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Hotel capitalization rates: Caveat emptor
December 7 2009

An imprecise consideration of cap rates when discussing lodging assets is fraught with danger.

Daniel H. Lesser

A capitalization rate (cap rate) is a ratio that can be used to estimate the value of income-producing properties. Put simply, a cap rate is the net operating income of an asset divided by its sales price or value expressed as a percentage. A cap rate is determined by evaluating the financial data of similar properties which have recently sold in a specific market. For example, a US$1-million sale price of an apartment building that produces an annual net cash flow of US$90,000, results in a calculated capitalization rate of 9 percent.

90,000/1,000,000 = .09

In theory, cap rates provide a tool for investors to use for roughly valuing a property based on its income. A comparatively lower cap rate indicates less risk associated with the investment (increasing demand for the product), while a relatively higher cap rate points toward more risk (reducing demand for the product). Factors considered in assessing risk include creditworthiness of a tenant; term of lease; durability of the income stream; quality and location of property; and general volatility of the market.

Similar to most lodging industry participants, I am often asked, “What are cap rates on hotels?”  My typical response is “I do not know” which normally elicits a “Come again?” reaction. Many real estate professionals loosely speak of cap rates relative to all types of commercial assets, however an imprecise consideration of cap rates when discussing lodging assets is fraught with danger.

Consider the following illustration of an assumed US$50-million hotel sale. Theoretically, eight different cap rates with a wide range from 5.4 percent to 10.4 percent have been derived from a single transaction.

 

 

When determining a hotel’s cap rate, it is necessary to first decide which year’s net operating income (NOI) will be used: actual calendar year or trailing 12 month NOI, or projected year one NOI.  Furthermore, a defined level of NOI must also be established, i.e.: NOI before or after consideration of hotel management fees (incentive and/or base charges) and/or reserves for replacement. If the NOI utilized in calculating hotel cap rates is after management fees and/or reserves, the selected amount of such deduction or deductions can have a dramatic affect on the conclusion.

When analyzing hotel sale transactions, in order to accurately calculate a cap rate which results in apples to apples comparison, one must know the accurate income and expenses for each hotel property sale, and be sure that the calculations of each were done in the same manner. In many cases, because this data is confidential and not part of any public record, the numbers are “guesstimated” resulting in a broad array of cap rates on a single transaction that are eventually disseminated to the investment community.

Use of a cap rate implies a durable and stable income stream, either in place or projected. It is important to note that unlike investors of other types of commercial real estate, such as office and multifamily, sophisticated hotel investors do not formulate pricing decisions using a single cap rate applied to one year’s NOI, whether actual or anticipated. Given the lack of long-term leases and the unique feature of a continuous re-pricing of the leasing of transient hotel rooms, theoretically lodging assets never stabilize. Furthermore, unlike investors in other types of commercial real estate, such as office and multifamily, that produce annuity-type income, hotel investors are typically an optimistic group who seek value-enhancement opportunities. To establish pricing on such prospects, hotel investors primarily rely upon a discounted cash flow (DCF) analysis which factors in a new sponsor’s perceived upside during the holding period.  The value conclusion of a hotel DCF analysis is then used to measure the implied cap rate or rates, based upon historic actual and/or projected NOI by backing into any such conclusion.

The next time you discuss hotel cap rates, caveat emptor, and make sure you are not comparing apples to oranges!

Daniel H. Lesser has specialized in real estate appraisals, economic feasibility evaluations, investment counseling, and transactional services of hotels, resorts, conference centers, casinos, and timeshare properties on a worldwide basis for the past 28 years. He currently serves as the senior managing director-industry leader of the Hospitality & Gaming Group at CB Richard Ellis (CBRE). He can be reached at (212) 207.6064 or Daniel.lesser@cbre.com.

The opinions expressed in this column do not necessarily reflect the opinions of HotelNewsNow.com or its parent company, Smith Travel Research and its affiliated companies. Columnists published on this site are given the freedom to express views that may be controversial, but our goal is to provoke thought and constructive discussion within our reader community. Please feel free to comment or contact an editor with any questions or concerns.

