Deal sponsors must know how to identify and neutralize seasonality in a hotel investment. By planning ahead, you’re sure to have enough working capital to keep a healthy operation year-round.
Demand for hotel rooms fluctuates throughout the year. Factors like weather, economic conditions, the city’s event calendar, and others define these seasonal fluctuations. The last thing you need is to be left cash strapped because you didn’t spot a soft demand period.
In this article, I’ll highlight the three strategies to neutralize seasonality on the front-end.
- Identify Seasonality with Forensic Financial Analysis
- Use a Monthly Cash Flow Model to Capture Fluctuations
- Capitalize the Deal Appropriately with Cash Reserves
Compare Monthly Revenue Year Over Year
Seasonality is defined as variations that appear at regular times throughout the year. It may show up in expenses, like with utility cost fluctuations. However, most seasonality appears on the revenue lines, which reflect demand variation throughout the year.
Regular patterns are at the heart of spotting seasonal differences.
At a minimum, you will need two years of operating statements to identify a consistent seasonal pattern. Still, three years or more would be most beneficial. A longer comparison period allows you to pick out inconsistencies caused by special, one-time events. Natural disasters and sporting events are the most common occasional events that will trick you.
In all cases, you need monthly data to get the level of clarity you need to identify seasonality in a hotel’s operation.
Smith Travel Research (STR) made hotel investments approachable for the conservative investment world in 1988. That’s when they launched the Smith Travel Accommodation Reports (STAR). STR produces these reports monthly based on data from a competitive set of hotels selected by the hotel owner.
Hotel operators use the reports to measure the success of their revenue management strategies and tactics. Owners and investors use them to spot revenue patterns to take advantage of gaps in the market.
The Competitive Set Report (“Comp” tab) is the best place to start. This report explicitly shows 18 months of data along with three months of annual data. Annual figures don’t give you a sense of seasonality, but they can point to the need for additional research where there’s a significant year-over-year change.
Some simple math using percent change figures can extend monthly data to a full two years and annual data to four.
Take out a nearby December 2019 STAR:
- Go to the “Competitive Set Report” (“Comp” Tab)
- You’ll see month-by-month Occupancy (%), ADR, and RevPAR tables
- July through December 2018 is provided
- To produce January through June:
- Find the % Chg table for each statistic
- Start with January: [January 2018] = [January 2019] / (1 + [% Chg January 2019])
- Iterate through all months and statistics that are missing
- Follow a similar process for annual data
A single year-end STAR will give you a good idea of where to start looking for both market and property seasonality. However, additional reports can provide a more complete picture over more than two years.
At a minimum, you should request:
- Latest month’s STAR
- Prior year-end STAR (e.g., December 2019)
- Three years prior year-end STAR (e.g., December 2017)
This will give you four years of monthly occupancy and revenue data to tease out clear patterns in market demand.
Detailed Financial Statements
Hotel financial statements offer a more in-depth view of the subject property’s seasonality. Any institutionally managed property probably has a high level of granularity in their financial statements. However, less sophisticated operations would provide an annual roll-up at best.
Many small operators use a non-USALI standard chart of accounts in QuickBooks, which makes sophisticated analysis a bit more complicated. At the very least, request monthly financial statements to identify month-to-month differences.
Standard USALI financial statements provide a detailed view of demand by business segments – Transient, Group, and Contract. These high-level segments are further broken down as follows:
- Association / Convention
- Tour group / Wholesale
A month-by-month financial statement over two or more years will show how demand in each segment changes throughout the year.
Look for occupancy peaks and valleys to highlight opportunities to raise rates in high-demand periods, known as rate compression. This gives your sales team the ability to strategically sell group business into peak months, which drives up transient rates. This perspective also helps you prepare appropriately for a valley.
Detailed financial statements also give you a good picture of expenses throughout the year.
Early-stage deal evaluation is meant to uncover and produce good questions for the seller. Look for expenses that are unusually high or low compared to previous months or years. They could be one-time anomalies or an indication of a consistent pattern.
Special Events vs. Consistent Seasons
Consistency is critical when looking for seasonality, whether in revenue or expenses.
An examination for seasonality may be as simple as reviewing year-over-year percent change and moving on. However, there are times when the percent change is so significant that it requires additional explanation.
Revenue and expense increases of 8% or more in any month are worth looking into. Anything less than 8% can just be a great sales effort on the revenue side or an uncommonly hot summer in expenses. Anything above 8% may result from special, one-time events in the market or property.
External factors that significantly influence demand tend to leave a paper trail. As mentioned, major conventions, sporting events, elections, or natural disasters are prime suspects. In many cases, they’ll be easy to find by quickly searching the news from that time. You may even want to consider the atypical timing of national or religious holidays.
You may be thinking, “why don’t I just ask the seller?”
