An imprecise consideration of cap rates when discussing lodging assets is fraught with danger.
Daniel H. Lesser
Daniel H. Lesser
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.firstname.lastname@example.org.
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