|

1980s

H[

1990s

Productivity

Source: Smitti Travel Researcii.

divided by annual, non-supervisory hours). During the 1980s, room demand rose at less than 1% annually, while supply increased at a rate over 2%. Operators increased the number of employees to add more services, frills, amenities, and other bells and whistles to the property in order to justify the sharp rate increases. Higher productivity levels were achieved by using more part-time help and controlling staffing so that total labor hours did not increase at the same rate as employment. Sophisticated labor scheduling techniques were available. However, it was not until the 1990s that the traditional operators paid more than lip service to them. In the 1990s, the room rate has not increased (in terms of 1982-84 dollars), average weekly hours and employment have stabilized, and productivity is up a healthy 3%. According to official sources, the U.S. economy reached a peak in July 1990, and then fell to a low in March 1991 (the official end of the most recent recession). By comparison, demand for rooms in the lodging industry peaked in October 1990 and did not really begin to recover from the recession until June 1991. Exhibit 3 charts room supply, room demand, and room revenvie from January 1988 to January 1994 and projects figures to December 1997. The slight dips in the room revenue and room demand lines shown in Exhibit 3 reflect the impact of the recession. Forecasts of room supply, de-

mand, and revenue

for

1997

are:

6

Hotel Investments Index of

Exhibit 3

Room

Demand, and Revenue

Supply,

12-Month Moving Average 1 988-1 997P

PERCENT 180

160

140

120

100

L JNASFJDMOMAJ JNASFJDMOMA I

J

Rm

Supply

I

J

I

I

Rm Demand

Rm

J

L

Revenue

Source; Smith Travel Research.

•

Room Supply

•

Occupancy

•

Room Revenue

3,252.000 rooms

70% $54.3

billion

In the ten -year period covered by the chart, room revenue will have risen 70%, room demand by almost 40%. and room supply by slightly over 20%.

Internationalization "Internationalization" was a buzzword of the early 1960s. At that time, the large and powerful U.S. lodging organizations, which had developed brands and had ambitions to be global chains, truly began their quest for overseas growth. Hilton, primarily using the vehicle of management agreements, was the first to spread its international wings. Others, such as Intercontinental and Sheraton, soon copied the Hilton formula, as their corporate leaders pounded the pavements of many nations" capitals in search of would-be eager owners. Links with airlines or other conglomerates seemed a key to global expansion. Often, it became a symbol of a cit> "s prestige to have a Hilton or other brands with American accoutrements. The term "coffee shop" soon became part of a new international lexicon. U.S. business travelers who were also searching for new lucrative overseas markets made such places not just their hotel, but their

"havens" and "clubhouses."

An Industry

Perspective

7

1960s and early 1970s brought more U.S. companies These companies, such as Holiday Inn and Ramada. mistakenly tried to export their homespun concepts of interstate /suburban development to Europe. By the mid 1970s, international financial setbacks occurred and newcomers were

The

late

into the international arena.

forced to rethink their operating and financial strategies, especially in Europe. Simultaneously, certain European companies decided to expand out of their backyards and entered the U.S. market. They too misunderstood their non-domestic markets and soon fell victim to misconceptions about their ability to "Europeanize" the American hotel consumer. Companies such as Grand Metropolitan Hotels and Trust House Forte (as it was then known) took their losses and beat hasty retreats when they realized that having a downtown U.S. property was often flying in the face of the trends of urban blight and decay. They understood too late that in order to succeed in the new suburban markets they clearly needed a domestic distribution network and a known brand. European companies retrenched but still groped for U.S. strategies in their attempt to globalize the industry. More failures and false starts followed for some of them. Trust House Forte acquired Travelodge and seemed to let it languish. Ladbroke acquired Rodeway, suffered the slings and arrows of a difficult product with an oblique position in the market, and finally sold the company. Accor generally made half-hearted attempts to enter the U.S. market with Sofitel Hotels and, to a lesser degree, with some Novotel and Ibis products but, again, with no great success. Meridien made tentative moves, often using Air France's balance sheet and its banking relationships, but experienced limited and mixed success. Swissair also made tentative moves into the U.S. market and was somewhat "bloodied" in the process. All of these companies were, however, relatively successfvil (in different degrees) in growing across their trans-European borders. Airlines such as TWA, PariAm, United, Swissair, KLM, British

Airways, Air France, Lufthansa, Japan Airlines, All Nippon Airways and British Caledonia all made attempts, either individually or in groups (such as Penta Hotels), to use their distribution networks to fill up their own hotels. There are few corporate success stories of hotels run by airlines. Clearly, lodging is a very different business

and American Airlines proved that you can sell services and reservations (through its Sabre system) without owning the hotel! The explosive growth of the Japanese stock market and banking system in the 1980s, and a quest for international recognition and diversification, led to aggressive Japanese-backed financing of, primarily, U.S. opportunities. This seemingly insatiable financial appetite soon led to a desire for corporate acquisitions. After all, they reasoned, if they already owned the lodging industry's real estate, why not own the management companies themselves and keep the fees and brand values for themselves. Westin and Intercontinental Hotels traded at "huge" prices and perhaps, it could be

8

Hotel Investments

speculated, subsequently gave their new ownerships severe cases of internationad financial indigestion! Hilton International was bought by Ladbroke of the United Kingdom. This seemed a true international growth strategy, for it was clearly designed to combine the synergistic benefits of linking Ladbroke's existing U.K. hotels with the Hilton International brand. They were soon integrated into one group with substanticd international brand recognition and presence. However, their U.S. entry with its Vista brand was seemingly weak and half-hearted.

Omni was

traded to Wliarf Holdings in Hong Kong in anticipaand Regal (also of Hong Kong) acquired the Aircoa Group. Consolidation was in the air and "globalization" became a much-used term of vague hope often without, so it seems, a real strategy behind the buzzword. Ramation of continued U.S. growth,

—

da's financial strategy finally caused it to be sold. It was split up its International and Renaissance brands were sold to New World of Hong Kong. The balance was sold to Prime and. after that organization's financial problems, Ramada went to H.F.S. along with Days Inn, Howard Johnson, and Super 8. We have just passed the early 1990s, with its recessions, capited markets contraction, liquidity crisis. North American oversupply.

when

unemployment, "bubble bursting" in Japan, uncertainty over the effects of Economic Union in Europe, capital needs for reunification of Germany, and financial crises in the Eastern bloc, Gulf Wars, peace dividends, and so on. All have had a sobering effect on the lodging industry. Finally, many properties have been financially restructured, the recession is ending, money is beginning to become available, and smiles are again showing on the faces in the corporate corridors of power. A question mark hangs over the industry' as prudent investors wonder whether lessons have been learned or whether the same lemming-like mentality that allowed oversupply and product overbuilding to occur will come to the fore and repeat history.

A

Picture of the Present

The supply of guestrooms has grown since World War II at about the same pace as the population (1.3% annually), although there have been periods of very slow and very rapid growth. In the 1990s, the supply is expected to increase at an annual rate of less than 2% while demand grows at nearly 3%. Occupancy ratios should continue to improve to 70% or more in the latter part of the decade. However, because of the tendencies toward widespread discounting, the average daily rate may increase at less than the Consumer Price Index annually. Wliile general industry trends may be headed in one direction, property-specific or market-specific trends may be headed in another direction. Given the size, diversity, and complexity of today's lodging industry, investors need to understand the various industry segments and geographical markets to assess investment

An Industry

Perspective

9

opportunities. For example, even within the sanie market, it may to find downtown properties performing well while airport properties are experiencing difficulties. Virtually every market and segment within the lodging industry has its own unique trend. Segmentation is a much abused term "bandied" around generously in the lodging industry. However, the lodging industry can reasonably be simply divided into three groups by management type: chain, franchisee and independent. The first offers only passive investment opportunities while the others can be either passive or active. It can also be separated into price, location, and type categories, each offering the customer a somewhat different product.

be possible

Segmentation by Management Type The lodging industry can be segmented

in relation to three

groups of management types: chain-managed properties, franchisee-managed properties, and independently managed properties.

While the chain-managed segment offers only passive invest-

ment opportunities, the other two segments may offer either passive or active opportunities for the investor.

Chain-Managed Hotels. Chain-managed hotels are operated disome cases, indirectly, by the parent company of the

rectly or, in

(i.e., Hilton. Holiday, Marriott, or Sheraton). These properties are either partly or wholly owned by the parent company. Investment is generally restricted to ownership of stock in the parent company, with each hotel being subject to a different real estate

chain

"deal."

Franchisee-Managed Hotels. Franchisee-managed properties are identified by a chain's name but are not operated by the parent company. This segment includes the professional management companies that operate groups of properties under different banners, as well as the many chain -affiliated hotels operated by individuals. Investment can be made either in groups of hotels or in individual properties and can take many forms since the companies are using all sorts of financing devices, techniques, and methods, including the use of the public markets.

Independently Managed Hotels. Independently managed properties are not affiliated with a chain, or they are associated in name only and not under the chain s supervision or control. This segment includes several loosely identified groups which share a com-

mon label but remain independent in management style and operation. Investment in this segment is normally limited to the individual property. Exhibit 4 shows that the independent segment comprises over half of all properties (53%) and accounts for nearly 40% of the guestrooms in the industry. The franchisee-managed group is second in terms of both the number of properties and guestrooms. Only about one in four of the total guestrooms is in a chain-managed facility.

10

Hotel Investments

Exhibit 4

Property Distribution by

Distribution by

Management Type and Room

Management Type

Property Distribution

Source: Smith Travel Research.

The number of independent operations has been dechning gradually for many years. In 1987. independents accovuited for 50% of the properties and 44% of the guestrooms in the industry-. Since 1988, over 2.200 hotels comprising a total of nearly 222.000 guestrooms converted from an independent status to affiliation with a lodging chain. During the same time period, fewer than 1,700 hotels totaling 181,000 guestrooms switched from a chain affiliation to an independent status. In the past two years, the trend has accelerated. In 1992 and 1993. the number of independents that joined a chain was nearly 50% greater than the reverse conversion. The chain-managed segment s share increased from 12% of the hotels in January 1987 to 13.5% in December 1993. Segmentation by Price The lodging industry can also be segmented in relation to the which the product will be sold. The following fi\ e price categories are used in the U.S. Lodging Industry database maintained by Smith Travel Research: price level at

1

An Industry Exhibit 5 Property Distribution by Price Level and by Price Level

Perspective

Room

1

Distribution

Property Distribution

Source: Smith Travel Research.

•

•

Luxury properties have actual room rates above the 85th percentile in their market. Upscale properties have actual room rates above the 70th perand below the 85th percentile in their market.

centile •

Mid-price properties have actual room rates above the 40lh percentile and below the 70th percentile in their market.

•

Economy percentile

•

properties have actual room rates above the 20th and below the 40th percentile in their market.

Budget properties have actual room rates below the 20th

per-

centile in their market.

Exhibit 5 shows the property and room distributions of the toU.S. lodging industry within these five price levels. There is obviously a size factor involved in the distribution: the economy and budget hotels are smaller properties than the higher -priced operations as shown by their respective shares of the room distribution as compared to the number of properties. This brings up some interesting problems for the prospective financial participant to analyze. For example, is the product priced lower to serve a need or tal

—

12

Hotel Investments

merely because a small (amd presumed less expensive) property is pegged in the lower levels? Exhibit 6 shows the management and price level segments on a combined basis. Although there are some economy and budget properties in the chain-managed segment, a majority of the franchisee-managed and independently managed hotels are in the mid-price level or below.

Segmentation by Region Exhibit 7 shows that the South Atlantic states contain 24% of the properties and 22% of the rooms, by far the largest portions of each. The combined portrait of the regional breakdown and the distribution by price is shown in the "stacked bar" chart of Exhibit 8. The charts can be cross-tabulated with a little careful analysis, depending on the purpose. For example, one might select a management type and price level and then refer to the charts of the distribution by management /price and by region.

Segmentation by Location The lodging industry can be divided five location •

in relation to the following

segments:

Urban properties are located in the central business

districts of

large metropolitan areas. •

Suburban properties are located in the surrounding areas of large metropolitan markets, or in city areas not large enough to be considered urban.

•

Airport properties are located adjacent to or on the grounds of an airport and receive significant demand from the airport.

•

Highway

properties are located on major highways, or in small

towns. •

Resort properties are located in areas that are destinations for vacationing travelers.

Exhibit 9 shows the distribution of rooms by location and price Most of the urban and resort rooms fall in the luxury price level segment, while the highway and suburban rooms fall in the level.

economy and budget

price level segments.

Segmentation by Product Type Grouping properties by product type is the most subjective of ways to segment the lodging industry. Product t\pe definitions rely more on the requirements of guests than on the physical charall

acteristics of properties. Six

segments •

commonly recognized product

type

in the lodging industry are as follows:

Hotels are generally considered high-rise properties, Eire usually in central business districts, and cater to guests traveling for business purposes on short (1-3 nights) \asits.

An Room

Exhibit 6

Distribution by

Industry Perspective

Distribution by Price by Management Type and Price

Room

Management Type by Room

Distribution by Price by

Management Type

Percent

57.3

60

51.3

46.9

50

39,6^

40

36.3 37.8

28

30

26A_

20

10

0

Chain-Managed

I

Luxury I

I

^|

Upscale

Room

Franchisee-Managed

^|

Distribution by

Mid-Price

Independent

^§

Economy

Management Type by

^

Budget

Price

Percent

40 33.7

30.6

30 27.2

18 iLfi

20

n

Luxury

Chain-Managed I

m

10.3

Upscale

I

Source; Smith Imvcl Research.

Mid-Pnce

Economy

Franchisee-Managed

Budget

^|

13

Independent

14

Hotel Investments Property Distribution by Region and

Exhibit 7

Room

Distribution by

Region

Property Distribution

East North Central

South Atlantic

5.9%

East South Central

West North

11.8%

Central

6.5%

West South Central

9.9%

24.2%

Middle Atlantic

9.1%

New England 4.2% 11.3%

Mountain

Pacific

Room East North Central

17.1%

Distribution

12.2% South Atlantic

East South Central

West North Central

22.3%

6.5%

8.4% Middle Atlantic

West South

Central

9.2%

Mountain

New

England

8.1%

5.0%

10.6% Pacific

17.6%

Source: Smith Travel Research.

•

Motels /inns are generally low-rise properties, are usually not located in central business districts, and cater to short-term visitors.

•

Convention hotels are large hotels with a significant amount of space for meetings and conventions and operate a full catering department.

•

Casino hotels are properties with gaming rently found in only a few states.

•

All-suite hotels are

facilities

and are cur-

extended stay properties frequently offering and designed with adequate guestroom

self-catering facilities

space •

for

guests to work and entertain clients.

Bed & breakfasts are small properties offering v^er\' personal service, and are frequently located in areas of historical significance.

An Industry Exhibit 8

Regional Breakdown

New

Perspective

15

— Room Distribution by Price

England

Middle Atlantic

South Atlantic East Nortti Central East Soutti Central

West North

Central

West South Central Mountain Pacific

40

60 Percent

I

Luxury

Upscale

Mid-Price

Economy

Budget

Not Classified

I

Source: Smith Travel Research.

Not surprisingly, the hotel and motel /inn segments constitute of the properties and 85% of the rooms. However, all-suite hotels are a small but relatively growth-oriented portion of the total, with 4% of the properties and over 5% of the rooms. There are relatively few convention and casino hotels, but together they account for nearly 250,000 rooms, almost 8% of the total rooms available nationally. With casino hotels, the core business is the casino operation, not guestroom or meeting room sales. The guestroom actually functions as a marketing tool for attracting players to the casino operation. This is a fast-growing and evolving lodging industry segment. Its characteristics will change in the fviture as gaming becomes legalized in more jurisdictions. Most of the convention and casino properties are chain-managed and nearly 75% of the rooms in these two segments are in the kixury and upscale price levels. The distribution is shown in Exliibit 10.

95%

City Trends Exhibit 11 shows a comparison for a five-year period (19901994) of the standard measures of performance for the segments so far discussed. The ratios for 1994 have been forecast for the balance of the year based on the trends through January 1 994. The analysis

16

Hotel Investments

Exhibit 9

Room

Distribution by Location by Price Level and

Room

Distribution by Price Level by Location

Room

Distribution by Location by Price Level

Percent

60 n

Upscale

Luxury

Urban I

I

Q]]

Suburban

Source: Smith Travel Research.

Mid-Price

^|

Airport

Economy

Highway

Budget

Resort

An Industry Room

Exhibit 10

Perspective

Room

Distribution by Type by Price Level and

Distribution by Price Level by Type

Room

Distribution by

Type by Price Level

Percent

70 60.9

Upscale

Luxury

Hotel I

I

Q

Budget

Casino

Convention

Motel/lr Inn

Room

Economy

Mid-Price

Distribution by Price Level by

stS

All-Suite

Type

Percent

100 91.3 87.9

80

60 49.6

40 22.6

20

14.9 5.1

2.2

.

^^11 2.5 2.5

Luxury I

|^

Upscale

Source; Smith Iiavel Rese

to

»-

t31 tu

a?

(/)

Q.

to

^

3

o

-c

£ o

>

to 0)

S

~

3 2 13.

CL

E E o

—

•E

o

tn

tu tn

!2 to

V

tg

to t/3

o ^

V>

E

2

CC

E to

1

(I)

o

o o to £

.

o B

+ E '•

S

- CO Q)

II

O Q> a> to

UJ

5J

oq:

'-g

-2

.y

— CO O) — ~ Q

§_.|.

I

O

II

II

tu

to

1.1 -

o tu

I

§

5 C o

1=

1 °-

"to

tu

—

£

2>

CO

55

o

to

E 3

CO

tu

«

I

5

Hotel Investment rate.

The result

is

and Risk Analysis

35

the discounted or present value of the future inis selected to reflect the expectain the marketplace regarding the

come stream. The discount rate tions and attitudes of investors

value of future income. A reasoned, supportable estimation of future cash flows is the keystone of a dynamic analysis. An accurate estimate of future cash flows is particularly critical (and difficult) for hotels, as hotels can be complex businesses with multiple revenue sources, high levels of labor costs and other fixed expenses, a broad national or international marketplace from which to draw the consumers of its services, and a perishable inventory of product (rooms) that must be sold on a daily basis (see Exhibit 4). In principle, given adequate market information and the correct interpretation of that information, both approaches should 3aeld equivalent estimates of value. If a property has achieved stabilized operating levels, analysis of specific operating results should also be similar. Many appraisers and investment analysts use both methods as a means of cross-checking their results.

Analyzing or Forecasting Cash Flow

The accurate estimation of cash flows is essential for both operating a hotel as a business on a daily basis and determining the value of the hotel as an asset. As an asset class, hotels are particularly subject to fluctuations in cash flow on a daily, annual, and multi-year basis. This fluctuation is partially due to the nature of the business (which involves the daily resale of a fixed inventory), but it also relates to a number of general and industry-specific factors.

The fundamentals

for

accurately analyzing or forecasting cash

flows for hotels include: 1.

2.

Understanding the market from which the hotel will draw its business, and the competitive position of the hotel within that market. This is critical for determining pricing and demand for the rooms that are available for sale each night of the forecast period. It is also critical for developing an assessment of ancillary revenue sources such as room service, meeting room rentals, telephones, laundry, food and beverage outlets, etc. Understanding the contribution oj management, both at the property level and at thefranchise or management company level. As an investor, you need to understand how the present manage-

ment team contributes nomic potential of the 3.

to the

economic performance and eco-

hotel.

Understanding the translation of revenue into cashflow. This requires an understanding of the hotel's daily operations, so that you have a sense of the level of services required to successfully sell the rooms inventory, and the costs associated with those services. This provides the basis for segregating costs into

36

Hotel Investments

Exhibit 4

Hotels as

Complex Assets

Complicating the determination of investment value and market value as operating businesses and real estate assets. For example: for hotels are the complexities inherent in hotels

Hotels as Operating Businesses 1

.

The key commodity, guestrooms,

is sold on a daily basis, making forecasts of future occupancy susceptible to short- and long-term shifts in

demand

(or supply).

2.

There are often multiple sources

3.

There are a number of service costs (transportation, frequent guest programs) that are largely variable expense items (fluctuate with demand) and that are indirect costs necessary to support the generation of guestroom revenue.

4.

Different property management or chain affiliations can have a significant impact on the demand for a specific hotel and on operating efficien-

of revenue (food outlets, meeting rooms, banquets, telephone departments, etc.) that are largely dependent on internally generated demand.

cies 5.

in

that hotel.

Hotels can be viewed as independent businesses filling a consumer need in a specific market or as part of a service or brand distribution system. The latter case can result in a "strategic" value premium.

Hotels as Real Estate Assets 1

.

Hotels are often complex physical plants that need to operate 24 hours a day with enormous shifts in required capacity for such items as heat, power, water, and services.

2.

Physical obsolescence is often difficult to measure. It involves not only mechanical and structural systems, but also the appearance and functionality of such items as guestrooms and public spaces.

3.

Hotels may have indirect real estate value. Hotels in mixed-use. masterplanned, or theme-park projects may contribute value as an amenity to other real estate uses that is greater than their value as independent operations.

4.

The

attractiveness of a location may change, but you cannot move the Numerous roadside hotels were developed based on proximity to

hotel.

major thoroughfares. Changes in exits and the building of bypass routes can have an enormous impact on a hotel's competitive position.

elements or portions of cost elements that do not directly vary with occupancy or usage levels) and "variable" or "incremental" costs (those costs that vary with occupancy or usage levels). "fixed" costs (those cost

Investors acquiring hotel properties typically have a great deal of faith in their ability to generate incremental occupancy, rate, and revenue while either maintaining or decreasing fixed expense lev^els. They anticipate increases in cash flow (and value) by adding new

revenue against which they

will

have only incremental expenses.

Hotel Investment

This

makes

it

and Risk Analysis

37

understand which expenses are and how they vary at different levels of occupancy.

critical that investors

truly incremental

One way of viewing the valuation process is as a forecast of incremental cash flow. Whether the property is existing or to be developed, the analyst is studying the increments of cash flow that will result from operations, re-investments, or new development. In order to calculate the level of returns available, you need to understand how much net operating income or cash flow can be added, the timing for the receipt of those monies, the costs that must be incurred to generate the additional monies, and your own return requirements. With these basic ingredients, the various measures of investment return can be applied.

Measurements

of Return

As mentioned previously, to be useful, any measure of investment return requires something that it can be measured against. This can be an industry standard, another property, or another form of investment. As an investor, you will typically have specific return requirements that yovi will use as the ultimate measure of the attractiveness of an investment. Since most of the measures of return are relatively mechanical, prior to applying them you must properly evaluate the items that can have an impact on the cash flows available to you and understand the impact that those items might have.

