By David Lund
Determining the current selling or asking price for a hotel is a bit tricky. Compared to estimating the present value of a house it’s more like a detailed math exercise rather than a google search on Redfin. That’s what this piece is all about, how you can estimate the value, AKA sales price.
Commercial real estate firms specializing in hotel valuations are what your bank is going to require that you use if you’re asking them for financing to buy a hotel. That makes sense because the bank will want to protect their interest. If you own a hotel and want to sell it you can go that route as well but it’s not like two tickets to the movies; it’s more like two tickets to paradise for the winter, if you know what I mean. $$$
In order to establish a value/asking price or price to offer (all the same concept) you’re going to need to establish a number based on the current incomea. You may also want to level this current income out into a “stabilization” year if the hotel is newer or in a growth mode. You’re also going to need to make an adjustment for any planned or in-construction hotels that would be competitors in the same market. That also makes sense because they’re going to affect your income and earnings in the future.
An additional aspect of importance is using the Uniformed System of Accounting for the Lobby Industry (USALI) for measuring your financial results. You can read more about “sally” here.
Using the correct format will get you a higher level of attention and review by potential buyers. People who know hotels will expect you to present your numbers in this format. If you want a sample hotel profit and loss statement, send me a note and I would be happy to get you one.
Now onto the main feature, how to calculate your hotel’s value in your market. To do this you’re going to use what is called the income approach. Hotels trade in today’s market on a multiple of cash flows. So, in order to establish your selling or asking price you’re going to need to know two very important things.
One, you’re going to need to know the current capitalization rate in your local market. Commercial real estate, especially hotels, utilize “cap rates” for an easier way to express the health of that market and a bit of a buzz word for the transaction. Cap rates are the inverse of the selling price relative to the income. A bit more about the income calculation in a couple of paragraphs.
The cap rate is easy to grasp once you understand the math. Imagine the hotel down the road sold for $10,000,000 and according to a local commercial real estate broker the Cap Rates in your area are currently 8. What that means is, we need to divide 100 / 8 which equals 12.5, we take the 12.5 and divide it by the selling price. ($10,000,000 / 12.5) = $800,000. This is the adjusted cash flow.
We use 100 as the base because it is a convenient way to express the relationship between the income from an asset and its value. That capitalization rate (or cap rate) is a percentage that is used to convert income into value. Using 100 as a base makes it easy to compare cap rates among different properties. For example, if two properties have the same profit, the property with the higher cap rate will be worth less. This is because the higher cap rate indicates that investors are less willing to pay as much for the property.
Two, we need to use the right measure to establish the net profit, also known as EBITDA. Net income is a more traditional measure of profitability, but it can be misleading because it includes non-cash expenses such as depreciation and amortization. EBITDA is a more accurate measure of a company’s operating performance, and it is used to assess a hotel’s ability to generate cash from its operations.
One very important caveat to this, we want to exclude any deduction for capital reserve. Most hotels don’t use or record a “reserve for capital replacement.” You can read more about how the reserve works here. If you don’t have a reserve then you’re good, don’t worry about it.
I know for some readers your head is spinning with the math and terminology, so let me spell it out another way. Here is the layman’s calculation. Start with total revenues, subtract all payroll, then all expenses, but exclude the following expenses: debt payments, amortization, depreciation, income taxes and the reserve if you have one. When you do this, step by step, you have your number.
Now take that number, that’s your cash flow before depreciation, amortization, and taxes, your (EBITDA) and multiply it by the inverse of the cap rate. Cap rate is 8, so we use 12.5. My EBITDA is $750,000 – So ($750,000 x 12.5) = $9,000,000 which is the estimated market value of my hotel today in my local market.
Other things that may affect the final price are location, amenities, current market conditions, deferred capital/maintenance, environmental issues, brand, and reputation. Both seller and buyer should do the same income analysis and then negotiate.
One other item to mention on establishing the income. Be sure to look back to prior years (3-5 years) to make sure the expenses in the stabilized year are not lighter than historical values. Some would be prone to fattening up the bird before slaughter, so buyer beware.
The last item is just a note. Artificial intelligence was used to research some of this information and many financial terms and measures can be interchangeable by some, so make sure whatever number you use you clearly understand what’s included and excluded in the calculation.
Happy hunting!
