Simplicity is essential when learning how to underwrite a hotel. You often only need a few data points to pull together a solid financial model. Further, a good understanding of the market falls to a few factors relating to cost of capital and recent transactions. The six data points below should be enough to build a simple quick analysis, and they may inspire you to dig deeper into each broader category.
1. Penetration Index
Hotel room sales is a highly competitive business. Guests can shop hundreds of hotels on a single website with a variety of comparison tools, including maps, pricing, and past guest reviews. Revenue managers have limited pricing power when a hotel’s available room nights are largely unsold. However, you do have control over how you set up your hotel to compete aggressively for your target guests.
Competitive set penetration shows the relative strength of a subject property against a selection of competitive hotels. It is created for each of the major descriptive statistics – occupancy, average daily rate, and RevPAR – by dividing the subject by comp set figures using the STAR Report.
Get a good understanding of the relative quality of the competitive set in your STAR as the basis of your analysis. Tour the properties consistently to establish up quick rules of thumb for how to underwrite a hotel.
Your fair share of the market is defined by a 100% penetration index. Your property will rarely reach 100% penetration on all metrics. This would mean that your hotel is running right in the middle of the pack. In most cases, the subject will be above or below the set.
2. Profit Margins
The USALI standard hotel financial statements have three major expense categories – departmental, undistributed, and fixed. Each of these is followed by profitability to that point, and opportunity exists at each expense level for improving operational efficiency and profitability.
Think of each expense category in terms of its influence in hotel operations. Departmental profit is related to the front-line, direct guest interaction. Gross operating profit following undistributed expenses is associated with back of the house operations. EBITDA following fixed expenses is linked to asset management.
Become a massive consumer of profit margin data at all levels to build mental connections between profitability at all levels. These market and industry standard data points will help you quickly identify areas for opportunity in a new investment.
Note, in the case of undistributed and fixed expenses, there are additional expenses – namely management fees and FF&E reserves – that produce a second level of profitability. These are typically taken as a percentage of operating revenue, so margins are easy to translate.
3. Per Room Investment
The sum of all money invested into a deal is known as total capitalization. Divide total capitalization by the number of rooms to get your per room investment. This simple figure represents the high watermark to surpass for investment profitability.
The adage, “you make your money when you buy,” is an oversimplification, but it is an important consideration. It’s difficult to be unreasonably profitable if your basis is too high to begin with. Your total invested capital is the basis for relative return through the investment period, and it allows you to realize capital appreciation return when you recapitalize or sell.
Collect recent comparable sales for sale price per room and cap rates. These will give you an idea of where your total per room investment should be in today’s market. A reasonable thesis about future value should be related to economic growth and new supply. Knowledge of replacement cost for competitive hotels may also be helpful to justify competitive barriers to entry.
Reasonable projections for operational profits will ultimately drive value for the hotel. Net operating income divided by total capitalization gives the yield-on-cost, which is the invested equivalent of a cap rate. The spread between yield-on-cost and cap rates represents your opportunity for capital appreciation.
4. Cost of Capital
The capital you use to finance a deal comes with defined risk and return requirements. The capital stack is an intuitive representation of this with least risk on the bottom and most risk at the top – senior debt and common equity, respectively. The hotel will only produce so much cash flow, and these different tranches claim ownership of that cash flow based on their contractual position in the deal.
Each investor in your capital stack has a target return. The blended cost of capital is the contractual payments divided by capital invested. Your profit as a deal sponsor is the difference between the cost of capital and deal return.
As an example, assume you have a loan with an interest rate of 6.00% on 70% of the capital and a joint venture partner that is looking for a 18.00% return on 25% of the capital. This leaves you with an 8.70% blended cost of capital (6.0%*70% + 18.0%*25%). That means you need to come up with 5% of the capital stack, and you’ll keep everything beyond 8.70% unlevered return. This emphasizes the importance of unlevered analysis when learning how to underwrite a hotel.
Note, your lenders are paid monthly, but equity investors understand that they must wait their turn with available cash for distribution. That said, the value of money is associated with time. An investor’s return requirement will be satisfied with less absolute money in year one than in year two.
5. Recapitalization and Sale Value
Operating cash flow pays your debt service and provides consistent investment returns to equity investors. However, the biggest returns in many deals are in capital appreciation.
Capital appreciation can be accessed in two ways – recapitalizing a deal or selling the asset. The former is often simplified to a debt refinance, but recapitalization may also include replacing equity partners while maintaining control of the asset. These are known as capital events because they are aimed at paying back invested capital after catching up outstanding preferred returns.
Recapitalization and sale values are based on prevailing market conditions at the time of the capital event. It is often difficult to predict with certainty how big these payments will be. However, current figures for interest rates and cap rates are a good place to start. You’ll need to look for additional economic information to project how these will move over time.
It would also be valuable to have a good understanding of price per room in the local market and with similar assets in other markets. Remember, your investment opportunity is one in a sea of other deals available to lenders and investors. You should always strive to get the best deal when the time comes, but a conservative approach to projecting capital events will ensure that you exceed your goal.
6. Investment Returns
Profitability is evaluated with absolute and relative measurements.
Absolute profitability is the sum of all cash flows minus invested equity. This is more elegantly stated in the multiple on invested equity (MOE), which is calculated by sum of cash flows divided by equity invested.
Relative profitability is commonly measured with two return metrics – cash-on-cash return and internal rate of return (IRR). Generally, private investors prefer the former, while institutions prefer the latter.
Internal rate of return is a discounted cash flow approach to estimate the annual compounded return on equity including capital events. Business plans that rely on capital appreciation, like value add and opportunistic deals, favor this approach because net cash flow in the early years is limited if non-existent. Institutional investors prefer this approach because it fits well in modeling the way each deal will fit into their fund portfolio.
Cash-on-cash return is the net cash flow after debt service divided by equity invested. This provides a clear annual percentage return on investment that ignores capital events. Private and conservative institutional investors like this approach because it doesn’t attempt to project asset appreciation. It gives a clear picture of the annual income to be expected from an investment.
Internal rates of return are susceptible to excessive financial engineering. As you learn how to underwrite a hotel, you’ll also learn how to pull the right strings to get to a return target. Still, a good deal based on sound fundamentals will always be a good deal.
Each investor has a different approach to analyzing a deal. Experienced investors have a cocktail of data points, which they can use to evaluate a deal on the back of an envelope. Underwrite every opportunity that comes across your desk to find the right mix that works for you. Experience is the best and most efficient way to learn how to underwrite a hotel deal.