Overall Return. One of the most common measures of investment return is the overall return. It measures the relationship between the net operating income and the amount invested (debt and equity). It provides a simple measure of the percentage of net operating income generated by the investment for a given period. It is typically applied to a one-year time period that reflects a stabilized operating level. For example, if you invested $2 million to create new meeting space for your hotel and the resulting increase in net operating income was S200,000. the overall return would be S200,000 $2,000,000, or 10%. Assuming that the investment was made with equity, you could then decide whether 10% met your retvirn requirements.

Return on Equity. Another measure commonly used, return on between the cash return (beforeinvestment and the amovmt of equity or after -tax) generated by an one-year time period. The invested. It is also typically applied to a same as the method method for calculating return on equity is the numerator is cash flow the for calculating the overall return, except

equity, illustrates the relationship

and the denominator is the equity invested. In the meeting space example cited earlier, if you borrowed $1.5 million of the $2 million cost at 8%. with annual interest-only payments, the return on equity would be: (after financing)

38

Hotel Investments Net Operating Income:

$200,000

Minus: debt service:

8120.000

($1.5 million x

8%) $ 80,000

Before-tax cash flow:

$500,000

Equity investment: ($2 million

- $1.5

Return on Equity:

million)

$80,000 ^ $500,000.

or

16%

Again, whether this was an acceptable return level would derisk associated with earning this return and your return requirements for equity investments.

pend on the

Debt Coverage Measure. A lender might analyze this case by applying the debt coverage measure, which relates net operating income to annual debt service. This measures the margin by which net operating income exceeds {or is below) scheduled debt service pajmients. For this example, it would be calculated as follows: Net Operating Income:

Debt Service: Debt Coverage:

$200,000

$120,000 $200,000 ^ $120,000. or 1.67

For a stabilized hotel with standard financing, debt coverage in excess of 1.4 or 1.5 is considered acceptable to a lender: that is, NOI can decline by 40 to 50 percent without jeopardizing debt payments. However, the level of acceptable coverage will vary depending on the hotel and the requirements of the lender.

Present Value and Net Present Value. Conceptually and mathematically, present value and the related measure net present value are more complex measures of return. They involve adjusting cash flows received (or expended) over a number of periods to their current value net of the costs incurred to generate those cash flows. The process of deriving a present value is often referred to as a discounted cash flow analysis. The concept of present value involves adjusting a stream of cash flows received over time to the value that they would ha\ e at a specific time typically the beginning period or the value as of the date of the analysis. By convention, a discount rate is calculated and applied to each cash flow to reflect the time value of money. The discount rate can represent your interpretation of how the general market would view the risk associated with a particular investment and the resulting cash flows, or it can represent your risk and return requirements. The important point is that the discount rate provides an adjustment over time that takes into account risk and return. The basic underlying assumption of the time value of money concept is that a dollar (or an amoiuit of cash flow) received at some future date may not be of equal value to an investor as a dollar (or an amount of cash flow) received today. The time value of

—

Hotel Investment

and Risk Analysis

39

money expressed

in the discount rate typically reflects two components: anticipated inflation and a risk or opportunity premium. The inflation component is an adjustment for the effect of inflation on the value of money (or the value of receiving a specific cash flow at some future time). The risk component or opportunity component is intended to capture the inherent risk associated with future cash flows, adjusting for such factors as the potential (1) loss in value of the cash flows at the time of receipt, (2) loss in the amount of the future cash flows due to adverse events, or (3) loss in value of future cash flows compared to alternative investments or investor

return requirements. The present value of a streain of cash flows may be evaluated independently of the costs incurred to generate that stream. However, it is more common to combine the analysis of the cash flow returns with the costs required to generate those cash flows, resulting in the net present value. If the net present value is positive and the discount rate reflects your return requirements, then the investment is estimated to provide returns in excess of the returns

you

require.

The internal rate of return (IRR) takes this analysis one step further. The IRR is the discount rate that results in a net present value of 0. If the IRR resulting from an investment analysis is greater than the discount rate that you would use to analyze the cash flows estimated to be generated by an investment, then the investment is estimated to have positive or above -required returns. Present value analysis and net present value measvires are increasingly common investment analysis tools. This is due to the increased availability of electronic spreadsheets and their widespread use to

for

analyzing investments

for

other asset classes.

Example of a net present value analysis. Assume you are able purchase a $35 million hotel for $10 million equity, and that the

is forecast to generate annual aifter-tax cash flows during its three years of $1 million, $1.25 million, and $1.65 million, respectively. Also assume that you anticipate selling the hotel at the end of year three and receiving, after taxes, $10,280,000. You determine that a risk-adjusted discount factor for this type of investment is 12%. Based on these facts, your calculation of the net present value could be illustrated as shown in Exhibit 5. The present value is represented in Column D. It is calcvilated by multiplying each annual after -tax cash flow (Column B) by the discount factor adjusted to reflect the year the cash flow is received

hotel

first

(Column C). The net present value

sum

of the present values

of the investment (line 6) represents (he in lines 1 through

(Column D) calculated

the present value of the investment returns minus the present value of the investment cost. The internal rate of return represents the discovuit factor that would be required in Column C in order to arrive at a net present value of 0. In this case, the net present value is positive, so the IRR 5. In effect,

it

is

40

Hotel Investments

Sample Net Present Value Calculation

Exhibit 5

(B)

(C)

(D)

After-Tax

12% Present

Present Value

Cash Flow

Value Factor

(A)

Period

(000)

of

Cash Flow (000)

1.

0

($

10,000)

0

(S

2.

1

$

1,000

.893

$

3.

2

$

1,250

.797

$

996

4.

3

$

1,600

.712

$

1,139

$

10,280*

.712*

$

7,319

5.

Sale

6.

Net Present Value (sum

7.

Internal

Rate

of

Column D)

10,000)

893

$

347

13.4%

of Return:

*Calculation of Reversion (Sale) Value a.

Total Investment:

$ 35,000

b.

Net Operating Income

c.

Capitalization Rate:

d.

Gross Sales

e.

Less Sales Cost

in

Year

$

4:

of

3,250

Assumed

.09

Assumed

$ 36,111

Price:

2%:

Equity $10,000

$

722

b/c *

d

.02

d - e

Net Sales Price:

$ 35.389

g-

Less Outstanding Debt:

$ 25,000

Assumed

h.

Available Pretax Cash:

$ 10,389

f

Capital Gain:

$

389 109

f.

i.

j-

Capital Gain Tax at

28%:

$

k.

After-Tax Available

Cash Flow

$ 10,280

#These

Equity * i

-

h

+

(i-j)

.28

Equity

figures can be calculated using the following formula:

PVnM =

or

- g

1

/ (1

+

/C)

PV

=

present value

n

=

number of periods

k

=

you can use a standard Table

discount rate of Present

Value Factors for a Single Cash

Flow.

(13.4%) is greater than the discount rate (12%) used in the present value calculation.

Risk Analysis Risk can be defined as the probability^ that anticipated or forecasted events will not occur. Stated another way. the fundamental

1

Hotel Investment

and Risk Analysis

4

risk in a hotel investment is the possibility that the hotel will not generate the cash flows that are estimated for future years, or that these cash flows will not translate into the anticipated value.

Types of Risk Risks associated with hotel investments can be divided into four basic groups: 1

.

Business or operating risks

2.

Real estate or market risks

3.

Legal or governmental risks

4.

Financial risks

groups contribute to the uncertainty of investment return in the hotel industry and, therefore, are factors in raising the level of return necessary to attract investment. The amount and timing of return are equally important criteria in analyzing the variability of return and risk; both directly influence the present value of a return.

All four risk

Business or Operating Risks. Investing in lodging facilities has often been characterized as investing in both real estate and an operating business, unlike more passive forms of real estate investment (warehouses, land, and so on). As with investment in other financial products, the income returns and the value of lodging properties can be greatly influenced by the actions and effectiveness of management. Effective management can make a tremendous difference in both generating revenue and controlling the costs of a hotel operation. Good management can resvilt in increased cash flow, value, and ultimately investor return. But where there is opportunity, there is also risk: risk that the hotel s management will be unsuccessful in its efforts, or that it will be less successful than its competitors. This is a classic example of business risk. See Exhibit 6 for examples of business risks for hotels.

—

—

Real Estate or Market Risks. Factors such as the market and the product are included in real estate risk. Examples include: building the wrong product (a no-frills hotel in a luxury market); building a new hotel in a market with limited, or already satisfied, lodging demand: building to fill a market niche that no longer exists (such as building a hotel next to a military base slated for closing); or having an existing property in an already stabilized market where new additions to supply are not accompanied by increases in

demand.

A good example of market

risk is

what happened

to

many of the

roadside motels built by Holiday Inn and others across the country following World War II, prior to major expansions of the interstate highway system. In many instances, when the freeways went in.

42

Hotel Investments

Exhibit 6

1.

Examples of Hotel Business Risks

Demand During periods of strong room night demand, the industry has typresponded by increasing hotel room inventory, thus limiting the opportunity for existing properties to reap revenue premiums due to relative product scarcity. As demand for hotel rooms decreases, owners and operators are faced with the prospect of lowering rates in order to maintain demand. However, if competitors are facing a similar lack of demand, they are ically

likely to

2.

respond

in kind.

Labor Costs Despite new labor-saving devices used in full-service hotels and the introduction of limited-service hotel products, lodging remains a labor-intensive industry. In most major metropolitan areas, labor is organized, which means management has limited flexibility in negotiating work rules or replacing benefit package and pay scale plans with revised plans more reflective of market (and profit) conditions. Hotels compete for a disproportionate share of the segment of the labor market that contains semi-skilled, dependable workers with moderate to good people skills. During times of economic growth, this segment of the labor pool is in great demand by a variety of industries. Difficulties in this area are reflected by hotel employee annual turnover rates that range from 1 0% to 50%.

3.

Operating Costs In

periods of low

utilization,

the significant portion of hotel operat-

ing costs are fixed costs. In these periods, additional cost savings

come

expense of customer service or asset maintenance. number of hotel operating costs readily adjust upward in periods of increased business, but do not readily adjust downward in periods of low demand. Examples include: real estate taxes, per-unit labor costs, insurance, and energy. In periods of high demand, hotels tend to staff to serve peak customer loads in order to always maintain service response times. This raises their cost basis and decreases the percentage of incremental at the

Also, a

revenue that flows through 4.

to

NO!.

Capital Expenditures Full-service hotels contain large amounts of public space and private areas compared to other real estate uses. This is a less efficient use of space. Guestrooms are rented on a daily basis. The appearance and upkeep of the hotel is a key component of a consumer's buy decision. The result is a higher ongoing capital cost basis than other forms of real estate. In periods of low demand, ownership may defer capital programs only to be faced with greater capital costs (because of the hotel's greater

when funds do become available. Other factors contributing to the high capital costs of hotels are: intensity and pattern of usage (open 24 hours); complexity of energy systems; and the variety of uses (laundry, food service, sleeping rooms, meeting rooms, and so on). deterioration)

Hotel Investment

5.

and Risk Analysis

43

Legal Requirements Unlike most other types of private real estate, hotels are subject use and the consequent scrutiny of the public and public

to continuous officials. life

The consequences

safety legislation

(fire

of this high profile

have been

reflected in

safety requirements, etc.); social legislation

(Americans with Disabilities Act); and environmental legislation (hazardous material laws). Over the years, increasing government scrutiny and higher physical plant requirements have increased the capital and operating costs of the industry. 6.

Management and Franchise

Affiliations

Management and franchise companies are primarily service organizations whose survival depends on their ability to generate fee income. Over a period

of years, the specific

competencies and the com-

these companies may shift. This can have a direct impact on the competitive position of a specific hotel, especially if it cannot readily change its affiliation. The public perception of the value of a particular hotel brand may shift, for better or worse, over time. And the support management and franchise companies provide for on-property management may change as these companies shift how they allocate internal resources. petitive position of

potential guests could not find the motels anymore because the new freeway exits bypassed them or hid them from motorists.

Legal or Governmental Risks. Legal or governmental risk refers to laws or governmental actions that entail additional costs or have other negative impacts on a hotel's cash flow or value. Examples include increased occupancy taxes; social legislation, such as the Americans with Disabilities Act, that can require expensive modifications to existing hotels or raise the cost of a new hotel; environmental legislation requiring, for example, expensive abatement of materials newly defined as "hazardous" or the replacement of existing air-conditioning systems with systems more environmentally friendly.

—

—

Financial Risks. The fourth group of risks financial risks involves the amount of financial resources invested in a hotel and the form in which they are invested. For example, if you bviy a hotel with 100% debt financing that has a variable rate of interest, and the interest rate

is tied to

economic indicators that increase rapidly

during periods of low inflation, you could be faced wilh increased debt service without the corresponding ability to raise rates and revenue.

Another aspect of financial risk involves liquidity. If you invest a stock, you can generally sell the stock in a matter of minutes in order to capture gains or limit losses. Investments in real estate, in

hotels in particular, can involve significant transaction costs and require months to complete. And, in periods when financing is not

44

Hotel Investments

available or is expensive, there are few buyers and limited options for releasing your capital so you can put it into other investments. Therefore, investment in real estate especially in hotel real estate is not as liquid as other investments that have more efficient dissolution systems (such as the market for tradeable securities). In addition, you have the risks associated with leveraging your investment through a mortgage or some other loan. If you purchased a hotel for $20 million cash and it had a S2 million cash flow after all expenses except taxes, your cash-on-cash or equity return would be 10% ($2 million $20 million). If you could borrow 50% of the cost of acquisition ($10 million) at a 7% interest rate (interest only), your before -tax return on equity would be 13%. cal-

—

—

culated as follows:

Cash

$

flow aveiilable before debt:

Debt service on $10 million

Cash flow

at

7%:

after debt expense:

Equity (50% x $20 million):

$

1.3 million

$

10 million

13%

Before-tax return on equity: ($1.3 million

h-

$10

2 million

$ 0.7 million

million)

By

leveraging the investment, you are able to increase your cashon-cash return by 30%. from 10% to 13%. If you calculate your return on an after -tax basis, leveraging the investment increases your return even more, because the interest expense is tax deductible:

Unleveraged after-tax return:

Tax on $2 million cash flow

40%:

$

0.8 million

After-tax cash return:

$

1.2 million

Equity investment:

$ 20.0 million

at

6.0%

After-tax return to equity: ($1.2 miUion ^

$20 miUion)

Leveraged after-tax return:

Tax on $1.3 Tax

miflion cash flow at

40%:

on $0.7 million Interest expense at 40% tax rate:

$

0.52 mUlion

(credit)

Net tax paid: Net after -tax cash return: ($1.3 million

- $0.24 miUion

Equity investment: After -tax return to equity:

$ 0.28 million $

0.24 million

$

1.06 million

tax)

$ 10.00 million

10.6%

($1.06 million ^ $10 million)

—

This is great until your cash returns begin to fall below the loan's interest rate. At that point, you have a negative leverage situation. In the above example, if your cash flow before debt ser\ice fell to $1 million and other factors remained the same, your leveraged

Hotel Investment

and Risk Analysis

return would be lower than your unleveraged return (this to as "negative leverage"):

is

45

referred

Unleveraged before-tax return: Cash-flow before debt service:

$

1

Debt

$

0.0 miflion

Casli-flow after debt service:

$

1

Equity investment:

$ 20.0 million

service:

^ $20

.0 million

5.0%

After -tax return to equity: ($1 million

.0 iniflion

million)

Leveraged before-tax return: Cash-flow before debt service:

$

1.0 million

Debt service (SlO mUlion

$

0.7 miflion

Cash-flow after debt service:

$

0.3 miflion

Equity investment:

$ 10.0 miflion

at 7%):

After -tax return to equity:

($0.3 million ^

$10

3.0%

million)

Measurements of Risk was characterized as the probabilforecasted events or outcomes would not occur as forecasted. Central to this technical concept of risk is the notion that future events or outcomes can be objectively or subjectively estimated, and that the estimated outcomes can be assigned In the previous section, risk

ity or likelihood that

a probability. Also central to this concept of risk is that we cannot measure the possibility that completely unforeseen events will occur (technically, this is the concept of uncertainty). Hence our concept of risk is limited to what we can measure, and our measurement of risk and probability assumes that unforseen events will not occur. Simply stated, the link between probability and risk is: If you can estimate the probability that your hotel will achieve a specified cash flow, you also have a measure of the risk that it will not achieve that cash flow. For a specific hotel investment, if the cash flow for the hotel can be estimated for future years with no possibility of error, then there would be no risk, because the probability that this outcome would not occur would be 0%. As the chances increase that the estimated cash flows may not be realized, risk increases, and may approach 100%. In practical terms, lowering risk means increasing the likelihood that expected cash flows will be achieved. For analyzing hotel investments, the forecasted outcome typically involves estimating a number of key variables and translating these into a financial forecast. This forecast represents the best estimate of the analyst /investor concerning future outcomes. Once

46

Hotel Investments

this forecast is

made, there are several methods

for

determining

ranges of probability: •

Abstracting trends or patterns from past events

•

Abstracting trends or patterns from controlled experiments

•

Translating and applying theoretical relations between fundamental factors or events

•

Structuring and quantilying subjective assessments

The goal of each of these methods is to arrive at a probability distribution; that is, an estimate of the likelihood that the forecasted cash flow will be achieved as it was forecasted, as opposed to some other outcome. The probability distribution pro\ides a mathematical measure of the anticipated frequency that an expected occurrence should occur.

Structuring and Quantifying Risk In

many

cases, there are no readily available, objective

mea-

sures of probability. This is particularly true for hotel investments, where so much can depend on the actions of management, the \ision of the investor, and the future state of the market. Also, in cases

where complex relationships

exist

between economic variables and

operating performance, the costs of researching, abstracting, and applying objective measures can be time and cost prohibitive. In these cases, you may have to rely on subjective estimates of probability. These estimates can be extremely valuable if they are based on careful analysis and if they reflect the best information available. At the least, they can provide a structured re\'iew of vari-

ous risk factors and assist you in sorting through relationships that can have an impact on future returns. A simple risk analysis, based on subjective probability weights, is provided in Exhibit 7. This case illustrates the basic methodology that underlies the various tools for measuring risk set out in Exhibit 8.

Linking Risk to Value

As mentioned previously, in a world where there were no risks, future cash flows (before or after tax) could be perfectly forecasted. These future cash flows would then be adjusted for the known future tax rate and discounted by a safe discount rate (for example, the known fixture inflation rate, if any) to arrive at the after -tax present value of the cash flows that would be generated by the hotel being analyzed. The hotel investment decision rule would then be straightforward: choose hotel projects with the highest after -tax net present value. The only difference between this decision rule and the investment analysis calculations illustrated pre\aously would be that the discount rate used in the present value analx'sis would be a risk-free

Hotel Investment

and Risk Analysis

47

Sample Risk Analysis

Exhibit 7

Assume

that you own a 200-room hotel in a mid-size city. You learn developers are considering constructing a new hotel. Based on your discussions with government officials and industry experts, you reach the following conclusions regarding the probability that a new hotel will be built: 50% that no hotel will be built; 40% that a hotel of 200 rooms will be built; and 10% that a hotel of 400 rooms will be built. You have estimated the market value of your property at $8 million, based on an analysis of anticipated future cash flow without the new hotel. You have also developed an estimate of the present-value impact that a new that various

hotel

would have, given each

of the three scenarios.

Based on your assessment

of the information you have gathered, you construct the following risk analysis in order to quantify the expected impact the new hotel will have on the value of your hotel:

Number

of

New Rooms 0

200

400

Impact on Present Value

Probability of

Occurrence

50% 40% 10%

Weighted Value

$0.0

million

$0.0 million

$2.0

million

$0.8 million

$6.0 million

$0.6 million

Expected Impact on Value:

$1.4 million

Given these three scenarios, the expected impact of a new hotel on your hotel's current value is $1 .4 million. This represents 17.5% of your hotel's

current $8 million value.

Assuming that you have correctly estimated the probability of each scenario, and that you have accurately forecasted the impact that each scenario would have on the present value of your property, you have identified and quantified your risk. You are now in a position to decide what you should do. You can sell your hotel before the market learns that a new hotel is under development (transfer the risk); you can try to insure against the risk; you can sponsor a development moratorium or a down-zoning of competitive sites; or you can take other measures designed to change your assessment of the probabilities associated with the new development.

known inflation, or the rate required by an investor to invest in a stream of known future cash flows. There would be no perceived or objective risk factor included in the calculation of the rate reflecting

discount rate. All investment analysis is based on expectations. Risk analysis provides a method for specifically addressing investor expectations by considering the probability of other outcomes. Given that we do not live in a risk-free world, analysts of hotels (and other investment prodvicts) must measure risk and include it in the valuation of investment opportunities. Linking risk to value involves taking into account possible variances in achieving the cash flows offered (or expected from) a specific investment opportunity. Each variance corresponds to a probability ranging from 0%, when the outcome does not have a chance of occurring, to

100%, when an outcome

is

certain to occur.

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" is bound to "lose" because the results of impact studies clearly make a decision for one side. However, both parties would win or lose equally if the impact study defines the price to compensate for impact. The following sections examine seven steps typically followed in conducting an impact study:

—

1

.

Evaluate existing property characteristics.

2.

Analyze the competition and the market.

3.

Profile the applicant property.

A Critical Analysis

of Hotel Impact Issues

181

company.

4.

Profile the franchise

5.

Compare

6.

Project

7.

Determine the impact.

the current situation with past impact situations in similar markets.

occupancy and average daily rates

for the existing hotel.

In the sections that follow, the terms "existing property" and "existing hotel" are used to identify the property already in the franchise system. The terms "applicant," "applicant property," and "applicant hotel" are used interchangeably to identify the prospective new entrant to the franchise system. Also, the term "analyst" is used to refer to the entity charged with conducting the impact study.

Evaluating Property Characteristics

The first step in conducting an impact study should be to evaluate the characteristics of the existing hotel. Exhibit 2 lists general characteristics and specific information to be gathered. The analyst needs this information as the basis for evaluating the existing property's overall ability to compete in the market. Also, the information enables the analyst to identify competitive advantages and disadvantages of the existing property in relation to the applicant property whether the applicant represents a proposed conversion of a hotel already in the market, or a new hotel development. Thus, an evaluation of existing property characteristics is an important factor in estimating the amount of base impact or incremental impact.

—

Competition and Market Analysis

Once the

anailyst has a thorough understanding of the existing he or she should evaluate the current and future characteristics of the competitive lodging market. Exhibit 3 indicates the types of information that may be gathered about competing hotels,

hotel,

future lodging supply, current and future demand, and projections of occupancies and room rates. By understanding the supply and demand characteristics of the market, the analyst can assess the

market's ability to absorb

new

competitive supply.