COMMENTS   Show All
HotelBanker
12/11/2009 1:52:00 PM
(cont'd from below)...hurdle characteristic of a totally unlevered deal. Conversely, for a “Hotel Itch” out on Route 66, fifty miles west of Gallup, New Mexico it’s a safe bet the unlevered equity and IRR hurdle assumption is the approach to take, and pray that some guy doesn’t throw up a brand new box next to yours in the next 5 years after the advent of the economic recovery. Just wanted to pencil in some detail the rather broad brush strokes I had painted in my prior post. With that, I will stand down off my soapbox and leave the preaching to others.
HotelBanker
12/11/2009 12:19:00 PM
As a follow on, I wanted to add a qualifier to my prior comments on looking at IRR's as an adjunct or substitute valuation tool instead of cap rates, specifically as they apply to the top echelon of hotels (upscale or luxury hotels in core CBD's in gateway markets with lots of barriers to entry and little in the construction pipeline). While many investors are saying in a broad general sense they are looking for a >20% IRR for better assets, nobody is seeing appreciable numbers of those transactions are actually taking place today. Unlike the '80's when regulators took a much more heavy handed approach to curing institutional problems and had little aversion to foreclosing and dumping assets of all quality levels on the market (creating a supply driven market), they now take a much more circumspect approach to dealing with troubled assets. Given regulatory fund constraints and an adverse political reaction to wholesale bank closings, regulators appear to be taking a much more slower, methodically paced approach to taking down assets and killing off troubled institutions. Coupled with the sticky legal structures of CMBS which make it difficult for servicers to work out or sell troubled assets, it is difficult for the active pool of savvy investors to actually buy better assets. While it seems counterintuitive, in effect what many are hearing consistently is that there is a bit of a demand driven market at the top tier of the quality scale. Thus, while investors talk about a 20% IRR hurdle, I think the "real" hurdle for the upper echelon assets is realistically going to be more in the teens for 2010. Conversely, for the guys chasing deals for budget to midscale, on-the-highway stuff in the broad market, there is abundant product out there that looks like a 30% plus IRR candidate (and gosh, it better be for the risk involved because you will be fighting new supply again in 3 or 4 years after enduring a slow consumer recovery – how many supply cycles will we go through where any stiff with a half-million bucks and no experience at all can go queue up a budget franchise in some tiny backwater town and some idiot will lend on it? Stupid, stupid, stupid.). Additionally, keep in mind the IRR view is also generally a view of returns only on the un-levered capital in a deal, which in turn depends on the availability of debt. While the conventional wisdom is there is simply no "debt" out there for the immediate future, it seems this is only partially true. There is certainly a dearth of fresh new debt - no arguing that - but there is a vast abundance of "hidden" debt, comprised of lender debt capital already buried in distressed assets. The reality is in many cases a rational lender will strike a deal with credible new equity to cut their debt and risk and repatriate some capital, particularly if they can stay in at par vs taking a writedown and retain a now-performing loan. So in a sense, what I am also saying is that to solely look at the IRR implicit on an a totally “unlevered” deal structure is theoretically faulty. On a case by case basis determining whether “available” debt might exist and at what structure in terms of LTV, DSCR, etc., depends on what the unique nature of the asset is from a quality, flag, location, barriers to entry, and supply perspective as well as whether there is already debt in place on the deal, and what the size of the equity commitment will need to be. For say, a big W or a Four Seasons or a Marriott or a Hyatt in a core CBD like a Manhattan where the lender can salvage a piece of the debt capital immediately and turn the remainder into a performing loan on 50% LTV with good coverage (or where a savvy new lender might in fact consider lending new capital in a patently conservative way), and where the equity can limit its capital injection to a more manageable number rather than cutting a check for all of the the capital, it would be intellectually faulty to assume you have to hit an IRR
Rick rogovin
12/11/2009 8:05:00 AM
Dan, excellent article and great insight! As you noted, a cap is simply a calculation of typically the 12-month trailing NOI and the sales price. In essence, it is the current return at the time of sale. Assuming that a sale occurs at a 5.5% cap rate, it is a safe assumption that the buyer will not be satisfied with that return for the life of the investment. Therefore, the buyer has made some assumption regarding occupancy, ADR growth, and expenses. These assumptions were (or hopefully were) based on an in depth analysis of market conditions, and a myriad of other factors. These factors and assumptions are then compiled into a projection of income and expense, and discounted back to present value dollars at an appropriate rate of return. Without knowing these assumptions, you cannot really understand the true motivation of the buyer. If the buyer provided a cap rate based on stabilized income, it would be more meaningful. Therefore, by using the trailing 12-month cap rate to value all subsequent transaction is unreasonable. Another great point you brought out is that by just looking at the cap rate you never know what is NOI is being used. Does it include management fees (base and incentive and at what level), a reserve for replacement, and ground rent? Without knowing this information, just knowing the cap rate is not meaningful. Again, great article Dan.
HotelBanker
12/9/2009 4:32:00 PM
Thanks Dan for illustrating the pratfalls of simply relying on cap rates for valuation of hotels, particularly the oft-overlooked point that cap rates for ANY kind of real estate are only highly reliable in an equilibrium market (and conversely, very unreliable in a volatile market). This topic is often the centerpoint in the war of words between the credit and business factions within banks these days, and between lenders and borrowers as well. In a volatile market like today (as was the case during the S&L crisis) the DCF is a much better method of valuation given the roller coaster nature of revenues and cash flows in the early years of the projection period. I think few in either the lender or investment community expect (or perhaps the better term is hope) that 2009 or 2010 represents other than the trough years of the current recession. That being the case, simply assuming that the trailing year or first forward year NOI assumption is "stabilized" as tends to be implicit in using an average cap rate from a market survey seems an error in judgment. In addition, hotels are much more unique in nature and much more operationally complex than other real estate. Each and every hotel is different in character and earnings potential; why value unique assets simply using a single metric measured at a point in time that is tied solely to an average market level from a survey? It's kind of like assuming a Pee Wee Herman has the same ability to slam dunk as a Michael Jordan. I also find it useful to analyze the cash flows from the DCF, including the assumed value at sale at the end of the holding period (i.e. the terminal value), from a perspective of what intrinsic IRR they indicate. This serves as a sort of back-check on the validity of the appraised value and to the extent one wants to look at it, the implied going in cap rate. If the IRR indicated from a valuation analysis is in the single digits, then it is a fair characterization that the valuation analysis is faulty. Most investors I talk with today are looking for strong value added all-in IRR opportunities north of a threshold 20% depending upon the risk profile and size of the investment. By the same token, an IRR of more than 40% would generally be an red flag for investment grade caliber hotels (as the implied value opportunity would be so compelling that it would invite much more competitive demand, which would tend to compete the price upward and drive the yield down). An IRR north of 40% might be appropriate for high risk assets with extreme cap ex, legal, or other issues capital and lead-time intensive issues, but would seem and unrealistic expectation for well-located, quality assets in gateway markets with barriers to entry that are experiencing temporary market stress on cash flows. Thanks again, nice take on the issue and well presented.
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