Applicant Profile In order to evaluate impact there should be as much detailed information as possible regarding the applicant. When the applicant is a proposed conversion of a property already in the market, the analyst should gather the same types of information as are gathered to evaluate the existing property characteristics. (See Exhibit 2.) This would inclvide an assessment of the hotel as it is today and as it will be following the conversion. When the applicant is a new entrant into the market, the profile should contain a mix of factual information and assumptions regarding its planned development.

182

Hotel Investments

The Impact Study: Evaluation of

Exhibit 2

Existing Property

Characteristics General Specific Information to Consider

Characteristics Physical Attributes

Number

rooms and room types Food and beverage facilities of

Size

Concept Meeting space Size

Capacity Recreational

facilities

Corridor type

Age and

condition of property

Historical renovations

and planned improvements

Signage Locational attributes including: Visibility

Access Surroundings Proximity to

demand generators

Area amenities Hotel Amenities

Exercise room

Concierge

Pay movies Airport shuttle

Parking

Guest laundry Other amenities

Demand Segmentation

Historical (3 years)

market segmentation stated

in:

Occupied room nights Seasonality patterns by segment

Average room Major

rate by

segment

demand generators

Contracts Walk-in patterns

Occupancy and Room Rate

Historical (3 years)

monthly occupancy and rate

statistics including:

Weekend/weekday occupancy and

rate patterns

Single and double occupancy Full

house patterns

Seasonality

Reservation Information

Number

of

bookings & timing

Denials

Room Projections

and Budget

rates

Projection (3-5 years) of occupancy,

room

rates,

and

market segmentation

Planned renovations and costs Piitiiro LUIIlldClo ^^nntrQptc rUlUIC

Management

Characteristics

How

long has the

management team been

In

the lodging

business?

What types

of properties

does the management team

operate? Is

the hotel staff well trained and professional?

How knowledgeable

is

the

management team about

property and the competitive market?

the

A Critical Analysis of Hotel Impact Issues

183

The Impact Study: Evaluation of the Competitive Market

Exhibit 3

Category

Specific Information

Inspection and evaluation of

competitive tiotels

Pfiysical attributes

Locational attributes Historical operating

performance

Demand segmentation Major demand generators Historical

and planned renovations

Seasonality patterns

Competitive advantages and disadvantages Evaluation and determination of future lodging

New

hotels to

be constructed

in

the market

Potential conversions

supply

Room

additions

additions to existing hotels

Deletion of existing hotels

Area review and analysis

of

general market conditions

Collect relevant

economic data and analyze the general

market conditions which may impact the existing hotel as well

as the competitive lodging market. Key economic factors might include:

Demographic trends

Employment trends Transportation patterns

Tourism patterns Office

space developments

Include the effects of other developments that

will

provide

information regarding general economic trends and growth patterns.

Evaluation of current and future

demand

for lodging

Understand why demand

Assess

accommodations

Interview

Projection of market

On

occupancy and average

projected

daily

room

rate

is

present

in

demand and project key demand generators.

potential

the market area.

its

future growth.

the basis of the above research, prepare an analysis of

demand

for lodging

accommodations

in

the market

under two scenarios: 1

.

2.

With the addition of the applicant under evaluation

Without the addition of the applicant under evaluation

In this case, Exhibit 4 indicates the general characteristics

and spe-

information that should be gathered. The analyst needs this information as the basis for evaluating the applicant property's overall ability to compete in the market. Also, the information enables the analyst to identify competitive advantages and disadvantages of the applicant property in relation to the existing property whether the applicant represents a proposed conversion of a hotel already in the market, or a new hotel development. cific

—

Franchise

Company

Profile

Since incremental impact measures the business lost by the exdue to the addition of a specific hotel brand, the analyst should have a thorough understanding of the franchise company

isting hotel

184

Hotel Investments

The Impact Study:

Exhibit 4

Profile of the Applicant

General Specific Information

Characteristics

Proposed Property Description

A

description of the proposed physical attributes

and

amenities planned for the applicant property, including anticipated development costs Site Description

The

Opening Date

The assumed date

specific location of

and locational

attributes

opening

Budgeted Operating

Budgeted occupancy and rooms

statistics, including

Performance

detailed description of published

room

Hotel

Name

Whether or not the name

will

location or attribute (Hotel

rates

a

and discounts

include reference to a particular

X Airport

or Hotel

X Convention

Center)

and the brand(s) being evaluated. Relevant information on the hotel brand includes the following:

Number

•

of existing hotels

and planned annually

under contract, under construction,

for the

next

five

years

National marketing dollars and a description of how and where these funds will be spent

•

How the

•

reservations system works and statistical information including: the net business that comes through the reserv^ations system, the seasonality patterns of reservations, the number of denials through the system and when they occur, room rates and discount rates available on the system, etc.

•

Priority club, frequent traveler

programs, and other travel

in-

centive programs •

Dates when new hotel directories are printed as well as the information is presented in the directory

•

Demographics of brand-loyal Gathering this information

company may have

how

travelers

is

useful because each franchise

different reporting standards

and systems and

may

also provide different services to the traveler. The strengths and weaknesses of a franchise company will vary. It should be the responsibility of the analyst to understand the various factors that influence a customer's decision to use a specific hotel and /or hotel

brand.

Comparison

to Impact Situations in Similar Markets

Discussions with hotel companies regarding comparable conversions or new hotel developments where incremental impact was an issue can be helpful in evaluating the situation under study. It

A

Critical

185

Analysis of Hotel Impact Issues

may

be difficult to find situations that are directly comparable. However, discussions with hotel managers who have had new rooms from the same brand or same hotel company added to their market area may show how incremental impact has (or has not) occurred and how the existing hotel has responded to the situation. This type of information often lends support for substantiating an impact determination.

Occupancy and Average Daily Rate Projections Once

the relevant information is gathered and analyzed, a prooccupancy and room rates may be prepared. Projections may be done under three scenarios:

jection of

1.

As

assuming the applicant does not

Is:

exist ("as is" case)

2.

Base Impact: assuming the new rooms (or newly competitive rooms) will not be affiliated with the same brand

3.

Incremental Impact: assuming the applicant's hotel rooms be the same brand

The

rooms revenues for the existing hotel between and scenario 2 equals the amount of base impact the

difference in

scenario

1

will

—

amount

of revenue the existing hotel wovild lose with the proposed change to supply. The difference in the existing hotel's performance between scenarios 2 and 3 equals the amount of incremental impact the additional revenue that will be lost as the result of same brand competition and the mutual use of the company's reservations system.

—

Impact Determination impact are straightforward and systemthe steps previously described are completed by a competent analyst with expertise in the hotel industry, then the conclusions of the impact study should be highly reliable if the impact determination is made in qualitative terms, such as "a great deal of impact," or "some impact, or "no impact at all." Refining the conclusions of an impact study beyond general qualitative terms to specific quantitative measures (such as occupancy points or room rates) is the most challenging and svibjective part of an analyst's task. This refinement is problematic because impact analysis is a subjective exercise that requires empirical data, numerous opinions, and ultimately the judgment of the analyst conducting the study. Quantitative conclusions of an impact study become even more subjective as an analyst evaluates impact over a specific period of time into the future, normally between one year and five years. While quantifying the conclusions of an impact study will always be a subjective task, various methods may help gauge the

The steps

to evaluate

atic. In fact, if

"

186

Hotel Investments

reasonableness of the conclusions and minimize the subjectivity of the analysis. "Reasonableness" tests might include the following: •

Quantify the results from similar impact situations in other markets.

•

Obtain agreement on certain base assumptions from involved in the impact situation.

•

Prepare an annual spread of occupancy and rate projections that reflect seasonality of business.

•

Prepare market penetration competitor (if applicable).

•

Develop a matrix of occupancy projections against differing

room

(fair

all

parties

share) projections for each

rate alternatives.

By conducting these reasonableness

tests, the analyst avoids

many

of the potential shortcomings often associated with incremental impact studies.

Potential Shortcomings of Impact Studies Regardless of whether an impact study is commissioned by the existing hotel, the applicant property, or the hotel company, and even if the study is conducted by a third-part\' consultant, numerous shortcomings may exist which could affect the conclusions of the study dramatically. Impact analysis is not a science. Conclusions may be inaccurate due to a variety of factors. Yet. with any projection, if reasonable assumptions are made, if facts are verified, and if the person performing the analysis is experienced, then projections should be reliable within some general pcirameters. if not to a specific degree as measured in occupancy points or room rate dollars. The following sections identify potential shortcomings of impact studies. Awareness of these potential shortcomings should prove txseful in evaluating the recommendations and conclusions of an impact study.

Assumptions About the Applicant Hotel Wlien completing the impact study of a new entrant into the market, the only reliable information about the propertv' is its location. Projections and assumptions should be made as to the potential room rates and occupancy points that will be likely for the new hotel. In the case of conversions, there may be a product improvement plan outlining the facilities to be provided, but who is to say when (or if) all the improvements will be done? Also, an estimate of the timing of entry for the applicant hotel is just that an estimate. If the timing assumptions prove wrong, then the potential for impact may be greatly reduced or increased from that of the original study.

—

A

Critical

Analysis of Hotel Impact Issues

187

Evaluation of Reservations System Data

The reservations data tracked by the various hotel companies and provided to the analyst when conducting an impact study may not provide the information that is necessary to accurately evaluate reservations made through the system. For example, a reservations system generally tracks denials. An analyst could then assume that a certain number of denials means that an applicant property with the same brand might get all denial business. But denials are only based on the availability that a property specifically puts into the reservations system for a certain room rate and may not accurately reflect true denials. For example, assume that a prospective guest tries to reserve two rooms for three nights. The guest fails to place the reservation when told that one room is not available for one of the requested nights. A reservations system might record this transaction as six denials (three nights times two rooms). The number of denials recorded by a reservations system can be misleading when the system fails to account for special events. For example, during certain peak periods of demand, hundreds of denials may occur on a single day in relation to one special event (such as a local high school or college graduation). However, the reservations system may lump these denials into a cumulative total, obscuring the fact that a sizable number of the total denials occurred during a single day and would fill the hotel only on that day.

Brand Awareness

A major consideration in evaluating impact is brand awareness, or the degree to which the image of the hotel company is a factor in a guest's decision to stay at one of the brand properties. The shortcoming of this factor (as it pertains to evaluating impact) is that brand awareness is a matter of judgment on the part of the individual performing the impact study. While it is true that one hotel brand may have greater brand awareness than another due to factors such as marketing and the sheer number of hotels in the system, in the end, it is the judgment of the person conducting the impact study that determines the strength of the brand and its ability to be recognized by prospective guests. One might think that all hotel companies track customer perception and could provide the analyst with statistically reliable and valid data regarding brand awareness. However, there is no standard system for measuring and tracking brand awareness. Determination of Future Supply At the time an impact study is conducted, there may be no basis for assuming that new lodging supply will enter the market area. However, this situation is always subject to change. If unanticipated new supply enters the market, obviously the projections

188

Hotel Investments

of occupancy points and room rates of a past impact study might be well off target.

Determination of Future

Demand

Similar to the projection of future changes in supply, demand projections are based on estimated future market conditions and travel plans for a variety of demand sources. For example, a major demand generator in a specific market may opt to leave that market. If the analyst had known this while conducting an impact study, there would most likely be a change in occupancy projections. Even with a reasonable amount of due diligence on the part of the analyst, demand projections are speculative.

Impact Determination

— Rate Versus Occupancy

For those hotel companies that require only occupancy to be evaluated in determining impact, the major shortcoming in the analysis would be the assumption that room rates wall remain consistent with current business patterns. If room rates are a primarv' factor in selecting a hotel, isn't it reasonable to assume that any changes in rates would have a significant impact on occupancy?

Potential Shortcomings of Impact Policies While perhaps due to the fast-paced changes in business conditions over the last several years, many current impact policies of hotel companies fail to specifically provide a fair and equitable means of addressing the conflicts that arise in relation to impact issues. The following sections identify some of these shortcomings and provide suggestions for resolving them.

Unclear Impact Policy

As previously mentioned, some

companies clearly define impact on an individual, case-by-case basis. Today's business conditions warrant WTitten impact policies. Even if franchisees do not agree with the decision to add a competing property to their markets, they at least understand the policy. impact

hotel

policies, while others evaluate

Inadequate Notification and Timing of Responses I recently spoke to a franchisee who complained that he would never develop another hotel under a "Brand X" franchise becavise he was never notified by the franchisor when a new franchise of the same brand was built near his hotel. The franchisor responded that a letter was sent informing the franchisee. The franchisee denies ever receiving a notification letter. To avoid such situations.

A Critical Analysis

of Hotel Impact Issues

189

franchisors should take full responsibility for both written and oral notification of franchisees of potential impact situations. Moreover, some impact policies state that, after receiving an impact notification letter, the franchisee has only 10 to 15 days to submit substantial quantitative and qualitative data regarding the potential for impact. Assistance in filling out forms and obtaining data should be made available for franchisees if franchisors expect responses with such short deadlines.

Selection of Inexperienced Analysts policies contain a list of approved analysts are authorized to perform impact studies for a specific hotel chain. In theory, these consultants are independent and are experts in their field. A select list of independent analysts is a good idea because it avoids the situation in which a franchisee or franchisor decides to hire an analyst who may be less than objective when conducting an impact study. But the question remains, who decides if analysts are qualified and experienced in conducting hotel impact studies? The franchisor should take responsibility and provide a list of analysts who are knowledgeable about the chain and knowledgeable about current impact issues, who provide good references, and who subscribe to

Most written impact

who

ethical standards

and accepted

practices.

Questionable Impact Thresholds Thresholds mark the amount of impact considered sufficient to or terminate a new project's construction. As previously mentioned, some hotel companies define in writing what specific factors determine the threshold for significant impact. An example for denying a new application due to impact might be if incremental impact averaged three or more percentage points of occupancy during the first five years of the projection period. Another example might be if incremental impact reached five or more percentage points of occupancy during any of the first five years during the projection period. The question of what is an equitable threshold has yet to be answered. Many argue that the threshold should only be on impact to occupancy. Others state that the threshold must be viewed as impact to revenue per available room (REVPAR), which is a com-

deny a conversion

bination of occupancy and room rate. Still others believe that the impact to net operating income, which is the bottom-line profit, is the key threshold to evaluate. Adding to the problem of consensus over the correct measurement for impact threshold is the question of how many years out should impact be evaluated. Some argue that impact should be evaluated for one year. Others say that impact must occur for at least three or five years to deny an applicant in relation to new hotel

development.

190

Ho tel

In ves tments

While I cannot define the specific parameters justifv'ing impact, do recommend that impact be evaluated in terms of REVPAR and that it be evaluated over a three -year time frame. I

No Monitoring

of Impact

Over Time

Despite the due diligence of analysts and all others participating in impact studies, future changes in market conditions can prove past impact determinations to be totally wrong. However, most impact policies do not allow for "retrospective" impact studies. In cases where impact can be proven, some monitoring of impact over time should be part of every policy. Moreover, if impact is proven, a defined method of compensation should also be outlined in every policy. It is important to note, however, that retrospective impact studies can be expensive and may prove impractical.

The Future of Impact The relationship between a franchisor and franchisee in the hotel industry is almost always created out of necessity. Each party would almost assuredly prefer to grow and prosper without the other, but like the two sides of a coin they are inextricably linked. Impact is an issue that is of major concern to the franchise community. If impact policies for a specific hotel chain are unfair, or if the outcome of an impact study is flawed, then someone, be it the franchisor or the franchisee, is subject to lost income. This lost income may be minor, or it may cause an indi\adual to lose his or her only means of business. It is important that impact policies become a priority of the hotel community and that franchisors and franchisees be fairly and equitably treated in any impact policy. In the future. I believe you will see fewer impact conflicts due to territorial protection clauses that will be negotiated and agreed upon before a franchise agreement is signed. These t\pes of clauses assure the franchisee that no other franchisees with the same brand will be developed within a defined territory'. In exchange, the franchisor will probably require that the existing franchisee maintain specific quality standards and pay all franchisee fees in a timely manner. While territorial protection may work as a short-term fix, the establishment of and adherence to an agreed-upon methodolog\' for resolving impact conflicts will greatly assist in maintaining long-term, productive franchise relationships.

more

9 Valuation: Regulation

Versus Reality By Daniel

C.

Hanrahan

II

C. Hanrahan II, MAI, is a principal at Pinnacle Advisory Group, a real estate appraisal and hospitality consulting firm. Prior to Joining Pinnacle, he was the national director of real estate valuation at Pannell Kerr Forster and a Senior Associate at Miller & Kajes Associates, Inc. Mr. Hanrahan is an active member of the Appraisal Institute, serving in a variety of capacities on local and national committees. He is a certified national instructor for the Appraisal Institute and teaches regularly for the Institute at Rutgers University. Mr. Hanrahan maintains

Daniel

numerous professional

affiliations specific to the real estate industry, including the National Association of Corporate Real Estate Executives (NACORE) and the Urban Land Institute (ULI).

REAL ESTATE IS GOVERNED by a multiplicity offerees and prineiples. It is the convergence of these elements that shape and define not only real estate markets, but real estate value. Change in the real estate market is "the result of the cause and effect relationship among the forces that influence real property value" (from The Appraisal of Real Estate, 10th edition, p. 33). The pervasiveness and influence of change is abundantly clear in real estate, where social, economic, governmental, and environmental forces are in constant transition. Defining the rate, direction, and influence of these forces is the challenge facing real estate

appraisers.

Changes

in

the Appraisal Industry

Appraisal theories, unlike the real estate markets they profess have not undergone dramatic changes in recent years. The generally accepted approaches to estimating value have been, and remain, the cost approach, sales comparison approach, and income approach. The application, processing, and reporting of these approaches is what has so dramatically changed, through the rapid creation and evolution of the Uniform Standards of to interpret,

191

— 192

Hotel Investments

Professional Appraisal Practice (USPAP). the Ethics (created by the Appraisal Institute),

Code and

of Professional state licensing

legislation.

Uniform Standards and Assumptions. The guidelines that govern professional appraisers and serve as the foundation for licensure legislation require an appraisal's assumptions and conditions to be well documented and "reasonable." The standards established by USPAP serve as the general framework within which a professionad appraiser arrives at and communicates his or her analyses, opinions, and advice in a manner that will be meaningful to the client, and will not be misleading in the marketplace. Originally, the standards were constructed to address only market value appraiisals. However, over the last four years the standards have been expanded to incorporate a variety of other valuation and consultancy services. Despite these guidelines, discrepancies among appraisers on opinions of market value can and do occur, because what appears "reasonable" to one person may not be viewed as such b}- another. If different appraisers can reach different conclusions about market value, how do you know if you have received an accurate appraisal? It isn't easy. Presuming the party commissioning the appraisal has no predeterminations, the ultimate measures of an appraisal report's quality rest in (1) the disclosure of the key factors influencing value, and (2) the support documentation there should be enough support documentation to enable readers to follow the appraiser's analyses and conclusions. USPAP outlines the minimum requirements for appraisals. It also serves as the foundation for state licensing legislation. Yet as the Financial Institution Reform, Recovery, and Enforcement Act known as FIRREA took root in the late 1980s, the appraisal community seemed to interpret it as a dramatic change in the industr>\ requiring increased anadysis. documentation, and reporting. Wliile this was never the intent of FIRREA. some financial institutions created ominous checklists that altered the content of appraisals. Just as appraisers can reach different conclusions when presented with the same information, so too did the financial community reach various conclusions when interpreting FIRREA. USPAP itself is once again undergoing change: the Appraisal Standards Board has permitted departure from the generally accepted appraisal format through the creation of a "limited appraisal." So, as you can see, the way appraisers construct an appraisal report and present their findings continues to change.

—

—

The Impact of Licensure.

Professional appraisal organizations (such as the Appraisal Institute) that offer designations specific to appraising require appraisers to have extensive professional education and experience. These organizations helped state governments come up with minimum requirements for appraisals. The intent of the licensing law was, and remeiins, sound. However, the minimum requirements and qualifications for licensure are such that a whole new population of appraisers was created and

Valuation: Regulation Versus Reality

193

legitimized to participate in federally related transactions, with only a few of these new appraisers possessing the skills necessary to deal with a complicated asset class such as hotels. On the positive side, state licensing forced the more qualified, professionally designated appraisers to become sensitive to aspects of the appraisal process that, for whatever reason, they had come to overlook in their practices. And some financial institutions created large appraisal staffs filled with appraisal technicians capable of dealing with outside appraisers on the highest, most technical level, thereby improving the appraisal process and achieving

the objective of the legislation. In light of all this, it's easy to see why there is still no substitute for an experienced appraiser. You should always look for an experienced appraiser when you need an appraised of a property's market value.

What

Is

an Appraisal?

is this thing known as an "appraisal" that has drawn attention since the late 1980s, causing Congress to exact regvilatory guidelines and promulgate statewide licensing? An appraisal is still best defined as "the act or process of estimating value. Appraisals, just like appraisers, come in a variety of shapes and sizes. You— the potential customer, reader, or reviewer of the appraisal should be aware of this fact, and provide sufficient information at the beginning of the appraisal process so the appraiser can offer you a menu of services and products to choose from. It's essential that you fully understand what you need and communicate this to the appraiser. The appraisal process begins with the definition of the appraisal problem. The following seven points of the definition establish the parameters of the appraisal:

So what

much

so

"

—

1

.

Identification of the real estate

2.

Identification of property rights to be valued

3.

Use

4.

Definition of value

5.

Date of value estimate

6.

Description of the extent of data collection

7.

Identification of

of the appraisal

key assumptions and /or limiting conditions

Can the appraisal problem be defined in more than one way? Without question. However, most people requesting an appraisal seek an estimate of market value. The definition of "market value" has changed in recent years. The most current definition, based on Title 11 of FIRREA, states that "market value" is:

194

Hotel Investments

the most probable price which a property should bring in a comand open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to bu\'er under conditions whereby: petitive

1.

Buyer and

2.

Both parties are well informed or well advised, and acting what they consider their best interests;

3.

A reasonable

4.

Payment

is

of financial 5.

The

seller are typically motivated:

time

is

in

allowed for exposure in the open market:

made

in terms of cash in U.S. dollars or arrangements comparable thereto:

in

terms

price represents the normal consideration for the property by special or creative financing or sales con-

sold, unaffected

cessions granted by anyone associated with the sale.

One can

and would have an impact on the reported outcome. These include: What if the buyer and seller are identify

closely

examine

many aspects

that,

if

this generally accepted definition

altered,

not typically motivated? What if the parties are not well informed? if a property's exposure in the market is not reasonable? if financing is offered (versus an outright sale)? As the definition states, market value appraisals reflect the most probable price a property should bring. Armed with similar information pertaining to a property and market, several appraisers, in theory, should reach similar conclusions as to market value. While this seems reasonable, all too often different appraisers come up with different findings. Most of the time these differences can be traced to the definition of the appraisal problem, where appraisers establish different assumptions and conditions. An appraisal will be of little or no value unless the appraisal problem is well defined at the outset.

What What

Reasons

for Appraisals

Determining market value is only the stcirting point in many appraisal assignments. Appraisals are tj^aically sought for one or more of the following reasons: •

Mortgage financing/ collateral valuation

•

Bankruptcy /foreclosure proceedings

•

Buy/ sell investment analysis

•

Renovation /alteration consideration

•

Repositioning or change in affiliation

•

Condemnation

•

Insurance analysis

•

Basis for taxation

Valuation: Regulation Versus Reality

195

•

Establish value for financial statements

•

Negotiate terms of a lease, either whole property or underlying land

In some of these cases, simply determining market value best serves your objective. Often, however, determining alternate or multiple values is far more helpful in fvilly understanding the business choices available to you.

Alternate Values

What other types of asset value are there besides market value? Other, or alternate, values include disposition value, liquidation value, investment value, insurable value, net realizable value, and prospective value. Each of these values carries specific meanings in the context of appraisal theory. Disposition, liquidation, net realizable, and prospective values are essentially derivatives of market value. The difference is that disposition and liquidation value have limitations and extreme limitations placed on the marketing period, as well as compulsion and extreme compulsion to sell on the part of the seller. If you the owner, manager, or prospective investor establish as an objective the maximization of property value and return on investment, both disposition and liquidation values can serve a meaningful purpose as a downside analysis. Net realizable value, simply stated, is market value minus the cost of disposition. Prospective value is a forecast of the asset's value as of a specified future date. Prospective value estimates enable you to assess change in property value over the holding period, thereby enhancing your ability to make an informed business decision. A property's value can change because of the market or because of changes or expenditures occurring at the property, such as a renovation, repositioning, change in management, or change in affiliation. More often than not, changes or expenditures at the property have a more significant impact on value (and warrant both market and economic feasibility analysis) than do general market-condition changes. Regardless, an examination of prospective values allows you to more accurately gauge the investment prospects of a hotel on a year-to-

—

—

year basis. Alternate values can be confusing as well as helpful. The appraiser must precisely define each alternate value so it is not confused with market value. It should be noted that estimating alternate values does not relieve appraisers from exercising caution when developing their findings. Each alternate value must meet the requirements of USPAP. Restrictions and conditions that are specific to a single user or specific to a certain situation (instance) should be carefully identified, to avoid misleading the reader of the report or reaching a conclusion that is of no use.

196

Hotel Investments

Highest-and-Best-Use Analysis

—

The importance of alternate values all of which can be generated under a variety of physical and operational scenarios is borne out in the appraisal's highest-and-best-use analysis. Earlier, "market value" was defined as the most probable price that a property would bring in an open market. With new development all but ceasing to exist in the lodging industry in the last few years, the market has exhibited countless cases of highest-and-best-use analysis for all types and classes of lodging products across the country. Each of those cases presented a valuation problem that was sourced and solved based on market analysis and economic

—

principles.

"Highest and best use" is defined in The Appraisal of Real Es10th edition, as "the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value." Today more than ever, an appraiser should examine the present operation of a lodging property and test and measvire at a minimum each of the following: tate,

• •

Are there areas where the operation can be improved?

How

is

achieve

the condition of the property affecting revenue and profit potential?

its ability to

maximum

current management capable of making changes or realizing the property's potential?

•

Is

•

Is the hotel's present affiliation generating the greatest cost/ benefit to the property?

A relatively recent phenomenon is to quality estimates of market value with the term "as is." These two simple words can cause a great deal of confusion to both providers and consumers of appraisals. "As is" does not mean that an appraiser should assume the property will continue to operate in perpetuity as it is functioning at present and price it accordingly. The appraiser should make reasonable projections of value based on the highest and best use of the property. However, it is unacceptable to base an opinion of a property's value on unsupported assumptions pertaining to highest and best use: the appraiser must be able to describe the scope and character of proposed improvements and outline the probable timing and costs associated with such. It must also be remembered that, just because the opportunity exists to improve a proper t\^s operation and hence its value, it does not automatically or necessarily mean the market would recognize and pay for such improvements. The ultimate determination of highest and best use is rooted in primary market research and subject to change as market conditions themselves change. You mvist give careful consideration to both the benefits of altering the operation or the property itself and the costs associated with such a change. The costs are many and go beyond the direct

Valuation: Regulation Versus Reality

197

expense associated with a contemplated renovation program or reflagging of the property. Other costs are the opportunity costs associated with forgoing alternative investments and the losses that may occur because you invested in an asset class (hotels) that is

somewhat

risky.

Decisions about whether to renovate a property or change its affiliation have been made with increasing frequency over the last few years, and many of you will be faced with these decisions in the near future. Highest-and-best-use analysis is where the market and economic feasibility of such changes are quantified. Ignoring, or inaccurately gauging, the economic impact of these decisions was one of the problems the lodging industry fell victim to in the 1980s. The lesson has been learned, however, and today economics, not emotion, drives the hotel investment engine. Worthy of note are some key concepts and definitions that underscore highest-and-best-use analysis and are woven throughout the fabric of an appraisal report. These concepts and definitions include:

—

•

Market study a macro-economic analysis that examines the general market conditions of supply, demand, and pricing, or the demographics of demand for a specific area or property type.

•

Marketability study a micro-economic study that examines the marketability of a given property or class of properties, usually focusing on the market segments in which the property is likely to generate demand. Marketability studies are useful in determining highest and best use. testing development proposals, and projecting appropriate tenant mix.

•

Economic feasibility the ability of a project or an enterprise to meet defined investment objectives; an investment's ability to produce sufficient revenue to pay all expenses and charges and provide a reasonable return on and recapture of money in-

—

—

An investment property is economically feasible if its prospective earning power is sufficient to pay a fair rate of revested.

turn on

its

complete cost.

Market feasibility by itself does not answer the question of which policy renovation, change in affiliation, change in management, etc. would help a property reach its highest and best use and therefore maximize its value. It might seem that, if left unchecked, appraisers can get mired in detail that will preclude them from rendering an opinion, given the potentially countless opportunities that could be considered in a highest-and-best-use analysis. The criteria of highest and best use that the project be physically possible, appropriately supported, and ultimately financially feasible serve as screening devices whereby many, if not most, possibilities can be

—

—

—

—

eliminated. A soiuid highest-and-best-use analysis will present only a limited number of truly viable options, from which the optimal program can be selected. An appraisal that tests and measures alternate values that are market-derived becomes a useful tool for

198

Hotel Investments

decision-making; an appraisal that offers no such analysis, or is based on an assumption or condition that is not clearly attainable within the market, is of no use and is highly misleading. Once the appraiser has established a sound basis for an opinion of highest and best use, then and only then can market value be estimated. Appraisers must use great care when interpreting data to help them arrive at a hotel's market value. For example, as mentioned earlier, by definition "market value" presumes the buyer and seller are typically motivated. An examination of hotel sales over the past few years calls into question whether buyers and sellers during this period were typically motivated. First, the predominant sellers of lodging product have been the federal government

and

financial institutions. Second, activity

was down

substantially

1990s and has gradually improved in both pace and average price realized. Third, debt capital has remained all but non-existent, and institutional-seller financing has been required in many cases to effect a transaction. These conditions raise the question as to whether most of the hotel transactions during the past few years reflect the true market value of the hotels, or rather in the early

reflect the "disposition" or "liquidation"

value of the hotels. If the appraisers should interpret recent years' transaction data with caution when estimating the market value of a client's hotel. Presuming that the transactions where duress has influenced either the marketing time or compulsion to sell can be identified and allowed for, it would appear that market conditions have dictated a change in pricing structures and investors' views of the risk associated with hotels. latter,

Factors that Affect an Asset's Value Factors that affect a hotel's value include the hotel s physical plant, the hotel's affiliation, the hotel's risk rating, and market conditions.

The Hotel's Physical

Plant

A significant portion of this textbook is dedicated to a hotel's operational aspects. Fundamental to a sound, mccaiingful appraisal is an understanding of the property's past operating performance. However, one of the most common mistakes hotel appraisers make is to analyze operations without understanding the hotel's physical plant and its limitations. There is no question that a hotel is an operating business (going concern), and as such is distinctly different from the more conventional contractual t^^Dcs of real estate investments. However, the bvisiness operates within a physical plant that directly influences the asset's ability to generate a profit. An appraisal based on cost savings or improved efficiencies that are based on industry averages or comparable operations when those cost savings or improved efficiencies are not possible due to the hotel's building design or local market factors (union versus non-union

—

Valuation: Regulation Versus Reality labor, for

example)

199

—can yield misleading conclusions and a misrep-

resentation of value.

Absent a change to the physical plant, an appraisal can only go so far in assuming improved operations. It therefore comes back to the highest-and-best-use analysis, where the appraiser must look to the market and identify the maintenance program that, when implemented, would maximize the value of the property. Given the fact that few appraisers are design, structural, or mechanical engineers, appraisers must typically rely on the input of a third party when considering maintenance programs. This is particularly true when the building is old or neglected, but should not be restricted to these instances. A study of a hotel's capital investment and preventive maintenance program is central to reaching reasonable estimates of value. Past expenditures, however, do not necessarily indicate what must be spent in the future. As markets have become overbuilt throughout the country, once-clear lines of competitiveness have become blurred. While it may not appear reasonable to continue to reinvest substantial capital into a property due to the heightened price sensitivity of the present traveling public, the short-term benefit of not reinvesting may be far outweighed by the potential long-term loss and more substantial expenditure that would be required when market conditions improve. Those properties that have been maintained or improved are the ones that today are in a more advantageous competitive posture, able to regain some of the ground lost during the recession. Their capital investment and preventive maintenance programs are now paying off, whereas those hotels that did not reinvest are now faced with the compound effects of potentially higher repair or renovation costs, temporary and permanently displaced business as a result of the work required, and the opportunity cost of lost business revenues. Appraisals are most valuable when the recommended maintenance program is market driven rather than owner or management driven. The programs of the hotel's owner and the hotel's management, presuming they are different, should serve as starting points when the appraiser tries to identify what is actually needed. If the programs of ownership and management are different, it is usually because the interests of each group lie in distinctly different directions. Management may be most concerned with the image and reputation of the property, as well as the need to cater to a certain market segment and enhance operations, while the owner typically is focused on the bottom line. Once again, by generating alternate values for those maintenance programs that appear most reasonable, the appraiser can illustrate the program that maximizes the value of the property, while showing the infeasibility of alternate plans or demonstrating the diminishing or lower returns of others that are feasible. The idea that "more will get you more is not true in the lodging industry. Timing and quality leading to consistency are what ultimately prove most beneficial in a capital or maintenance program. Furthermore, the appraisal must deal in terms of '

200

Hotel Investments

dollars rather than percentage relationships, to ensure that sufficient capital is made available.

The Hotel's

Affiliation

Just as the hotel's physical configuration and condition directly does its affiliation. Although this topic has been given an entire chapter in this text, its importance to the valuation process should be noted here. Over the past few years, property owners have closely examined the contribution associated with the flag on their properties. As ownership has consolidated and franchise companies have expanded, options have increased substantially for hotel owners. The temptation is to blame a hotel's poor performance on its affiliation, which clearly is not entirely fair. However, given the potential contribution that can result from a reservation and support system, an accurate analysis of a property must gauge the success of its present affiliation. Opportunities to convert a property may range from nonaffect its ability to generate revenue, so too

existent to numerous. It is the responsibility of the appraiser to identify the affiliation that will maximize the property's Vcilue. Offering alternate values can be extremely useful, especially if the owner intends to pursue a flag that does not maximize the value of the property. Performing such a multiple-value analysis can be costly on the front-end but yield material benefits over the long term. Sometimes overlooked costs associated with franchise conversions that the appraiser must consider include termination fees, legal fees, and product improvement plans associated with the new company. Once again, the tests for whether to convert are economic feasibility,

return on investment, and

maximum

vadue attainment.

The Hotel's Risk Rating

An appraisal must analyze the multitude of factors that influence the risk rating of a property. Rates derived specifically from the market remain difficult to come by for some lodging products, given the dearth of meaningful sales that have occurred. Most active have been the budget and limited-service segments, with recent increased activity in the mid-priced and full-ser\ace segments. As a result, price and yield parameters were based on the property- t\pe that was selling. An examination of investor -survey data specifically targeted toward the lodging industry reveals a gradual decline in debt parameters over the last 18 months, which has translated into a gradual reduction in internal rates of return. This, in turn, leads to higher property values, which potentially pro\1de economic justification for other programs that heretofore were not feasible hence the ever-chcinging nature of market value. Hotels compete for debt and eqviity capital with all t^pes of real estate eind non-real estate investments. Return requirements, both debt and equity, have always been substantially higher for hotels than for the more conventional contractual income streams that

—

Valuation: Regulation Versus Reality

201

come from shopping centers, apartment complexes, and office buildings. This is generally thought to stem from the management intensiveness of hotels and the business aspect of the cash flows that are collateralized. An appraisal of a hotel that is faced with a possible renovation, repositioning, or re-affiliation must be sensitive to the incremental risk that stems from each possible alternative. With an accurate market-based risk rating, coupled with sound projections, an appraiser should be able to render a sound opinion with supporting rationales. Market Conditions Unfortunately, external forces can negatively affect the best most efficiently run properties in both bull and bear markets. Value is greatly influenced, therefore, by the market conditions at the time a sale is contemplated. The merit of alternate values can be plainly seen when positioned against market value. As markets change, values change, yet an estimate of market value is like a photograph, portraying the value that exists at a specific point in time. Gauging and offering alternate values, all of which are based on the conditions that are known or foreseeable as of the effective date of the appraisal, enables the user to better understand and act pro-actively to the changes that lie in the future. Reactive policies often result in more dramatic swings in property value as compared to those which are pro-active. Clearly, ownership or management has no control over changes that are external to the property, yet to the degree that external changes can be softened by internal policies, value changes can be softened. kept,

Conclusion Throughout this chapter the emphasis has been on the appraiser's ability to accurately quantify the cost and benefit associated with renovating, re-flagging, or simply improving the operations of a hotel. The benefit initially refers to the impact on operating income. The ultimate benefit, which is measured against cost, is the translation of those earnings into an expression of value. While to some the concepts of highest and best use and alternate values may appear elementary, the vast majority of appraisals do not effectively take these concepts into consideration. Qualified appraisers who use these concepts can provide invaluable information to managers, owners, and potential investors, producing appraisal reports that can be extremely useful tools in the decision-making process. Self-promulgated standards, in concert with federally mandated state licensing, have served to focus and elevate the quality of the appraisal process to the point where today a well-constructed appraisal should contain a broad range of information and alternatives to assist the financial and investment community.

10 Taking the Gamble Out of Hotel Investment Strategy By Robert

j.

Crawford,

Jr.

Robert J. Crawford, Jr., is President and Jounder of Hospitality Resolutions. Inc.. a professional advisory firm

in Natick.

Massachusetts, specializing

in restoring

and

recovering hospitality values. A recognized and experienced hospitality executive, he previously was a Senior Vice President at the Stratton Mountain Resort in Vermont and was Vice President of Finance for the hotel division of the Howard Johnson Company. His experience also includes directing the strategy for a diversified hotel portfolio at a major Northeast financial institution.

it this far in the text, you have come appreciate the inherent risk involved in any hospitahty investment strategy. My colleagues have helped you identify that risk and have offered numerous recommendations on how to avoid a flawed strategy in hospitality investments. Let me offer a few words of caution: A hotel is an operating business with a minor real estate component. Hotel investments are both capital- and operatingintensive. The value of a hotel is principally based on operating cash flows. As an investment, a hotel offers a significant and continuing risk environment. Investments involving risks often become "troubled." Whether you are a hotel executive, a consultant, an investor, a developer, or a hospitality student, your ultimate success could well be governed by how you deal with a troubled hotel loan, asset, or investment. This chapter is designed to help you meet that inevitable challenge. You may want to keep this book handy as you proceed in your career. If you do, you may want to fold the corner of this page so you can refer to this chapter quickly when you encounter your first troubled hospitality loan, asset, or investment. You may find that this practical advice could save your career. If so, great! Perhaps this chapter will help you resolve an investment problem for a friend, a colleague, or an institution that has an investment in your

CONGRATULATIONS! By making to

hotel.

203

204

Hotel Investments

this chapter assumes that you know how to recogand acknowledge the signs of a troubled hotel loan, asset, or investment when you encounter them. If indeed you are not able to recognize and acknowledge the obvious signs of troubled loans, assets, and investments as they appear, you won't need to read this chapter. You may, however, want to spend some time updating your resume or getting reacquainted with members of your profes-

By the way,

nize

sional network. Many of my colleagues with interrupted or altered career paths were not victimized by a troubled hospitality investment. Nor were they affected by trying to deal with the troubled investment. Their downfall was caused by their failure to recognize a troubled hospitality loan, asset, or investment. Recognition skills can be readily acquired regardless of your professional discipline (finance, operations, marketing, dev^elopment, legal, etc.). Developing and refining your recognition skills are prerequisites to a successful career.

Workout Strategy For the balance of this chapter, we are going to talk about strategy. This type of strategy was once thought to be practiced solely by experienced bankers and other members of the financial community. Such is not the case today. Ex eryone who has any direct involvement with a troubled hotel, regardless of their professional discipline, must acquire a skill for developing and administering workout strategies. There are workout strategies that apply to the operation, marketing, finance, and administration of a hotel. Further, there are workout strategies that apply to capital investment, asset sales, and even asset disposition. Hotel executives in any capacity need to practice workout strateg\'. Bankers and financial executives for insurance companies and pension funds need to concern themselves with workout strategies for credit recovery, loan administration, asset management, and v^alue recov-

workout

ery plans. Lawyers need to understand workout strategies to deal liability, and bankruptcy proceedings. Even members of the trade press and the financial press need to understand workout strategy in order to better communicate news of corrective measures being applied to distressed properties. Professional mcinagers in every discipline, and their ad\asors. need to know how to develop and implement workout strategies. For our purposes, we will work with a very broad definition of workout strategy, one that can be further refined for specific application within any professional discipline:

with foreclosure, lender

Workout strategy

—

a planned course of action designed to improve current results. The strateg\' represents the how. not the what or the why. A comprehensive plan to achieve improved results is often supported by several complementary workout strategies, each focused on a particular issue or set of issues within a specific professional discipline. Workout strategies can be focused on marketing, operations, finance, inv^estment policy, or any other

205

Taking the Gamble Out of Hotel Investment Strategy

element involved In operating or administering a hotel loan or asset. Typically, workout strategies alter or may even replace the initial

strategies that failed to achieve satisfactory results.

That definition should suffice

for

our present purposes, but

you are free to further refine it as you practice the art of developing and implementing effective workout strategies. When you think about it long enough, you will readily recognize that, in some troubled time, you have had the experience of developing workout strategies. Those strategies may or may not have been effective. Think for a moment of those that failed. Later in this chapter, I will share with you a disciplined system designed to improve the effectiveness of workout strategies formulated and implemented for troubled hospitality investments. For now, however, I want to share with you a very easy method of disciplining your emerging workout strategy skills. It's a method have used for over ten years, in four different professional environments. It has worked equally well in small or large companies and it has worked well for my current and former clients. For me, it has yielded more successes than faikires, and am sure it will do the 1

I

same

for

you. Just give

it

a chance.

Remember

the

Gambler

Most of you will readily recall the opening lines of a song made popular by the country and western vocalist Kenny Rogers the song, "The Gambler." Even those of you who can't remember the melody will not forget the words after you have read through them

—

just once:

Know when Know when

to hold 'em. to

Know when to fold 'em. Know when to rim.

walk away.

gambler was successful. More forced to attribute that success to his simple statement of strategy. We can now imagine what led to the formation and implementation of that successful strategy. By looking at the song lyrics again, you will recognize it was a basic, yet comprehensive workout strategy presumably designed to yield improved results more money for the gambler than for his opponents. Since I never met the gambler, I will need to postulate what led to his success. That's an exercise in deductive reasoning that you can do

The song leads us importantly,

to believe that the

we are

—

along with me. We could probably agree that the gambler thoroughly understood the strength of his own hand. As a seasoned card player, he could readily visualize which cards to keep and which to discard in order to improve his position. He probably also had a good feel for the strength of his opponents' hands. If he didn't, he could observe how they go through the draw. He had probably met some of these opponents before, so he understood their method of operating. He could probably even read their appearances and know whether

206

Hotel Investments

they had a strong hand or were running a bluff. He could also tell whether he or his opponents were experiencing a run of luck. He could glance around the table to see how much money each opponent had at his disposal. He knew the amount of money available would impact their playing strategy. He then pondered his alternate strategies: whether to draw, fold, bet, or raise or when and whether to call. Finally, once he was comfortable with his decision, he implemented it and let it stick. There was no way to go back. Even after he was done, he watched the balance of the hand being played out. always observing the action and appearance of his opponents. Even if he wasn't in the game, he knew his observations would assist him in his next play. He recognized that his competitors' positions were constantly changing and if he could identify an emerging weakness, he would subsequently try to capitalize on it. The gambler was confident that if he focused his attention on the game, constantly evaluating his strength and his opponents" weaknesses, he would ultimately win. Or, if he were outmatched, he would contain his losses and live to play another day. 1

egy

would propose that the gambler was following a natured

—an important concept for us to examine. The Concept

strat-

of Natural Strategy

asked you to think of occasions where you applied be an appropriate workout strategy' but it failed to achieve the desired results. Try to recall another situation, one in which you applied a strategy that had worked well before but when applied again, it failed miserably. I would venture to suggest that when strategies fail to meet your expectations, it is often because they are unnatural strategies. Natural strategies usually Recall that

what appeared

1

to

achieve the desired results. Could we agree that Napoleon's march to the Russian Front with an ill-equipped army was an unnatural strategy'? Further, could we agree that Sadam Hussein's strategy to invade Kuwait in the face of hostile U.S. threats was an unnatural strategN'? Conversely, could we agree that the emerging strategx- of AT&T to expand its lines of business to include transmitting cable broadcasts and other forms of entertainment media through its communication networks appears to be a natural strategy? Could we agree that Disney's strategy to develop its own hotels at DisncN'world was a natural strategy? Finally, could we agree that the strategy- to publish this book, and indeed even to include this chapter, was a natural strategy? Ponder those issues for a moment. Later, if you hav^e access to a group, debate these issues. Are there different points of view among members of your group? If there are, try to understand those differences. Try some other examples. As you do so. you will be learning about the application of natural strategies. You will come to understand a very powerful concept. Keep in mind that

Taking the Gamble Out of Hotel Investment Strategy Exhibit

1

What are

The Concept

of Natural Strategies

natural strategies?

•

Strategies that are most likely to work

•

Strategies that are appropriate to the asset

In

207

and environment

what ways can these strategies be helpful?

•

Preventing costly mistakes

•

Evaluating the reason for past failure

•

Identifying alternative strategies

•

Establishing liquidation objectives

•

Setting

•

Guiding an acquisition or recovery strategy

•

Establishing appropnate operating objectives

•

Identifying factors critical to successful workout/investment

right, realistic

expectations

Source: Hospitality Resolutions, Inc.

natural strategies tend to yield satisfactory, if not superior results, while unnatural strategies tend to yield unsatisfactory results, and sometimes even lead to disaster. Exhibit 1 summarizes what we have learned about natural strategies. Natural strategies are those that are most likely to work. They are strategies that are appropriate to the asset and to the environment. Pretty straightforward stuff, isn't it? I can assure you that if you keep this framework in mind when developing workout strategies, you will have fewer strategies that go wrong. Next time you formulate a strategy (and by the way, we formulate strategies all day long), simply ask yourself, "Is this a natural strategy?" You will be amazed at how you have mastered the concept and, like the gambler, you will be mvich more confident of your strategies. If an associate brings to you a strategy that seems to entail far too great a risk, simply ask whether the strategy is a natural strategy. If your associate is not familiar with the concept, share it with him or her and tell the story of the gambler. Once you have done so, you will have sharpened your associate s strategic skills. Now that we have mastered the concept of natural strategies, we will learn how to apply that concept in developing workout strategies for hospitality loans, assets, and investments.

Build Your

Remember

Knowledge

that the gambler

knew

the strength of his

own

hand, and he had a good feel for the strength of his opponents' hands. If he didn't, he knew how to quickly acquire that knowledge by observing their appearances. Remember also that natural strategies are those that are appropriate to the asset

and

its

environ-

ment. The gambler was probably following a natural strategy

-

208

Hotel Investments

because he knew his asset and his environment. How then do you gain sufficient knowledge to formulate effective workout strategies for hospitality investments? How do you gain the necessar\^ knowledge of the asset and the environment? First of all, you probably gain some knowledge from working with the asset or from reviewing the files. A complete file review is a good starting point, but it is never sufficient to dev^elop workout strategies. To supplement the historical view, you need a current view of the asset and its position within the competitive environment. There are a number of ways to acquire that additional information: you can visit the asset to build your knowledge quotient or you can seek assistance from a hospitality professional or an accomplished consultant within the industry. Your knowledge of the hospitality industry and the constraints placed on your time should be the primary considerations in deciding how^ to approach the task of compiling a complete analysis of the asset and its em'lronment. Knowledge of the asset and its environment is the foundation of effective workout strategies. Don't make the mistake of building your structure on a weak or outdated foundation.

The Hotel Value Recovery Grid Once

again,

clients to help

I

will

share with you a process we have used with

them formulate

effective

workout

strategies.

It

starts

with a disciplined review of the asset and its environment. First, look at Exhibit 2 the Hotel Value Recovery Grid. We use a computer assisted analysis to measure 100 critical elements related to the property and 100 critical elements related to the market. As we review each element, we rank the performance of the hotel or the

—

Exhibit 2

The Hotel Value Recovery Grid

? (part

Hotel Value Recovery Grid©

Source: Ho^>pitality Resolutions, Inc. (Registration pending)

1

Taking the Gamble Out of Hotel Investment Strategy

209

market on a scale from -5 to +5. Obviously, if an element has a very negative impact on our evaluation, it would receive a rating of -5. Conversely, if an element has a very favorable impact, it would receive a +5. Each element has been assigned a particular weight depending on the importance of the item to the strength of the hotel or the market. For example, the condition of the guestrooms would be given a heavier weight than the quality of the landscaping, but each is a measurable element in evaluating the strength of the hotel. Further, the strength of the local economy is weighted far more heavily than the attitude of local government, but each is a measurable element in evaluating the strength of the market. By utilizing a computer system, we are able to evaluate all of these elements and arrive at two composite ratings one for the strength of the hotel and a second for the strength of the market. Think about your hotel for a moment. You can probably identify many of the discrete elements we measure in the evaluation of a hotel and likewise many of the elements we measure to evaluate the performance of the market. Perhaps it would be helpful to review some of the major categories involved in the analysis. In evaluating a hotel, we divide the analysis into five segments:

—

Segment

Areas of Focus

Approach

Access, signage, exterior, security, etc. Lobby, front desk, facilities, etc. Appearance, furnishings, amenities,

Arrival

Guestroom

etc.

Management

Experience,

systems,

controls,

atti-

tudes, etc.

Competitive position In evaluating the market,

Facilities, value, reputation, etc.

we divide the analysis into three segments:

Segment

Areas of Focus

Demand

Local economy, leisure attractions, etc.

Community

Convention center, tourism bureau, etc.

Market

Market growth, business climate,

etc.

Each of these "areas of focus" is separated into measurable elements for the hotel and separable elements for the market. Each element contributes to the aggregate weighted rating for the strength of the property and a separate rating for the strength of the market. Now we will discuss what we do with these separate ratings. for a moment that the analysis leads to a rating of the hotel and a rating of 4-2.7 for the market. These ratings become the coordinates for placing the hotel on a specific location on the Hotel Value Recovery Grid, Exhibit 3.

Let's

-1-2.4 for

assume

210

Hotel Investments Exhibit 3

The Hotel Value Recovery Grid^

(part 2)

Hotel Value Recovery Grid©

M Weak

+5 Strong Hotel Strong Market

Hotel

Strong Market

p

P

-5

+5

Weak Hotel Weak Market

Strong Hotel Weak Market

M

-5

Source: Hospitality Resolutions, Inc. (Registration pending)

The location

of the hotel

on

this grid will lead

us

egies that are natural or appropriate for the hotel

to select strat-

and

its

environ-

ment. Note that in the case we have selected to illustrate, we would locate the particular hotel in a quadrant labeled "strong hotel, strong market." Once we have identified the particular quadrant, we can review those strategies that would be appropriate for a hotel located in that quadrant. We examine a whole series of natural strategies marketing, operating, fmancial. investment, and dis-

—

posal strategies. Before we go further in the application of the Hotel Value Recovery Grid and how this particular concept can assist in the evaluation of natural strategies, there are a few important issues to review. This concept is helpful not only in formulating strategies but also in evaluating strategies formulated by others. The latter feature is important because it enables a loan officer to evaluate whether strategies formulated by a borrower are natural to the position of the asset. If the borrower is following strategies natural for the asset, the collateral value of the asset is being maintained, or perhaps, even strengthened. On the other hand, if the borrower's strategy appears to differ from what would be natural strategies, the value of the collateral may deteriorate. Now we will examine strategies appropriate for hotels located in each quadrant of the graph.

Strong Hotel, Strong Market The central focus

of

all

and adminshould be to

the strategies for operating

istering a strong hotel in a strong

market

(Exliibit 4)

Taking the Gamble Out of Hotel Investment Strategy Exhibit 4

211

Strong Hotel, Strong Market Hotel Value Recovery Grid©

Strong Hotel, Strong Market

M

+5

Strategy: Sustain Strength

Candidate

for restructure

Invest capital

Market agressively Strengthen operations

Hold

to

achieve value

Target disposition

P

+5

Source: Hospitality Resolutions, Inc. (Registration pending)

sustain the strength of the investment. Typically, snch a property a market leader yielding superior operating and financial results. Capital should be reinvested on a periodic basis. The property should be marketed aggressively to attract more than its fair share of market demand. As a market leader, this property will always be the target of competitive marketing efforts. Operating strategies should be designed to take advantage of the property strength and to deliver a very consistent product. To achieve optimal results, this property should be managed by a strong hospitality team. As for investment strategies, a strong hotel in a strong market should be held to achieve an appropriate value. In the event an owner or investor chooses to sell or dispose of the property, he or she should consider a very targeted marketing program exposing the property to a limited number of well-qualified buyers who are capable of recognizing the strength of the property and willing to meet the seller's expectations for price. This property is not a distressed hotel. Could a hotel in this quadrant become troubled and be the subject of a loan workout strategy? Unfortunately, there are a number of conditions that could lead to such a consequence. Perhaps the hotel was financed for a five-year term and the note is now maturing. Current financing markets may not have an appetite for new hotel loans. Or perhaps the hotel, while yielding strong results, is simply over -leveraged. Acquisition and construction costs of the late '80s rose to extraordinary levels, and a number of strong hotels have difficulty achieving sufficient cash flows to service debt, particularly if the hotel was financed at 100% of construction or acquisition costs. Wliile not all strong hotels in strong markets is

212

Hotel Investments

become troubled investments, there are some that do and thereby become the subject of workout strategy. If a strong hotel in a strong market becomes a troubled hotel it is appropriate to consider a loan restructuring strategv'. An appropriate loan restructure (extending the term, reducing the interest rate, or spreading out the amortization) could permit the property to be viewed as a performing loan. Presumably, the increasing value of the hotel over time would strengthen the value of the collateral. An effective loan restructure can often yield far more satisfactory results than an ill-timed foreclosure. As long as this hotel continues to be operated and managed with strategies similcir to those outlined above, values will recover over time.

loan,

Strong Hotel,

Now

Weak Market

examine strategies that are appropriate

to a strong (Exhibit 5). Typically, a hotel in this quadrant was once a strong hotel in a strong market. The market then deteriorated. Often, the market collapse was brought on by a plant closing or some other form of economic contraction. Sometimes market conditions deteriorate as a result of new hotels coming on-stream at a far greater rate than local demand can absorb. Many hotels fall into this quadrant. Think for a moment about hotel markets formerly supported by significant defense contractors. Those markets may have been populated by a number of newer hotels all exhibiting strong operating and financial performance. Suddenly the market changes to a weak meirket as defense spending is dramatically reduced. The reduced level of let's

hotel in a

weak market

Exhibit 5

Strong Hotel,

Weak Market

Hotel Value Recovery Grid

Strong Hotel,

?

Weak Market +5

Strategy: Protect Share

Restructure with caution

Only selective capital Agressively build share Control costs

—

M

NO! NOI

build

Liquidate a mature

-5 NOI

— net operating income

Source: Hospitality Resolutions, Inc. (Registration pending)

Taking the Gamble Out of Hotel Investment Strategy

demand may not be recoverable. The change may well be permanent.

213

in mcirket conditions

The central focus of strategy for a hotel in this quadrant would be to protect its share in a very competitive market. Without a strong focus on protecting share, hotels in this market condition could fail. Capital investment in such a property should be carefully evaluated. Market conditions may not permit the level of increased occupancy or increased rates necessary to recover the capital invested in a strong hotel in a weak market. Excess investment in weak market conditions may only result in a further deterioration of the already unsatisfactory financial returns. This cautious investment policy does not preclude maintaining the property at an appropriate level, but it may preclude an expansion or even an extensive renovation. Marketing strategies should focus on aggressively building share. Operators faced with these conditions will find themselves in a constant state of competitive warfare. Operating strategies, on the other hand, should follow tight controls in order to harvest an acceptable share of profit from a stagnant or declining revenue base. Pressure on maintaining bottom-line profits will increase. As for investment strategies, an owner or investor should consider a near -term liquidation strategy. Recognize that this hotel may begin to exhibit declining profitability that will ultimately be reflected in a steady value decline. If this hotel were to become the subject of a loan workout strategy, it could represent a very difficult case. With profits having matured and with values set to decline, it may not be a strong candidate for an extended loan workout strategy. The lender in this case may wish to consider an appropriate exit strategy such as selling the note or accepting a discounted payoff.

Weak Now we move on strong markets

to

Hotel, Strong Market those hotels categorized as

— those hotels located in the upper

weak

left

hotels in

quadrant of

our graph (Exhibit 6). The central focus of all the strategies for operating and administering such hotels should be to initiate change. Tj^Dically, a hotel in this quadrant is an under -performing hotel located in an otherwise strong market. Presvimably, if the weak element can be identified and corrected, the operating performance of the hotel will improve dramatically as the hotel captures its fair share of occupancy and rate. Determine the weakness first. Is the hotel starved for capital and does it reflect an unacceptable room product? Often, such hotels are suffering from a pernicious disease known as capital malnutrition. Is the franchise affiliation appropriate for the hotel? Is the management team properly operating the hotel? Is the hotel marketing to a position of strength? Often, it is difficult to market this hotel without correcting the flaws in the product. Chances are you will find the weakness by reviewing, in depth, the marketing,

214

Hotel Investments Exhibit 6

Weak

Hotel, Strong Market

Hotel Value Recovery Grid©

Weak

Hotel, Strong Market

+5 Strategy: Initiate

M

Change

Questionable restructure Invest upgrade capital

Examine franchise Strengthen

management

Increase marketing Build strength or sell

Source: Hospitality Resolutions, Inc. (Registration pending)

operating, and capital investment strategies for the hotel. Take aggressive action in affecting a corrective strategy; monitor that strategy and look for results to improve. Often, such a hotel becomes a candidate for a loan workout strategy because it is under -performing. It is important to recognize that the hotel can only become a candidate for restructure if the element contributing to the weak performance has been identified and a corrective strategy has been set in place. There is little reason to expect a change in performance without a change in strategy. Restructuring a loan after the necessary corrective surgery can yield a significant uplift in the value of the collateral.

For an investor or owner, selling a hotel in a weakened condian appropriate value recover^'. On the other hand, for a buyer or potential investor, identifying and understanding a hotel in this category can lead to extraordinary returns. Hotels in this category are readily recognized as prime candidates for acquisition by experienced and well-capitalized hospitality investors. tion does not yield

Weak

Hotel,

Weak Market

Now we are ready to identify what strategies are appropriate for a weak hotel in a weak market a hotel located in the lower left corner of the grid (Exhibit 7). There are many hotels in this category. Typically, they are older hotels in secondary locations. Time has passed them by as acceptable hotel products. Capital reinvestment cannot be justified and the hotels continue to deteriorate.

—

Taking the Gamble Out of Hotel Investment Strategy Exhibit 7

Weak

Hotel,

215

Weak Market

Hotel Value Recovery Grid*?

Weak

Hotel,

Weak Market

-5 Strategy: Containment

Not a restructure candidate

Minimize capital spending

Market to a niche segment

Downsize operations Contain operating costs Liquidate early

5

M

Source: Hospitality Resolutions, Inc. (Registration pending)

When I review this category with client groups, I often ask if there are any golfers in the audience. By the way, I find that golfers seldom admit to their favorite pastime lest they be viewed as taking time away from their jobs. While I seldom get a large show of hands 1 am confident that the entire audience, including the reluctant golfers, knows what 1 mean when I say that if you have hotels in this category, "Tee them high, and let them fly." Far too much money and effort have been expended to attempt to restore the performance of these hotels. They represent the excess inventory of under -demolished product. Ignoring these facts, if indeed they are present, can lead to an interrupted or altered career path. There is no greater way to improve the economics of the hospitality industry than to permit the old weak hotels in declining markets to simply disappear. If you are required to operate one of these properties for any period of time, the operation should yield to a downsize strategy. Capital investment should be minimized. The property could possibly be marketed to a niche not currently serviced at an attractive budget price. All the efforts at the property should be focused on an early exit from this troubled investment. at the question.

Conclusion There you have it! I have shared with you what have learned from the song of the gambler. It is referred to as the concept of natural strategies applied to hospitality investments. It's pretty straightforward stuff. You could say it relies on common sense. Then again, many of us have heard the Will Rogers quote, "Common sense is not very common." I truly believe that if you practice I

216

Hotel Investments

some of the concepts and strategies noted in this chapter, you will experience more successes than failures in dealing with hospitality investments. One final thought. While these principles and concepts were developed for dealing with hospitality investments, there seems to be no reason these principles and concepts couldn't be applied to other forms of commercial real estate, including office buildings, shopping centers, or other troubled real estate investments.

=

11

Hotel Asset Disposition By Jeffrey

S.

Wilder

Jeffrey S. Wilder is owner and President of the Wilder Group, Inc.. a nationally known, award-winning, boutique hotel brokerage and advisory firm that has served the lodging industry since 1981. He supervises the operation of numerous Jirst-class Jranchised and independent hotels, has contributed over 120 published columns on hotel finance and brokerage to major trade publications, and is a member of New York University's Hospitality Advisory Board. His experience includes over a decade with Helmsley Spear, Inc., where he was Senior Vice President of Hospitality Services. In that capacity, he worked closely with Steve Brener, who was his mentor friend, and partner He also is a former President of Hotel & Motel Brokers of America (HMBA), of which Wilder Group. Inc.. is the New York-based member.

PEOPLE DISPOSE OF HOTELS for a Variety of reasons. Among the most common motives for sale are making a profit, ending a cash drain, unwinding a syndication, paying off debt, avoiding new debt, thinning out inappropriate properties from investment portfolios, avoiding intensified market competition, or simply retiring. Most institutional owners of lodging properties will confirm the 20/80 rule 20% of their investments take up 80% of their time. You can be assured that, more often than not, many of the properties in the "20% pot" are hotels. Lodging properties are management-intensive devourers of capital and time. They are usually vulnerable to intense rate and occupancy pressure from competitors and require constant cash flow monitoring and staff supervision if they are to turn a profit. When it comes time to sell, you want to be sure that you know what you have to sell, understand how best to market it, minimally disrupt the ongoing business of the hotel, and maximize your

—

value.

Determining What You Have

for Sale

Once you decide it's time to sell, you must, naturally, objecwhat you really own. It's often said that a hotel is not

tively look at

real estate but rather a business.

I

don't believe that

—

it

clearly

is

217

218

Hotel Investments

both. A hotel's ability to mortgage or lease a site- specific fee and depreciate assets lends it the coloration of real estate. Yet. the exigencies of managing and marketing the operation going on inside just as clearly make it a business. A hotel is a product with a bundle of rights and obligations. Two of the most important obligations that need be considered in deciding what you have to sell are the franchise and management contracts often associated with lodging operations. Both the franchise and management contract may impart value. It is valuable to know that the franchise is issued to the hotel owner/ operator, not to the hotel. Its life may end when the hotel is sold: the goodwill and benefits of the franchise terminate when title passes or the stock of the operating entity is sold. The incoming operator needs to make a fresh franchise application and meet the franchisor's current guidelines for continuation of the affiliation to be assured. Several years ago, 1 was asked to market an older franchised property for an insurance company. The 150-room hotel, in Albany, New York, earned a net profit of around S500.000 and the owner priced it for sale at $3,500,000 (seven times the profit). Since the franchisor is constantly concerned about the quality of its chain's product, hotels need to meet certain physical requirements and standards in order for that franchisor to agree to write a new affiliation contract at the point of sale (or conclusion of the existing agreement s term). In the example at hand, the franchisor felt tlie property did not represent what it envisioned for the brand in the marketplace. Therefore, it offered to renew the license for a term of only five years rather than the more traditional ten-year -plus period. The franchisor required that the new purchaser completely upgrade the hotel to current franchise standards. This policy decision, which in my judgment was appropriate, required a fresh capital investment of over $1,000,000. In other words, the ability of the hotel to continue receiving affiliation/reservation benefits and preserve its $500,000 net profit level demanded the expenditure of significant capital beyond the acquisition funds. There was little assurance that the franchisor could give to the buyer that the affiliation would extend beyond the flv^-year term offered. Once the buyer understood the impact of the franchisor s decision, he reduced his purchase offer to the seller by one

third— $1,000,000!

When the seller loudly objected, 1 remember tlie franchisor's representative telling me to "let the insurance company o\v^ler know that half the hotel value is in its real estate and half the \ alue is in the franchise. While the preceding is somewhat overstated, there was significant truth in that assertion. Any franchisee that loses its affiliation and faces the day of reckoning when that reservation machine goes silent will attest to the critical importance of keeping an appropriate brand name on the building to retain over"

all

hotel Vcdue.

— Hotel Asset Disposition

Many "uneducated

sellers"

who

initially

turn a blind eye

219 to the

rights and importance of the franchisor are soon awakened from their ignorance, and the overall selling price is adjusted accordingly. What you have to sell may be. and often is. also affected by an

existing franchise contract's early-termination clause. A number of years ago, I was engaged to sell a franchised property in St. Louis. Missouri. The hotel was sold to a customer who elected to convert the property to another brand. Unfortunately for the seller, the purchase contract did not reqviire the buyer to continue the hotel's current affiliation. This called for early termination of the franchise contract with the existing franchisee /seller. The franchisor's reaction was to simply tote up what it otherwise would have earned over the remaining life of its existing agreement and present a bill to the seller for a mid -six- figure settlement. It had the effect of reducing the overall net consideration that the seller received for his equity by about 40%! Regarding management company contract rights, recent court cases in Maryland and elsewhere have had the effect of slamming a two-by-four over the owners' heads to wake them. If you sign a management contract, you are giving a company the right to earn substantial fee income over the term of the contract. Make sure you have a well-negotiated right to terminate. And be aware that termination fees in these agreements may be substantial as well. Since management companies are quite competitive, it is worthwhile to point out during contract negotiations that it is your equity at risk, not theirs. If they don't offer a liberal back-door clause, it is in your interest to show them the front door. When you sign a franchise or management agreement, their benefits surely have the potential to add value to what you own but your financial responsibility to the franchisor and /or the managing agent just as surely needs to be accounted for. You should be sure you have a way out of these contracts, at a cost that is not onerous. Naturally, the appropriate time to negotiate the "back door" is before you sign the franchise or management agreement not when you wish to terminate it.

what you have to sell is affected by government regulaenvironmental issues, conformance to the Americans

Finally,

tions

(i.e.,

with Disabilities Act, and the like), local competitive conditions, the assumability of existing financing, and liquidity in the debt and equity marketplace. This discussion regarding the determination of what you have to sell is not meant to be all-encompassing. However, I have used examples meant to illustrate that the capitalization of current income, by itself, may be an insufficient method of arriving at the value of what you own. Can you keep your franchise and /or management company in place? Indeed, do you want to? What are the costs associated with continued affiliation? What is the effect on business of early termination? These questions, and others, all need to be analyzed before

you can

get at

what you

truly have for sale.

220

Hotel Investments

Alternative Sale

Methods

Let's say you've committed to sell and are now faced with the decision of how you Intend to dispose of the asset. Three common alternatives are: •

Hire a broker.

•

Sell

•

Consider an auction.

it

yourself.

Hiring a Broker

The

traditional,

lodging property

is

and probably most

reliable, method of selling a through the use of a qualified hotel broker.

a specialization that demands financial and legal market acumen, product knowledge, networking skills, negotiating talent, and writing/ editing ability. The experienced hotel broker has usually faced the challenge of getting a deal offered and successfully sold hundreds of times before. It's safe to assume that the lodging broker specialist has faced almost every conceivable consideration or obstacle that a hotel transaction could present and has a variety of solutions and a perspective that helps move the transaction toward a successful conclusion. Often, brokers such as those in Hotel & Motel Brokers of America (HMBA) work together in a co-brokerage relationship in order to meet a client's needs. HMBA is a nationwide association of 50 lodging property brokerage firms that has been in existence since 1959. Whether you hire an independent broker or one associated with a specialized network such as HMBA, it is naturally important to check the broker's credentials and recent closing record before hiring him or her to sell your multimillion dollar investment. Selling hotels

is

expertise, franchise familiarity,

Selling

It

Yourself

Sometimes, an owner feels that the best course of action is to attempt the direct sale method. Perhaps the owner knows a series of logical buyers and wishes to "save" a brokerage commission: perhaps the owner is concerned that the hotel operation will suffer if it becomes common knowledge that the property is on the market: or perhaps the owner won't agree to give any one broker the exclusive agreement that most good brokers today require. The seller, who is usually unaccustomed to offering a hotel property for sale, must commit himself or herself to preparing a first-class property offering brochure, sourcing and screening customer prospects, and negotiating directly uath buyers. Most owiiers do not elect this route, since they are often not as experienced as the hotel broker in marketing a lodging facility.

1

Hotel Asset Disposition

22

Auctioning

The auction approach to selhng hotel property enjoyed a in appeal as an adjunct to more traditional hotel disposition methods beginning around 1990. Most people in the hotel industry understand the depressing impact on hotel employee morale and transient business that develops once it becomes known that a growth

be auctioned. Discretion in marketing a hotel that is to lodging industry professionals responsible for the operation itself. Ownership instability is usually unsteadying to the business. Yet. when the Resolution Trust Corporation became responsible for liquidating an incredibly large portfolio of real estate, auctions became an important vehicle for quickly pushing property back into private hands. During the early '90s, some hotels were naturally auctioned as part of this process. After the RTC popularized the approach, private attempts to auction hotels began. This is a way to market property sales in the hope of maximizing value and clearing inventory; auctioning is also a way of selling hard-to-market property, as well as generating commissions for the auction and brokerage houses involved. The record of success with this approach is spotty. Sometimes, properties do not get offers that hit or exceed the reserve price (also called the upset price), and the hotels are withdrawn from auction. Often, the auctioned properties are sold at moderate value levels. I suspect that this occurs for several reasons. First, there's a lot of diligence involved in buying a hotel, and most buyers seem unwilling to invest the time necessary for open competitive bidding. If one physically goes to the auction and makes a bid, it's likely to be very conservative, so as to leave a cushion for "analysis of value" error. This is in contrast to private sales of lodging properties wherein buyers are far more willing to become involved with inspection, indepth operational analysis, consideration of alternate franchise affiliation opportunities, working capital costs, legal compliance requirements, and so forth. Since the analysis of hotel value requires such diligent review. I believe professional buyers simply are property

will

for sale is

most important

often unwilling to make the time commitment if they don't believe that a seller will engage with them in serious private negotiations.

Finding a Broker Locating a qualified hotel broker is primarily accomplished through personal contact, recommendation, review of brokers' ads in lodging industry periodicals (such as Lodging Magazine. Hotel & Motel Management, and others), and contact with national broker networks such as the Hotel & Motel Brokers of America. Sometimes, regional or national real estate firms that do not specialize in hotel brokerage can produce qualified customers, but these firms are not usually in the river of information available to lodging property broker specialists. Finally, active brokers may well contact hotel owners to see if they may be thinking of selling.

222

Hotel Investments

It is

relatively

some questions •

Does the

office infrastructure have systems in place to tap into extensive hotel purchaser databases? Does it have the templates, resources, and knowledge to create first-class property

offering •

easy to determine broker qualifications. Here are

that should be answered:

packages?

How many cently?

sales (both size

and

type)

has the broker closed

•

What

•

Is

• •

What costs does the broker cover (i.e.. advertising, What do the broker's brochures look like?

•

Does the broker furnish monthly written progress reports?

•

Have you spoken with

•

Do you

is

re-

Where? the broker's policy on co-brokering?

the broker licensed in the state where the business conducted?

feel

clients the broker

will

be

travel)?

has represented?

comfortable with the broker?

Many institutional sellers have created request-for -proposal (RFP) formats in order to get at all this information. They send these RFPs out to three to five brokers and make their selection by reviewing the completed proposals and personally meeting the brokers. Private sellers are less likely to go through this formal approach and will generally rely on a more informal and personalized method of broker selection. Yet. "liking the broker" is simply not a good enough selection method. Diligence on the part of the seller in selecting a broker is likely to be rewarded with a positive outcome and a successful closing. The

Listing

Agreement

There are three t5^es of

listing

agreements that are generally

used: •

This format, which may be oral or written, the broker brings a buyer to the seller and the deal closes, the broker will get his or her fee. It does not obligate the seller to work solely with that broker.

The open

listing.

simply says that

•

if

Exclusive agency. This agreement is almost always wTitten and it obligates the seller to work through one broker for a specified period of time, traditionally six to nine months. It should be noted that the seller does have the right to sell the hotel directly to another principal, in which case no brokerage com-

mission need be paid. •

Exclusive right to

sell.

This agreement

is.

also,

almost always

obligates the seller to work with one broker for a period of time, usually six to nine months. All customers or brokers that are interested in the property during that period in writing.

It

Hotel Asset Disposition

223

of time axe directed to the exclusive agent. Even if the owner sells the deal "directly," a commission is deemed necessary.

Mutually Acceptable Terms

The basic questions that should be addressed agreement are: •

Wliat

is

•

What

is

in

any brokerage

the length of the agency relationship? the

amount

of the

commission and how

is it to

be

paid?

•

When is the commission earned? Who pays for marketing costs?

•

What

•

is the broker's responsibility vis-a-vis preparation of the property offering brochure, working with co -brokers, providing formal update reports, and absorbing certain marketing costs?

At the minimum, these five issues should be discussed, agreed upon, and be in written form.

The Relationship Once an owner has selected a broker, both must make sure that they are truly on the same side pragmatically, not just contractually. To the practical extent possible in any temporary relationship, each party needs a clear idea of what to expect from the other. The initial interview process and subsequent listing agreement negotiation are two excellent places in which to express each other's needs and expectations in a candid and forthright manner. The broker must accept the assignment with the idea of maximizing the seller's value, not the broker s commission. Too often, brokers try to keep co-brokers at arm's length in the hope of selling the property directly and earning 100% of the commission. All would agree that this is human nature, but it clearly is not always in the seller's best interest, nor does it conform to the Law of Agency. Human nature must be restrained by the ethical and legal requirements of the agency relationship. On the other hand, it is wise for the broker to keep control of the offering process. Hotels are valuable "going business" assets and the sale of such properties must be marketed professionally and discreetly. Brokers should be given the avithority to screen both potential customers and co-brokers in order to determine if they are appropriate receivers of the valuable, private information available in the property offering brochure. After all, the brochure contains P&Ls, existing debt financing, purchase money debt proposals, and other facts and assumptions that are really quite privileged information. Owners must be open to accepting their broker's advice and counsel regarding the selling price and terms necessary to move the asset. This demands a trust between owner and broker that is central to the success of their relationship. Both parties

224

Hotel Investments

be cooperative in providing information, insights, and the hotel is to attain its maximum realizable value. Finally, let me say a word about brokerage exclusives from a professional broker's point of view. Sometimes, owners want to maintain the flexibility that they believe an open listing provides. Really, what they usually receive is a catch-as-catch-can "one shot" effort by the broker. Brokers, who are only paid upon closing, are usually unwilling or unable to devote the diligence or staff time necessary to professionally market a hotel under an open listing arrangement. There is usually neither the level of trust or confidence present in this type of relationship that is so essential in achieving an owner's goals. The broker who receives an exclusive assignment clearly understands that he or she has won the confidence of an owner who is relying on the broker to achieve a successful result disposal of the hotel asset. The broker accepts a high level of responsibility- and is invested with a client's trust in his or her ability to perform. The professional broker is obligated to spend the appropriate time necessary to assemble a first-rate property brochure and develop sales pricing and a strategy that gets the job done. And brokers are morally obligated to spend their time and assets on behalf of those who have granted an exclusive. Other business, such as open listings, cannot achieve the same level of importance in a broker's office. I believe an owner is best served by choosing one broker and investing that company with the responsibility of maximizing value in the marketplace and concluding a transaction on the seller's behalf.

ought goals

to

if

—

The Broker's Opinion of Value If you've elected to sell a hotel through a broker, there are three opinions of the property's value that couxit: yours, your broker's, and that of the marketplace. If only the harmonious svTithesis of all three were the norm; usually that's not the case. Your agent s opinion of value is important because he better believe in the offering price, or there is a fatal flaw in your relationship. The best way to understand your broker s opinion of value is to ask for a written analysis, having first provided complete, detailed hotel information subsequent to the broker's property and cirea

visit.

In order for a realistic "guesstimate" of value to you'll

need

be generated,

to provide:

P&Ls

•

Several years'

•

Structure of post-closing debt assumptions

•

Costs of maintaining the brand

•

Costs to meet

•

Available market

all local, state,

affiliation

and

federal laws

and property information, including appraisarea economic development material, site facts, and other data in your possession that affect value als,

Hotel Asset Disposition

The

225

must remember

that the broker is usually providing hope of winning the assignment. One should not expect the level of analysis that a prepaid appraisal may develop. Yet, what the owner will receive from the broker is a good idea of what price range is acceptable to the current hotel purchaser market. Realistically, a broker's desktop analysis of value without a site/area inspection is, in my judgment, inadequate. The broker must develop his sense of hotel value by: seller

this professional analysis gratis in the

•

Inspecting the property and understanding the cost of modernizing and conforming it to relevant codes

•

Analyzing competitors

•

Visiting with the

•

Studying area road patterns

•

Analyzing

•

Studying the subject's performance

management team and

demand

franchisor

generators

identifying its strengths

in the

marketplace and

and weaknesses

is going on in the marketplace and could potentially affect future performance

•

Determining what

•

Examining alternative franchise and repositioning ideas

how

it

It is only after really understanding the specific product and market the hotel serves that one can give an educated opinion of value. The knowledgeable hotel broker brings the eye of a realistic market-driven expert with good perspective and a keen appreciation for "vision" to his or her analysis of value. Understanding and selling "vision" to the hotel buyer is the broker's responsibility. Poor management equals earnings under -achievement: a tired hotel with a dose of capital expenditure can increase both occupancy and average daily rate (ADR). A change in the niche market may bring improved gross income and /or net profit. An alternate brand affiliation may also improve earnings. All these factors, and more, race through a broker s mind during the inspection trip. Since the hotel broker's customer database consists primarily of hotel entrepreneurs, the buyer will appreciate a cogent view of the property's potential. The buyer s talent and hard work should give reality to

the broker's vision. The vision of selling what a hotel business can be, in addition to what it currently may be, is part of the art of brokerage. Yet, the broker deals in the real world of cash and credit in exchange for sticks and bricks, so his or her feet must be planted on terra firma when it comes to establishing a suggested sales price and terms. A broker's opinion of value will provide you with a good "guesstimate" of value by a realistic professional with knowledge, perspective, and understanding of what buyers in the current marketplace are seeking. Whether written or orally proffered, the broker's opinion of value serves as a good starting point for arriving at an olTcring

— 226

Hotel Investments

Both the owner and the broker are well served by educating each other in a healthy and realistic discussion of property value. Once both points of view are synthesized into an agreement on market value, it is time to get started with selling the hotel. price.

The Broker's Plan of Action Establishing an Offering Price and Terms Let's assume that the broker's opinion of value is in line with the owner's. There are a variety of financing structures to achiev^e a return on that value, among them: •

An

•

Seller financing for a portion of the selling price, in

all

cash sale

tion with a buyer's

down payment— usually

combina-

in the

15-35%

range •

Joint venture

•

Net lease

Outside influences that affect the offering terms of sale include third-party debt availability; (2) franchise appropriateness, availability, and cost; (3) financing considerations; and (4) tax con(1)

siderations.

Third-party debt availability is an important consideration. If your existing property debt is short-term and /or not assumable. it's a good idea to ask the lender to restructure to either extend the term or moderate the debt service payments. If the loan is due on sale and there is no likelihood of third-party financing, you may believe you're in a box, but you're not. You could consider net leasing the hotel, as title would not pass in that scenario and the mortgage would remain in place. One could envision structuring a triple net lease deal that sees the tenant pledge security up front or invest capital into hotel upgrading. The rental pavment would cover existing mortgage debt service and the difference would be an "in your pocket" return on equity. The tenant might receive a purchase option, exercisable once acquisition financing beccime more available. Franchise appropriateness, availability, and cost are other considerations. Is the existing affiliation the right one and. whether or not it is, what is the "all-in-cost" of changing or keeping it? Must you receive all cash, or are you able to hold purchase money financing? Often, creative owner financing can accommodate e£irly-year levels of thin earnings and allow for increased payments as time goes by. This allows the owner to achieve an increased price and the buyer to realistically manage cash flow the classic give-and-take scenario where both sides can win. Tax considerations often play an important role in deal structuring. A private owner who has taken considerable depreciation over the years may have a low tax basis. Often, the existing hotel

Hotel Asset Disposition

227

be in excess of that basis and a sale will involve booking a tax purposes, that is greater than the equity received at the point of sale. By way of example, let's say you have a $10 million hotel with a $7 million mortgage. You've owned the hotel for many years and your depreciated basis is $5 million. At sale, you receive $10 million, pay off your $7 million mortgage and you have $3 million cash in pocket. However, as far as the government is concerned, you've taken depreciation over the years and deferred taxes on income through depreciation sheltering. Now comes the day of reckoning. You have to pay tax on a $5 million profit, though you only have $3 million in cash. Since your tax is probably in the 35-40% range (depending on your state taxes and federal rules applicable at the time), you'll be paying to the government a significant portion of what you receive say $2 million in taxes on $3 million in hand. In this circumstcuice, it would be wise to consider deferring the gain by arranging to do an exchange transaction, wherein the equity gain you receive from the sale goes into the purchase of another property. You'd then defer the gain on the first hotel, have a new basis in your next purchase, and defer taxes for years as a result. Regardless of the deal structure or third-party influences on value, the bottom line is that hotels are sold on a multiple of perdebt

will

profit, for

—

ceived earnings. All other structuring considerations

bend

to this

reality of the marketplace. Capitalization rates for hotels historical-

range in the 1 1-13% range with debt costing 8-12%. Figuring in the positive impact of leveraging, equity yield should be in the 12-20% range. Remember that negotiations over value take into consideration three profit figures. The seller is trying to sell the "vision" of tomorrow; the buyer is looking at the actuality of current earnings and, in addition, is naturally figuring that he or she will do better. So, the price tends to get nudged up to a seemingly lower capitalization rate than would seem "justified" by current earnings. However, the blend of existing and potential earning is, after all, what serves as the basis for determining value. ly

Preparing the Property Offering Brochure

Once you've established an

offering price and terms, it is time broker to prepare the property offering brochure. Some brokers use the following sequence and list of components in preparing the brochures: for the

summary

and deal

•

Executive

•

Photographs of the property

•

Complete property description

•

Status of the existing franchise and alternative choices

•

Market Svimmary

•

List of competition

(including salient facts

theory)

228

Hotel Investments

demand

generators

•

Description of

•

Financial data, including

•

Historical operating statements

•

all

mortgage and lease obligations

Monthly revenue (including room occupancy and average daily 24-36 months to date

rate) for the past •

Disclaimer

A

brochure will go a long way togenerating marketplace interest. At any one point in time, there are hundreds of hotel listings on the market. The buyer must be motivated by the package and be excited enough to go "into the field" to make a property inspection. A well-prepared presentation with complete data about the offering wall not only be appreciated, but it will often accomplish the goal of inducing a physical inspection. I am also convinced that a first-class brochure helps maximize value. I would like to say a word about including pro formas of future hotel performance in the property brochure. That word is. in my judgment, DON'T. In our litigious world, it is a bad idea to make representations about future performance to a buyer. Buyers should do their own projections and not rely on any representations of the seller, or the broker, in making up their minds. The property brochure should provide facts, not conjecture.

ward

first-class property offering

efficiently

Disseminating Information to the Marketplace

An organized marketing effort, in combination with good personal contacts, is certainly the right track to a successful sale. When you are in a large community with numerous hotels, it is just as likely that the buyer may be another local person as it is that an "out-of-towner" will be the acquirer. However, while personal contact with local owners may well elicit an offer, it might not be the preferable route to travel. You are. after all. pro\iding detailed financial data on the hotel's operation to a competitive owiier. For that reason, and in the hope of widening the purchaser search and maximizing value, it is usually a wise idea to circulate the hotel offering, with care, as broadly as necessary. Generally speaking, 1 fmd that most successful selling efforts encompass similar methods. That is, they disseminate the information to a selected list of qualified customers from an extensive hotel owner /operator customer base and circulate the property brochure to a specialized network such as the Hotel & Motel Brokers of America. First, brokers should phone prospective buyers in their database, qualify their interest in the offering, and send property brochures when both the buyer and broker think it worthwhile. The next step is to recall the prospect after they have received the package to determine the prospect's interest level, answer questions, and arrange a property inspection.

Hotel Asset Disposition

229

Of course, the property inspection is central to the broker's selling effort. Someone who leaves his or her comfortable seat in order to visit a hotel site and area, usually hours from home, is a serious prospect. He or she may not buy the hotel you are promoting, but you know that you have a real prospect. All seriously interested, qualified potential customers should be personally accompanied through the property by a broker or an associate. All inspections should be made by appointment and in a manner least disruptive to the hotel's management staff and business operation. After all, you must remember that what is being sold is a going business with staff members whose morale must be kept high and a transient customer base that needs to be protected. It is the broker's professional and moral responsibility to keep these considerations in mind. The result of the telemarketing campaign to a targeted customer list, providing a first-class property offering brochure and accompanying all buyers on site inspections, is that you will usually generate serious offers, one of which will result in a successful closing.

Providing Status Reports After the broker has won the confidence of the seller, received the listing agreement, and begun the property marketing effort, it is obviously necessary to keep the seller informed about progress (or lack of progress) in the sales campaign. The selling process turns up new information and insights as well as customers. Written or oral status reports, provided to the owner on a periodic basis, are a good mechanism for discussing adjustment of the offering price and terms to the marketplace. Written reports allow you to more fully express rationales and conclusions that may be difficult to get across orally. Too, a seller probably appreciates being able to digest written information and reach conclusions in a quiet, deliberative manner. Naturally, status reports leading to the conclusion that the price needs to be dropped are not pleasant documents to read. But, if buttressed by a reasoned review of specific market reaction to the offering, the status report serves as an invaluable mechanism for keeping the owner and broker "in synch" with each other. It allows reasonable adjustment to pricing, if necessary, in order to achieve the sale result. Monthly status reports in combination with continuous phone updates are a good mix.

The Offering Process Qualifying Prospects

An integral part of the disposition process is screening the customer. Naturally, a buyer who shows purchase interest is "music to an owner's and broker's ears, as making a match is the whole goal of the hotel disposition effort and the missing ingredient "

230

Hotel Investments

the customer. Yet, hotel purchasers have preferences that need be acknowledged. What type of acquisition do they prefer? Limited service, full service, highway, resort, or in city? All cash, leveraged, how much cash? Are there guarantees required on the debt? What is the preferred area of the country? A good customer might be interested in a deal, but not so motivated as to maximize his or her offer. That customer is not going to be your top candidate for that hotel, but might be perfect for another. Of course, a customer's interest and capacity to perform (close) the transaction is most important. With so much lodging brokerage activity conducted on the telephone, it becomes incumbent on the sales agent to listen carefully to a buyer's needs get at motivation, cash availabilitA,' and t\pe of hotel desired during the telephone interview. "Yd like to make a good deal on a profitable property" is Interesting but useless information; so would everyone else! is

to

—

.

Telemarketing tried and true way to get to your logical customer a specific lodging brokerage assignment is through telemarketing. Effectively, it's knocking on the door. You can t beat that approach for unearthing a live customer. Some brokers assemble a list of potential prospects and personally call every single one. Brokers shovild not send someone a "blind package of information on a hotel unless they have first discussed the situation with them. After a customer has been carefully screened, a broker may en-

The most

base

for

"

customer's name into the brokerage's database. Computer storage capacities allow review of customer files and help identify customer preferences. When prospects indicate sincere interest, a broker may send either an executive summary or a full marketing package, depending on the customers' interest level. Several days after the package arrives, the broker may place a follow-up call in order to answer questions, discuss the deal in depth, and. hopefully, arrange for a hotel inspection. Rifle-shot telemarketing to a select list of qualified prospects pays the best dividends when it comes to screening the customer. The give-and-take dialogue between broker and buyer in a thoughtful telephone conversation is the next best thing to a personal visit, which is often impractical because of the distances involved between broker, customer, and property. ter the

Advertising

Many owners

look askance at publicly adv^ertising their hotels more sanguine. If the mutual decision is to advertise, the broker should provide a proposed advertising schedule, together with appropriate advertising copy. for sale; others are

1

Hotel Asset Disposition

23

Advertising is clearly a useful way to pick up activity, so long as you know where to do it and are willing to spend the time to screen out inappropriate customers. It is also quite expensive, since your cost is tied into general media circulation levels and it's a safe bet that few of the readers are motivated hotel purchasers. Selectively advertising in lodging industry publications is often a most cost-effective approach. Industry magazines such as Lodging Magazine and Hotel & Motel Management have real estate classified sections that buyers look to for opportunities. Other places to advertise include the Friday Real Estate Corner of the Wall Street Journal and Business Opportunity sections of such newspapers as The New York Times.

Co-Brokering 1 believe in selective co-brokering with other professional hotel brokers as a legitimate aspect of the overall marketing campaign. Some brokerage offices are loathe to co -broker because they feel a need to be in control of the offering process and /or they want to earn 100% of the commission. The former is understandable; the

commonly understood responsibility that a broker has to his or her principal under the Law of Agency. Simply put, venality has no place in brokerage. The lodging property brokerage community is relatively small and most competitors are also cooperators as long as the broker feels that he's dealing with another professional. The co-brokers' competence and honesty must be relied upon in doing right by the owner /seller. Not surprisingly, good brokers develop reputations that allow a comfort zone to exist and co-brokering to occur. Networks such as Hotel & Motel Brokers of /\jnerica (HMBA) encourage the development of trusted long-term friendships to thrive amongst member brokers. This unique association is the granddaddy of all lodging property co-broker networks, with affiliate offices throughout the country. As a longstanding member and past president of HMBA, 1 can unequivocally vouch for the high standards that it expects its members to adhere to. The bonds of cooperation that are the hallmark of affiliation are an invaluable asset that the broker brings to a listing. Often, an owner in one city will hire a broker in a second city to sell a hotel in a third location. A good broker will always be certain to accompany the customer on a property showing. Sometimes, perhaps due to scheduling conflicts, it's not physically possible for the listing broker to show the property. Yet, one needs to be responsive to a customer's wishes because the client seller has a right to expect it. An broker usually has the advantage of being able to ask an associate broker, who's relatively closer, to show a hotel listing. There are generally accepted split-fee arrangements in such circumstances, depending on how mvich work the showing co-broker does. The co-broker is of valuable assistance in providing seamless service to the owner. latter is in violation of the

—

HMBA

HMBA

HMBA

232

Hotel Investments

Aside from showing hotels, co-brokers may well have just the customer for the property. Selective co-brokering with trusted members of the lodging brokerage cormnunity is smart, pure and right

simple.

Inspections Property inspections are a most delicate part of the marketing process. When a hotel is for sale, word spreads to both the hotel staff and local businesses pretty quickly. Front desk staff, management, bookkeeping, and even the housekeeping cind maintenamce staff live in a small world and gossip cannot be contained no matter how hard one tries. Attempting to quell operational disruption, owners often tell staff that consultants, insurance people, or potential mortgage lenders will be inspecting the hotel, but it is probable that few believe this fiction. That being the case, it is wise to limit inspections to those customers who have been pre-qualified as to both their interest and capacity to perform (close).

The Offer and Purchase Contract Firming

Up

Offers

customer has shown interest and taken the time to init is likely that an offer to purchase will be forthcoming. It is normal for more than one person to be negotiating on a property during the selling period. You U want to be certain that the customer who succeeds in gaining the purchase agreement is also the one who closes the transaction. After ever\'one has worked so hard to locate a viable purchaser willing to pay an acceptable price, it is most disappointing for the contract to fall apart. You want to do all in your power to ensure that this does not happen. If you have three buyers interested in purchasing the same property at the same time, choose the buyer wisely, otherwise you might lose all the customers and end up with no sale. The person who offers the highest price, or most cash, may not be the right choice. You must examine the contingencies that the buyer incorporates into the offer, determine whether they are reasonable, how long it will take to satisfy them, and how much it will cost. You also want to confirm the financial capacity of the purchaser to perform. Of course, the best way to eliminate the risks inherent in signing a contract that includes contingencies is to simply say no to a buyer who won't put cash at risk on a contract. One hotelier was famous for saying that "a contingent contract If a is a free option period and I won't giv^e anybody free options. buyer does step forward to purchase the hotel and offers to put a significant contract deposit at risk, you should treat that person as your most serious purchase candidate. Now, how can you, as an owoier or broker, avoid many of the After a

spect the hotel,

"

risks inherent in signing a contingent contract?

Hotel Asset Disposition

233

In hotel transactions, buyers are concerned with reading environmental studies and learning the estimated scope and cost of modernization that the existing (or proposed) franchisor will require. These studies should be read before making an offer. Obviously, the potential expenditure on property modernization of many hundreds of thousands (if not millions) of dollars will have a dramatic impact on the purchase offer. So, too, will the cost of mitigating such environmental problems as asbestos, leaking underground storage tanks, and the like. I think it is both time-consuming and foolish for a hotel offering to proceed without the benefit of the buyer's having analyzed a pre-completed Environmental Phase I report or a franchisor's modernization study. If the reports are not available, buyers may make their offers contingent on receiving that information. It may take four to eight weeks for the franchisor and modernization experts to order and complete those reports and provide the results, which is all time that the hotel may be in contract and off the market. Too, any costs associated with the study's conclusions are simply going to result in a deal re-negotiation, with the seller in a weakened

of firming up an offer into the owner to get this information beforehand, provide it to any serious purchaser, and eliminate those important issues as contract contingencies. Having done this, you've made a major stride in firming up an offer into a worthwhile closeable contract. A final word on firming up offers. As the owner, or broker, it is entirely proper for you to let a buyer know that your goal is to only sign a contract of sale with the person you're sure will close. Alert the buyers that since you don't want to risk losing an interested customer, the buyer who is willing to minimize or eliminate the "due diligence period" (free option time) and pledge a significant contract deposit at risk, will be given preference. The purchasers who really want the deal the most will often respect your point of position. Therefore, the self-help

a meaningful executed contract

method

is for

view and put cash at risk. For an owner, the perfect world solely conditional on providing clear

is to

sign a purchase contract

title.

The Purchase Contract for

to

The hotel purchase contract, like most real estate agreements commercial property, is rather involved. I will not use this space go through all the elements of the contract. Rather, I'd like to

highlight certain areas that we, as brokers, focus on.

As-Is Representations. I recommend to owners that they sell the property as is and make no representations that survive the closing. The buyer should have access to all data that the seller believes is in his or her interest to share, and that is all. Don't put yourself or your firm in a position of having buyers come back to you for economic recompense because they say they relied on you for certain facts that did not prove to be accurate. The

-

234

Hotel Investments

onus

of discovery needs to be placed squarely on the buyer, not the This is especially important to contractually affirm today. The legal principle of caveat emptor (let the buyer beware) seems to be more attackable in courts today by buyers who seek post-closing financial redress (or even recision of the transaction) if they believe they've been financially disadvantaged. As a broker, 1 am not advocating that sellers hide salient information critical to a buyer s seller.

decision-making; 1 am just recommending that sellers not lay themselves open to post-closing financial liability, if at all possible. "What you see is what you get" should be the guideline.

Due Diligence

Periods. Due diligence periods are caution lights to broker spends months preparing the property' for market, offering it, negotiating with customers and getting to the lawyers so a contract can be hammered out. Now there is a stack of documents and an executed purchase contract. The seller is surely committed. But is the buyer? Any contract that contains a due diligence period requires a seller's "leap of faith" that he or she has chosen the right buyer who will do his or her best to close. However, due diligence periods are free options and little else need be said in the matter. brokers.

A

Financing Contingencies. Often, when a

seller needs, or wants, to cash." the buyer will require a financing contingency. The buyer needs a signed contract in order to take it to a lending source to obtain the required funding. This process may take months, the potential for failure is significant, and the possibility of the deal crashing is quite real. A few ways to minimize the seller's risks are: sell "all

•

Reqviire a letter of interest from the specific third-party lender, ensuring that the borrower has already pro\nded relevant data to that lender (financials.

•

and the

modernization and emironmental real prospect of your

and that there is a buyer receiving a funding commitment. studies,

like)

Committing the buyer to accept alternate purchase money financing from the seller in the event its third -part>" financing falls apart. The seller could offer a short-term, personally guaranteed, high-interest mortgage alternative that can be "put to the purchaser in order to ensure a closing and title transfer. This will induce the buyer to complete the more favorable thirdparty financing. However, it will commit the buyer to close, even if the financing option fails to appear. Remember, you don't have to offer the financing yovi have the option of doing so. If the buyer won't accept this concept, maybe he or she is not the right customer for the particular hotel acquisition. "

—

Franchise Responsibility.

If the property you're selling is chain the franchise contract will terminate (on the franchisor's side) once the hotel operator, or title, changes. However, as discussed earlier, the existing franchisee has a monetary commitment

affiliated,

Hotel Asset Disposition

235

must not be overlooked. Be sure to dovetail the termination of your existing franchise agreement with the sale of the property so that the owner's economic liability ends when the hotel is sold. If that is not possible, at least make sure that you've negotiated a modest termination payment provision with the franchisor. The same notion applies to existing management contracts, leases, or other obligations that the owner has taken on over the years. Do yovir best to end any liability that survives the closing. to the franchisor that

Between Contract And Closing Once the property is "in contract," you're in an operational noman's-land. The buyer tends to spend more time at the hotel, checking out a myriad of details, calling in consultants and purveyors, interviewing staff, and the like. While all this seems reasonable, it is most unsettling to the hotel staff and its operation of the business. It is usually a good idea to limit the buyer's access to the hotel until closing day. Wliile there are many good reasons to prevent access that causes operational disruption, the most compelling reason from an owner /broker's viewpoint is not an operational one. There's always dirty laundry in a hotel and it's not always found in the laundry room. The buyer, anxious yet nervous, may well hear stories that shake his or her confidence in going forward with the transaction. Deal confidence is a delicate commodity. As the seller, you want to offer as little opportunity for "second thoughts" as possible. Second thoughts about going through with a transaction can quickly escalate into fear, or concern, that may translate itself into a buyer walking off the deal or a re-negotiation. Imagine how a purchaser may feel upon learning from the sales director that a major motorcoach account might be leaving. Human nature being what it is, the buyer will focus on that, rather than the potential new corporate account the hotel may be about to snare.

The Closing If you cover every issue related to a closing in the purchase contract, you'll have a smooth, no-surprises, transfer. Everyone has an interest in making sure that happens. The closing should be a mechanical implementation of the purchase and sale agreement. The closing need not be a scene for re-negotiation or conflict. However, let me give you one example of how difficulties that could be avoided sometimes occur. Imagine the purchase contract is signed and both parties agree therein that the seller will offer purchase money financing to the buyer at a certain rate and term. Here's an entire economic understanding, including ground rules and remedies, that will be in effect for years after the closing. Yet. the mortgage and note denoting that agreement may not have been attached as an exhibit to the purchase contract when executed. Post-contract, the sellers' lawyer

236

Hotel Investments

sends his or her version of the note cind mortgage to the buyer's lawbut mutually acceptable language is not entirely agreed upon. "We'll finalize the language at the closing" are seven words that I dread hearing. Do your best to ensure that the closing of the hotel transaction involves mechanics, not negotiation. Because third parties, such

yer,

as the franchisor,

and

management company, financing

institution,

the liquor board) are often involved, it is a good idea to have a "dry run closing" a week or two before the actual closing. This needn't be in person, but all the appropriate papers, down to the last detail, should be addressed and resolved during the dry run so that the actual closing day goes smoothly. legal authorities

(i.e.,

I have tried to address the highlights of hotel asset disposition in this chapter. In doing so, I've naturally drawn on my own experience over 25 years of practicing hotel brokerage. Other fme brokers have their own outlook and unique methods of marketing that may be somewhat different from mine. However, be assured, the common threads that weave themselves through all hotel asset disposition marketing campaigns have been touched upon herein. 1 hope this chapter on hotel asset disposition will prove both useful and profitable to you in the future; if it does, it will have ser\^ed its

purpose.

12 Investment Analysis Tools By Bjorn Hanson

Bjorn Hanson,

Ph.D., CFE. FSCL is the Managing Director of Lodging and Gaming Investment Banking Jor Kidder. Peabody & Co.. Inc. Prior to Joining Kidder-Peabody he was a Principal. Managing Partner, and National Industry .

Chairman with Coopers has served as a

& Lybrand.

Dr.

Hanson

Visiting Assistant Professor at

Cornell University and is currently an Adjunct Assistant Professor on the faculty of New York University.

CHAPTER rcvlews basic financial analysis tools as they apply To present these tools, 1 have drawn heavily on excellent materials developed by the Educational Institute of the American Hotel & Motel Association in the following textbooks: Managerial Accounting. Third Edition, by Raymond S. Schmidgall, and Financial Managementfor the Hospitality Industry. by William P. Andrew and Raymond S. Schmidgall. Lodging statistics provide a basis for measuring the performance and understanding the condition of a business. There are four primary uses for lodging statistics:

THIS

to the lodging industry.

1.

To compare one establishment with another or with many others

2.

To compare the performance of one period with another

3.

To estimate future

4.

To summarize data

activity or results

in

a format that makes the data easier

to

interpret

Four types of

statistics will be presented in this chapter: financial statement ratios, specialized lodging ratios, statistical measurements, and capital budgeting ratios. When you compare one hotel or time period with another, make certain that the data being studied are consistent. For example, if one hotel's food cost /cost of goods sold includes the cost of complimentary meals, employee meals, and the cost of bar food, but another does not, a comparison of the two hotels would uncover

237

238

Hotel Investments

differences due to inconsistent accounting rather than performance.

and expense

definitions

The lodging industry has two primary sources of widely accepted accounting and account definitions, the Uniform System of Accounts for Hotels and a companion book, the Expense and Payroll Dictionary.

Financial Statement Ratios Ratio analysis is a traditional analytical approach to evaluating income statement and balance sheet information. It is an organized system applied to all industries. There are many published sources of financial ratios for example, RMA Annual Statement Studies by Robert Morris Associates. The HOST database prepared by Smith Travel Research is a source of income statement data for the lodg-

—

ing industry. Exhibit 1 summarizes ratios that are used for four tv^DCS of nancial statement analyses: ^

•

Profitability ratios

•

Activity ratios

•

Liquidity ratios

•

Solvency ratios

In the following sections

we will take a look at each

fi-

of these types of

ratios. 2

Profitability Ratios Profitability ratios relate the hotefs net profit to revenue, as-

and equity. Profitability ratios include on assets, and return on equity ratios. sets,

Profit

profit

Margin Ratio. Hospitality enterprises are

margin, return

often evaluated in

terms of their ability to generate profits on sales. The profit margin ratio is determined by dividing net income by total revenue. It is an

measurement of management's ability to generate sales and control expenses, thus yielding the bottom line. Based on figures from Exhibit 2, which shows income statements from the hypothetical Model Hotel, the 19X2 profit margin of the Model Hotel can be determined as follows: overall

Profit

Margin

Net Income =

Total Revenue

$146.700 X 100

$1,352,000

10.85%

CO CD

CO CD

E

E

o

o

CO

>< CO

D o CO

o

o CO

co 03

CO CD

E

E

CO

in

CO

o

o

o CD

CO

T3

O CO

o

CO 0)

CO

CO CD

>
>

0)

0)

CO

a.

>,

o.

CO

T3 CO

CO 0)

o^

O O

o o X

o O

o o

•K

;^

o Q.

Sc

Q) CO CO CO

CO

a5

>

.•t

=>

0)

•o

^ ^ Q.

c5

CD

c

c

!5

Q> ^ > CO CD CO CD O « y — o o 0) 2 lo CO c CO CO ^ CO CD Q) C -D CO O) > CO .E o b o q3 0)

^

>

O)

CD

CO

o ^ ° ^ to -ci o o CJ o

CD

CO

0 o c 0 > c

0 CO CO

CO

O o

*

-o

2

*^

"w

4-

CO I

CO

0 w CO CD

CD

"o Q.

S

-o

ro

cn

O-

q;

CO

CO

CO

0

CO

cn

CD

C X CD

_

CO

0 E E

E

-I r=

0

-s

— r

.55

CO

5 > 0 CO >

0 CO E ° o " —C .>

O CO

Ra

set

>..E

o AT

IE

CC

5 ro

1 E

c o c etu

2

£

(0 CO

qI

DC

'5 cr

o c > c

DO O

o c 0 > c 0

g 0 a. c g o 0 o o 0 O)

0 > 0 CD

CD

0 >


o o 0

OC

CO

CO

(0

o '5

o

cc

CO

cn

o o — c o T3 > S 0 O 0 X _ >«

C 0 0 -V .? 3 o

~

X)

-I

O
/uoid

780,000

$

810,000

oo,uvju

145,000

coo cnn

605,000

430,000

445.000

1

Uiner uircci txpenseb

60.000

ueparimeniai income

Food and Beverages:

Revenue uost

01

bales

148,000

and Related Costs

175,000

180.000

43.400

45,000

69,600

72,000

Revenue

40,000

42.000

Cost of Sales

30,000

31,000

10.000

10.500

Payroll

Other Direct Expenses Departmental Income Telephone:

Payroll

and Related Costs

Other Direct Expenses

Departmental Income Rentals and Other Income Total

Operated Departments Income

5,000

4,500

(5,000)

(4,000)

50,000

55.000

697,100

728,000

105.000

108 500

ol,5U0

>J\J ,\J\J\J

Undistributed Operating Expenses: Administrative

& General

Marketing

55 000

Prnnprtu Onpratinn A r uud Ly vyudduuii ot Maintpnanrp iviciiiiidiciiiv'v?

67.500

1

Energy Costs

80,250

81.500

302,000

312 500

395,100

41 s son

Rent

20,000

20.000

Property Taxes

20,000

24,000

Total Undistributed Operating

Expenses Income Before Fixed Charges

5.500

6.000

Interest

54,000

60.000

Depreciation

60,000

61.000

Insurance

Income Before Income Taxes Income Taxes Net Income

Source: William

$

P.

Andrew and Raymond

pitality Indiistiy (East

159,500

171,000

235,600

244.500

94,300

97.800

141,300

$

146.700

S. Schmidgall, Financial Management for the HosLansing, Mich.: Educational Institute of the American Hotel & Motel

Association, 1993), p. 61.

Investment Analysis Tools

241

If the profit margin is lower than expected, then revenue and expenses should be reviewed. Poor pricing and sales volume could be contributing to the low ratio. To identify the problem area, management should first analyze the operated departments' margins. If the operated departments' margins are satisfactory, the problem would appear to be with overhead expense.

Return on Assets Ratio. The return on assets (ROA)

ratio is

a gen-

eral indicator of the profitability of the hospitality enterprise's assets. Unlike the profit margin ratio, which is drawn only from income statement data, the return on asset ratio compares bottom

—

investment that is, to the total assets. This a variation of it, is used by several large conglomerates to measure the performances of their subsidiary corporations operatline profits to the total ratio, or

ing in the hospitality industry. Based on figures from Exhibits 2 and 3, the Model Hotel's 19X2 return on assets is calculated as follows: Net Income

Return on Assets =

Average Total Assets

$146,700 =

X 100

.5($1,065,000 + $1,176,300)

13.09%

=

The Model

Hotel's

19X2

ROA

of

13.09% means that there were

13.09 cents of profit for every dollar of average total assets. A very low ROA may result from inadequate profits or excessive assets. A very high ROA may suggest that older assets require replacement in the near future or that new assets need to be added to support growth in revenues and profits. The determination of low and high is usually based on industry averages and the hospitality establishment's own ROA profile that it develops over time.

Return on Equity Ratio. A key profitability ratio is return on equity (ROE). This ratio compares the net income of the hospitality enterprise to the owners' investment. This ratio is simply calculated by dividing net income by average owners' equity. Based on relevant figures from Exhibits 2 and 3, the return on equity for the Model Hotel for 19X2 is calculated as follows:

Return on Equity

=

Net Income

Average Owners' Equity

$146,700 X 100

=

.5($455,000 + $517,300) =

30.18%

The Model Hotel earned 30.18 cents

for

each $1 of equity.

242

Hotel Investments Balance Sheets (Report Form), Model Hotel

Exhibit 3

inQucI nUlcl

nA/«AmkAr Qi 'IQVA iOVO UGceniDef oi, iIjai, i^az i^au, iOVi

ASSETS

19X0

19X1

19X2

Current Assets:

Cash

?1

;

Marketable Securities

nnn

81,000

81,000

8i!ooo

100.000

90,000

140.000

Inventories

14,000

17,000

15,000

Prepaid Expenses

13,000

12,000

14,000

228,000

221,000

274,000

22,000

35,000

104,000

Accounts Receivable

(net)

Total Current Assets

Investments Property and Equipment:

Land Buildings

and Equipment

Furniture

68,500

68.500

68,500

810.000

850.000

880,000

170,000

170.000

172.000

1,048,500

1,088,500

1,120,500

260,000

300,000

345.000

11,500

20,500

22.800

Less: Accumulated

Depreciation Ctiina,

Glassware,

Silver,

and Uniforms

Linen,

and

Total Property

800 000 ACA AAA

Equipment &

Total Assets

^

*

H

809 000 Aec AAA

$ 1,050,000

>

1,065,000

60,000

t

53.500

4

798 300 1 "^C OAA

$ 1,176.300

l&RII ITIFQ ANn I.IHDIL.1 ICO HnU OWNERS' EQUITY 1

Current

1

Liabilities:

Accounts Payable

$

$

71.000

Accrued Income Taxes

30,000

32.000

34.000

Accrued Expenses

70,000

85,200

85.000

r^iirrQnt Ann L/Ullclll PArtinn rUIUUIl f\i Ul LUliy 1

Term Debt Total Current Liabilities

25,000

21,500

24.000

185,000

192,200

214,000

0-7C AAA 075,000

375,000

400.000

40,000

42,800

45,000

415,000

417,800

445.000

600,000

610,000

659,000

55,000

55,000

55.000

Long-Term Debt:

Mortgage Payable Deferred Income Taxes Total

Long-Term Debt

Total Liabilities

0"7C

AAA

jlAA

AAA

Owners' Equity:

Common

Stock

Paid-in Capital in

Excess

of Par

Retained Earnings Total

Owners' Equity

Total Liabilities

Source: William

110,000

110.000

290,000

352.300

450,000

455,000

517.300

1,065,000

$ 1.176.300

and

Owners' Equity

pitality

110,000

285,000

P.

Andrew and Raymond

$ 1.050,000

S.

Si

Schmidgall, Fiuancial Maim\;cmciit for the HosAmerican Hotel & Motel

Industry (East Lansing, Mich.: Educational Institute of the

Association, 1993), p. 60.

243

Investment Analysis Tools

Condensed Food and Beverage Statement, Model Hotel

Exhibit 4

Condensed Food and Beverage Department Statement Model Hotel For the year of 19X2

Food f^on nnn *J\J\J ,\J\J\J

iff

Cost

of Sales:

Beginning Inventory

11,000

Purchases pec- FnHinn Inupntnn/

1

1

Cost of Goods Used

Employee Meals

Less:

Cost

of

Gross

9,000

6,000

122,000

28,000 -0-

2,000

Goods Sold

Profit

6,000

^0,000

120,000

28,000

180,000

117,000

135,000

45,000

Expenses: Payroll

Other Expenses Total

Expenses

Departmental Income

Source: William pifaliti/

P.

Andrew and Raymond

S.

30,000

15,000

165,000

60,000

$ 15,000

$ 57,000

Schmidgall, Financial Management for the HosAmerican Hotel & Motel

Industry (East Lansing, Mich.: Educational Institute of the

Association, 1993), p. 71.

When preferred stock has been issued, a variation of the ROE the return on common stockholders' equity. Return on common stockholders' equity is calculated by dividing net income less preferred dividends by average common stockholders' equity. The Model Hotel has not issued preferred stock; therefore, preferred dividends are zero, and the entire amount of owners' equity belongs to the common stockholders. is

Activity Ratios

Also referred to as asset ratios, activity ratios demonstrate how managed or employed. Activity ratios include food inventory turnover, beverage inventory turnover, and fixed asset turnover ratios. Exhibit 4 is a condensed food and beverage department statement of the Model Hotel with food and beverage operations for 19X2 shown separately. Figures from this statement will be used to illustrate the food and beverage turnover ratios. In addition, Ihe beginning and ending inventories of food are $1 1,000 and $9,000, respectively, and the beginning and ending inventories of beverages are $6,000 each. effectively assets are

Food Inventory Turnover Ratio. The 19X2 over ratio for the Model Hotel

is

food inventory turncalculated as follows:

244

Hotel Investments Cost of Food Used

Food Inventory Turnover

=

Average Food Inventory

$122.000 .5($11,000 + S9.000) =

12.2 times

The food inventory turned over 12.2 times during 19X2. or approximately once per month. The speed of food inventor},' turnover generally depends on the type of food service operation. A quick-service restaurant generally experiences a much faster food turnover than does a fine-dining establishment. In fact, the quickservice operation may have a food inventory turnover in excess of 200 times a year. A norm used in the hotel industry for hotels that have several different types of restaurants and banquets calls for food inventory to turn over four times per month. Although a high food inventory turnover is desired, because it means that the food service establishment is able to operate with a relatively small investment in inventory, too high a turnover may indicate possible stockout problems. Failure to provide desired food items will not only disappoint guests, it may also result in negative goodwill if the problem persists. Too low an inventorv' turnover suggests that food is overstocked: in addition to the costs of maintaining inventory, the cost of spoilage may become a problem.

Beverage Inventory Turnover Ratio. The 19X2 beverage turnover ratio for the Model Hotel is calculated as follows: Cost of Beverages Used

Beverage Turnover Ratio

=

Average Beverage Inventory

$28.000 .5($6.000 + $6,000) =

4.67 times

of 4.67 times means that the beverage inventory of $6,000 required restocking approximately every 78 days (calculated by dividing 365 days in the year by the beverage turnover of 4.67). Not all beverage items are sold evenly: some items would have to be restocked more freqviently. A norm used in the hotel industry for hotels having several different types of lounges and banquets calls for beverage inventory to turn over 1.25 times per month or 15 times per year. All parties (owners, creditors, and management) prefer high inventory turnover ratios to low ones, as long as stockouts are avoided. Ideally, as the last unit of an inventory item is sold, the shelves are being restocked writh that item.

The beverage turnover

Investment Analysis Tools

245

Fixed Asset Turnover Ratio. The fixed asset turnover ratio is determined by dividing average total fixed assets into total revenue for the period. A more precise measurement would be to use in the numerator only those revenues related to fixed asset usage. However, revenue by source is not available to many financial analysts, so total revenue is generally used. This ratio measures management's effectiveness in using fixed assets. A high turnover suggests the hospitality enterprise is using its fixed assets effectively to generate revenue, while a low turnover suggests the establishment is not making effective use of its fixed assets and should consider disposing of part of them. A limitation of this ratio is that it places a premium on using older (depreciated) fixed assets, since their book value is low. This ratio is also affected by the depreciation method employed by the hospitality operation. For example, an operation using an accelerated method of depreciation will show a higher turnover than an operation using the straight-line depreciation method during most years of the assets' lives, all other factors being the same. Based on figures from Exhibits 2 and 3, the fixed asset turnover ratio is calculated for the Model Hotel for 19X2 as follows: Total

Fixed Asset Turnover

Revenue

=

Average Fixed Assets

$1,352,000 .5($809,000 + $798,300) 1.68 times

fixed asset turnover of 1.68 times reveals that revenue was 1.68 times the average total fixed assets. Everything else being the same, all parties (owners, creditors, and management) prefer a high fixed asset turnover. Management, however, should resist retaining old and possibly inefficient fixed assets, even though they result in a high fixed asset turnover. The return on assets ratio (discussed in the section on profitability ratios) is a partial check against this practice.

The

Liquidity Ratios Liquidity ratios are used to analyze the ability of an establishto meet short-term obligations. Liquidity ratios include current, acid-test, accounts receivable turnover, and average collection

ment

period ratios.

Current Ratio. The most common liquidity ratio is the current ratio, which is the ratio of total current assets to total current liabilities and is expressed as a coverage of so many times. Based on figures from Exhibit 3, the 19X2 current ratio for the Model Hotel can be calculated as follows:

246

Hotel Investments

Current Assets Current Ratio

=

Current

Liabilities

$274,000 $214,000 1.28 times or 1.28 to

1

A

current ratio of 1.28 means that for every Si of current liathe Model Hotel has $1.28 of current assets. Thus, there is a cushion of $.28 for every dollar of current debt. A considerable shrinkage of marketable securities and receivables could occur before the Model Hotel would become unable to pay its current obligations. By comparison, the 19X1 current ratio for the Model Hotel was 1.15 times. An increase in the current ratio from 1.15 times to 1.28 times within one year is considerable and would no doubt please creditors. However, would a current ratio of 1.28 please all interested parties? Owners /stockholders normally prefer a low current ratio to a high one, because stockholders view investments in most current assets as less productive than investments in primar\' assets of the business, such as "property and equipment" and "investments." Since stockholders are primarily concerned with maximizing the value of their firm-related investment, they prefer a relatively low current ratio. Creditors normally prefer a relatively high current ratio, as this provides assurance that they will receive timely pavments. A subset of creditors lenders of funds believe adequate liquidity' is so important that they often incorporate a minimum working capitsd requirement or a minimum current ratio in loan agreements. Violation of this loan provision could result in the lender demanding full payment of the loan. Management is caught in the middle, trying to satisfy both owners and lenders while, at the same time, maintaining adequate working capital and sufficient liquidity to ensure the smooth operations of the hospitality establishment. Management is able to take action affecting the current ratio. In the case of the Model Hotel, a current ratio of 1.5 times could be achieved by converting bilities,

—

—

$94,000 worth of marketable securities and accounts receivable to cash on the last day of 19X2 and paying current creditors.* Other possible actions to increase a current ratio include:

*This

may be determined mathematically using

CA - X - X

the following formula:

_ desired current ratio where .v indicates the amount ~ current assets which would be used to pay current

274.000 - X

214,000 - X

=

1.5

X = $94,000

of liabilities

Investment Analysis Tools

247

•

Obtaining long-term loans and /or obtaining new owner equity contributions and using the proceeds to increase current assets or decrease current liabilities

•

Converting non-current assets

•

to

cash

Deferring the declaration of cash dividends and leaving the in the business

cash

An extremely high current ratio may mean that accounts receivable are too high because of liberal credit policies or slow collections, or it may indicate that inventory is excessive. Since ratios are indicators, management must follow through by analyzing possible contributing factors.

A more stringent test of liquidity is the acid-test the quick ratio. The acid-test ratio measures liquidity by considering only "quick assets'" cash and near -cash assets. Excluded from current assets are inventories and prepaid expenses. In some operations, the difference between the current ratio and the acid-test ratio will be minor, while in others it will be significant. Based on relevant figures from Exliibit 3, the 19X2 acid-test ratio for the Model Hotel is computed as follows:

Acid-Test Ratio. ratio, also called

—

A J T * i-> Acid-Test Ratio

=

Cash, Marketable Securities, and Accounts Receivable

Current

Liabilities

$245,000 8214.000 =

1.14 times

The 19X2 acid-test ratio reveals quick assets of $1.14 for every $1.00 of current liabilities. Because they have minimal amounts of both inventory and accounts receivable, and because they generate large cash flows, many hospitality establishments operate efficiently with an acid-test ratio of 1 .0 or even less. If a firm has any inventory or prepaid expenses, its acid-test ratio will be lower than its current ratio.

The viewpoints

of owners, creditors,

and managers toward the

acid-test ratio parallel the viewpoints they hold toward the current ratio. That is, owners of hospitality operations prefer a relatively

low ratio (generally less than one), creditors prefer a relatively high ratio, and management is again caught in the middle.

Accounts Receivable Turnover Ratio.

In hospitality operations that extend credit to guests, accounts receivable is generally the largest current asset. Therefore, in an examination of a property's liquidity, the "quality of its accounts receivable must be considered. In the norniiil operating cycle, accounts receivable are converted to cash. The accounts receivable turnover measures the "

248

Hotel Investments

speed of the conversion. The faster the accounts receivable are turned over, the more credibility the current and acid-test ratios have in financial analysis. The accounts receivable turnover is determined by dividing revenue by average accounts receivable. A refinement of this ratio uses only charge sales in the numerator; however, quite often chctrge sales figures are unavailable to outsiders (stockholders, potential stockholders, and creditors). Regardless of whether reve-

nues or charge sales are used as the numerator, the calculation should be consistent from period to period. Average accounts reis the result of dividing the sum of the beginning-of-theperiod and end-of-the-period accounts receivable by two. When a hospitality operation has seasonal sales fluctuations, a preferred approach (when computing the annual accounts receivable turnover) is to add together the accounts receivable at the end of each of the 1 2 months and divide by 1 2 to determine the average accounts

ceivable

receivable.

Using relevant figures from Exhibits 5 and 6. the accounts receivable turnover for 19X2 of the hypothetical Grand Hotel can be calculated as follows: Total Revenue

Accounts Receivable Tvirnover

Average Accounts Receivable*

$1.352.000

8115.000

^

.

.

i

•

V.1

*Average Accounts Receivable

=

11.76 times

=

Accounts Receiv'able at Beginning = = and End of Year

—

2

$90.000 + $140.000 2 =

$115,000

The accounts receivable turnover of 11.76 indicates that the revenue for 19X2 is 11. 76 times the average receivables. This is lower than the Grand Hotel's 19X1 accounts receivable turnover of 13.68. Management would generally investigate this difference. The investigation may reveal problems or that changes in the total

credit policy or collection procedures significantly contributed to

the difference. Although the accounts receivable turnover measures the overall rapidity of collections, it fails to address individual accounts. This matter is resolved by preparing an aging of accounts receivable schedule that reflects the status of each account. In an aging schedule, each account is broken down to the period when the

249

Investment Analysis Tools Balance Sheets, Grand Hotel

Exhibit 5

Balance Sheets

Grand Hotel

December

31, 19X0, 19X1,

ASSETS

19X2

19X0

19X2

19X1

Current Assets:

Cash

20,000

$

Marketable Securities

Accounts Receivable

$

21,000

60,000

81

$

000

1

24.000 4^ onn

100.000

90,000

Inventories

14,000

17,000

15,000

Prepaid Expenses

13,000

12,000

14.000

207,000

221 .000

43.000

35.000

Total

(net)

Current Assets

Investments

140,000

40,000

Property and Equipment:

Land Buildings Furniture and Equipment

Less: Accumulated Depreciation

Total

silver, linen,

68,500

880,000

190,000

208,000

Assets

LIABILITIES

.048,500

1

,

1

UO,3UV Qfti ,uuu riAn •io

260,000

and uniforms

1

,500

20 500

22 800

800,000

809,000

798,300

$1 ,050,000

$1,065,000

$1,176,300

1 1

and Equipment

Total Property

68,500

850,000

170.000 1

China, glassware,

68.500

810.000

AND

OWNERS' EQUITY Current

Liabilities:

Accounts Payable

$

60,000

53,500

$

$

71,000

Accrued Income Taxes

30,000

o*:,UUU

34,000

Accrued Expenses

70.000

85.200

85,000

Current Portion Total

Long-Term Debt

of

Current

Liabilities

25.000

21.500

24.000

185,000

192,200

214.000

425.000

y1

AAA

/inn nnr^ 4UU.UUU

Long-Term Debt: IWortgage Payable

Deferred Income Taxes Total

Long-Term Debt

Total Liabilities

1 1^

40,000

42,800

45.000

465.000

452,800

445,000

650,000

645,000

659,000

Owners' Equity:

Common

Stock

Paid-in Capital

in

Excess

of Par

Retained Earnings Total

Owners' Equity

Total Liabilities

Source:

and Owners' Equity

Raymond

S.

55,000

55,000

55,000

110.000

110,000

110,000

235,000

255,000

352,300

400,000

420,000

517.300

$1,050,000

$1 ,065,000

$1,176,300

Schmidgall, Hospitality Industn/ Managerial Accounting, 3d ed. (East LanAmerican Hotel & Motel Association, 1995), p. 155.

sing, Mich.: Educational Institute of the

charges originated. Like credit sales, this information is generally available only to management. Exhibit 7 illustrates an aging of accounts receivable schedule. Owners prefer a high accounts receivable turnover, as this reflects a lower investment in non-productive accounts receivable. However, they understand how a tight credit policy and an overly aggressive collections effort may result in lower sales. Nonetheless, everything else being the same, a high accounts receivable turnover

250

Hotel Investments

Income Statements, Grand Hotel

Exhibit 6

Income Statements Grand Hotel For the years ended December 31, 19X1 and 19X2

Total

Revenue

Rooms! Revenue Payroll and

19X1

19X2

$1,300,000

SI. 352.000

S

780.000

related costs

1

S

ob.UUU

810.(X)0

145.000

62.500

fin

(wi

582.500

fin5

noo

Revenue

430,000

445.000

Cost

of sales

142,000

148.000

and

175.000

180.000

Ann

45 OOO

69.600

72.000

Revenue

40.000

42.000

Cost

of sales

30.000

31.000

and

10.000

10.500

Other Direct Expenses Departmental Income

Food and Beverages.

Payroll

related costs

A"^

Other Direct Expenses Departmental Income Telephone;

Payroll

related costs

Other Direct Expenses

Departmental Income

5.000

4.500

(5,000)

(4.000)

Rentals and Other Income Revenue

50.000

55.000

Operated Departments Income

697.100

728.000

105.000

108.500

Total

Undistributed Operating Expenses: Administrative & General

Marketing

51,500

55.000

Property Operation & (Vlaintenance

65,250

67.500

80.250

81,500

302.000

312.500

Energy Costs Total Undistributed Operating

Expenses

395.100

Income Before Fixed Charges Rent

20.000

20.000

Property Taxes

20,000

24 000

Insurance Interest

61.000 171.000

235.600

244.500 97.800

94.300

Income Taxes $

Net Income

Note

60.0(X)

60.000

Charges

Income Before Income Taxes

6.000

54,000

159.500

Depreciation Total Fixed

5,500

Data processing, human resources, and transportation expenses are

insignificant

141.300

$

146.700

and are not shown as separate cost

centers.

Source:

Raymond

S.

Schniidgall, Hospitnliti/ huiusiry Managerial Accounting, 3d ed. (East Lan-

sing, Mich.: Educational Institute of the

American Hotel

& Motel Association,

1995), p. 156.

indicates that accounts receivable are being managed well. Suppliowners, prefer a high accounts receivable turnover, because this means that hospitality establishments wall have more cash readily available to pay them. Long-term creditors also see a high accounts receivable turnover as a positive reflection of management. ers, like

Investment Analysis Tools

251

Aging of Accounts Receivable Schedule, Grand Hotel

Exhibit 7

Aging of Accounts Receivable Schedule Grand Hotel December 31, 19X2

Days Outstanding Firm

N3m6

Ace Co.

Acem

Corp.

Ahern. Jim

31-60

61-90

$600 400

$400 100

$200 -0-0-0-

$-0300 -0-0-

$-0-0-0-0-

-0-

-0-

50

100

100

1,000

Armadillo Co.

50

950 -0-

Zebra Zoo Equip. Total

Source:

Raymond S.

on

0-30

Inc.

America,

Qi

Total

1

Over 20 days

1

$-0-0-050 -0-

80

80

-0-

-0-

-0-

-0-

$145,000

$115,000

$18,000

$7,000

$4,000

$1 ,000

Schmidgall, Hospitality Industry Managerial Accounting, 3d ed. (East LanAmerican Hotel & Motel Association, 1995), p. 162.

sing, Mich.: Educational Institute of the

Management

desires to maximize the sales of the hospitality

operation. Offering credit helps maximize sales. However, management also realizes that offering credit to maximize sales may result in more accounts receivable and in selling to some less creditworthy

customers. One result of management's decision to offer credit is a lower accounts receivable turnover. On the other hand, while management may see a lower accounts receivable turnover as a consequence of higher sales, it does not lose sight of the fact that it also must maintain the operation's cash flow that is, it must effectively

—

collect

on the

credit sales.

Average Collection Period Ratio. A variation lated

by

number

of the accounts re-

the average collection period, which is calcudividing the accounts receivable turnover into 365 (the of days in a year). This conversion simply translates the

ceivable turnover

is

accounts receivable turnover into a more understandable result. For the Grand Hotel, the average collection period for 19X2 is as follows:

Average Collection Period

365 =

Accounts Receivable Turnover

365 11.76 =

31 days

The average collection period of 31 days means that on an average of every 31 days throughout 19X2, the Grand Hotel was

252

Hotel Investments

The 31 days is a four-day increase over the 19X1 average collection period of 27 days. What should the average collection period be? Generally, the time allowed for average pajmients should not exceed the terms of sale by more than 7 to 10 days. Therefore, if the terms of sale are n/30 (entire amount is due in 30 days), the maximum allowable average collection period is 37 to 40 days. The above discussion assumes that all sales are credit sales. However, many hospitality operations have both cash and credit sales. Therefore, the mix of cash and credit sales must be considered when the accounts receivable turnover ratio uses revenue, rather than credit sales, in the numerator. This is accomplished by allowing for cash sales. For example, if sales are 50% cash and 50% credit, then the maximum allowable average collection period should be adjusted. An adjusted maximum allowable average collection period is calculated by multiplying the maximum allowable average collection period by credit sales as a percentage of tocollecting all its accounts receivable.

tal sales.

In the previous example of a maximum allowable collection period of 37 to 40 days and 50% credit sales, the adjusted maximum allowable average collection period is 18.5 to 20 days (37 to 40 days X .5). Generally, only management can make this adjustment, because the mix of sales is unknown by other interested parties. The average collection period preferred by owTiers. creditors, and management is similar to their preferences for the accounts receivable turnover, because the average collection period is only a variation of the accounts receivable turnover. Therefore, owners and creditors prefer a lower number of days, while management prefers a higher number of days (as long as cash flow is sufficient).

Solvency Ratios Solvency ratios, also known as debt or leverage ratios, compare a hotel's overall debt obligations with its assets and earning potential. Solvency ratios include debt to total assets, number of times interest earned, and fixed charge coverage ratios.

Debt to Total Assets Ratio. The debt to total assets ratio relates total debt to total assets as to what portion of the assets are financed with short- and long-term liabilities, and is expressed as follows:

Debt

to total assets

=

(total

debt

total assets)

x 100

Number

of Times Interest Earned Ratio. The number of times earned ratio is based on financial figures from an establishment's income statement and expresses the number of times interest expense can be covered. The greater the nvimber of times interest

interest is earned, the greater the safety afforded the creditors. Since interest is subtracted to determine taxable income, income

— Investment Analysis Tools taxes are added to net income and interest and taxes, abbreviated as EBIT) of the ratio, while interest expense is the from Exhibit 6 can be used to calculate the interest earned ratio for the Grand Hotel: fore interest

Number Interest

of Times Earned Ratio

253

expense (earnings beto form the numerator denominator. Figures

19X2 number

of times

^^IT Interest

Expense

$304,500 $60,000 5.08 times

shows that the Grand Hotel could cover expense by over five times. The number of times interest earned ratio in 19X1 for the Grand Hotel was 5.36 times. This twoyear trend suggests a slightly riskier position from a creditor's viewpoint. However, in general, a number of times interest earned ratio of greater than 4 reflects a sufficient amount of earnings for a hospitality enterprise to cover the interest expense of its existing debt. The

its

result of 5.08 times

interest

and management) prefer a relahigh ratio. Owners are generally less concerned about this ratio than creditors, as long as interest obligations are paid on a timely basis and leverage is working to their advantage. Creditors especially lenders^ also prefer a relatively high ratio, because this indicates that the establishment is able to meet its interest payments. To the lender, the higher this ratio, the better. Management also prefers a high ratio. However, since an extremely high ratio suggests leverage is probably not being optimized for the owners, managers may prefer a lower ratio than do lenders. The number of times interest earned ratio fails to consider fixed obligations other than interest expense. Many hospitality firms have long-term leases that require periodic payments similar to interest. This limitation of the number of times interest earned ratio is overcome by the fixed charge coverage ratio. All parties (owners, creditors,

tively

—

Fixed Charge Coverage Ratio. The variation of the

number

fixed charge coverage ratio is a

of times interest earned ratio that consid-

ers leases as well as interest expense. Hospitality establishments

that have obtained the use of property and equipment through leases may find the fixed charge coverage ratio to be more useful than the nvmiber of times interest earned ratio. This ratio is calculated like the number of times interest earned ratio, except that lease expense (rent expense) is added to both the numerator and denominator of the equation. Using figures from Exhibit 6. the 19X2 fixed charge coverage ratio for the Grand Hotel can be calculated as follows:

254

Hotel Investments

Fixed Charge Coverage Ratio

EBIT + Lease Expense Interest

Expense and

Lease Expense

$304,500 + S20.000 S60.000 + S20.000

$324.500 $80,000 =

4.06 times

The result indicates that earnings prior to lease expense, interand income taxes cover lease and interest expense 4.06 times. The Grand Hotel's fixed charge coverage ratio for 19X1 was 4.18 times. The change of 0.12 times reflects a minor decrease in the Grand Hotel's ability to cover its fixed costs of interest and lease expense. The viewpoints of owners, creditors, and management are similar to the views they hold regarding changes in the est expense,

number

of times interest earned ratio.

Specialized Lodging Ratios The lodging industry has developed ratios specific to lodging establishments (see Exhibit 8). Specialized lodging ratios include paid occupancy percentage, average occupancy per room, multiple occupancy percentage, average room rate, room revenue per available room, total revenue per guest day, average length of stay, seat turnover, average food service check, ratio of beverage to food revenue, and other ratios.^ Paid Occupancy Percentage Ratio. The paid occupancy percentage ratio is a major indicator of management s success in selling its "product." It refers to the percentage of guestrooms sold in relation to guestrooms available for sale. Using the "Other Information" listed in Exliibit 9. the annual paid occupancy of the Grand Hotel can be determined by dividing total paid rooms occupied by available rooms for sale. If the Grand Hotel had 80 rooms available for sale each day, its paid occupancy percentage ratio for 19X2 is calculated as follows: Paid Occupancy

Paid

Rooms Occupied

=

Available

21.000 29,200

71.92%

Rooms*

5

CO