That’s a good point, and you can save time by directing questions like this to the seller. Still, you should also be looking for an unfair advantage. A sophisticated analysis includes a hard look at market and hotel seasonality. Many buyers don’t put in the time, though.
Go to the seller as a last resort. There’s always a possibility that the seller or broker would alert other buyers of the anomaly.
Use a Monthly Cash Flow Model
A solid review of financial statements and market dynamics is a critical first step to neutralize seasonality. Still, it doesn’t mean a whole lot if you’re working with an annual financial model. Your model needs to be flexible enough to capture cash flow nuances.
Convert Annual Operating Proforma
Monthly operating budgets take a long time to prepare. The three months from October through December is called “budget season” for a reason.
You don’t have time to build a monthly operating budget for every year in your investment projection, nor should you. Besides, accuracy degrades exponentially as you get past two years. The stabilized case doesn’t require such in-depth analysis, though.
It’s foolish to spend that time and energy.
The early years of your investment are usually the most impacted. For example, significant renovations displace thousands of room nights over many months. It would be helpful to have adequate reserves to protect the operation from that displacement.
The simplest approach is to model seasonality for a single year. Then, apply that distribution to every subsequent year.
Consider how the HIT Model handles this challenge. You build annual budgets with the option to enter monthly figures for a full year in the Monthly Cash Flow tab. The model distributes revenue and expenses for future years based on the prior year. You can adjust each year appropriately and establish a standard distribution for the stabilized years.
Build Capital Accounts to Hold Reserves
As an asset class, hotels are very capital-intensive. The constant wear and tear and operational uncertainty require an enhanced focus on capital planning and cash flow management.
Simple CRE financial models ignore capital concerns.
Working capital and interest reserves help you neutralize seasonality at the closing table. These cash reserves allow you to smooth cash flows and pay bills during lean demand seasons.
A working capital reserve primes your operating account to pay salaries and expenses.
An interest reserve helps you meet debt service when renovation displaces a significant amount of potential business.
Monthly cash flow models drain and replenish these capital accounts based on simple conditional rules. You will find many uses for this technique once you start using it. For example, loan construction draws become super easy to model with a horizontal capital account.
The basic structure of a capital account has the following lines:
- Beginning of period balance – the previous end of period balance
- Contribution – capital account in-flow
- Draw – capital account out-flow
- End of period balance – the sum of beginning balance and in/out-flows
The simplicity and elegance of this solution will astound you.
Play around with different scenarios. For example, you can delay equity distributions until you have a certain amount in your operating reserve.
There is no “right” way to use a capital reserve. The objective is to model as close to life as possible, so you know how to set up your capital stack.
Roll-up to Summary Using SUMIF
A monthly cash flow model is not pretty to look at, even if it is ideal for modeling seasonality. Still, it’s crucial to “show your work.”
The best way to show how your model works is to use multiple lines of computations on the back-end. Beyond that, you just roll up to a single cell on a separate worksheet.
Resist the urge to simplify on the back end.
I use the model-view-controller (MVC) framework used in the HIT Model. MVC separates the user interface (view) from the brains (model and controller). In that way, it enhances the user experience and protects the back-end from erroneous input.
An annual summary is the expected presentation for most CRE models. Therefore, it makes sense to roll up your monthly cash flows to yearly figures.
Just include a row for years that correspond with the cash flow columns. After that, you can roll-up any row in your model from months to years with the SUMIF function.
Your results are only as good as your ability to tell the right story. Let the brains function separately from the user experience to protect both stakeholders.
Capitalize the Deal Appropriately
All this work boils down to two things – preparing your management team and capitalizing the deal appropriately. Your ability to neutralize seasonality will have a dramatic impact on how lenders and investors perceive your deal.
Monthly Debt Service
Senior loans are built on predictability and security.
A business plan that accounts for seasonality goes a long way to alleviating many of your lender’s concerns. It shows that you’ve spent the time considering anything that would negatively impact cash flow.
Rough financial models account for debt service annually, which is fine for a back-of-the-envelope analysis. However, the lender expects you to stroke a monthly check. Therefore, you’ll want to understand whether you fall short in any month.
Go to your lender with a clear ask about much you need to reserve for operational shortfalls. It may make sense to ask for a larger working capital reserve than you need with the option to pay it down or distribute to equity upon stabilization.
Seasonality should never be an excuse for coming up short on debt service.
Most lenders are commercial real estate generalists. They don’t know all the details of operating a hotel. Your extra effort to account for demand fluctuations will prove your professionalism and reduce risk to the lender.
Remember, the lower risk is usually associated with a lower cost of capital.
Model True-to-Life Distributions
Investor distributions may be sporadic and inconsistent, depending on the business plan. For example, a deep renovation may delay equity distributions until the property stabilizes. That only becomes a problem if it is unexpected, like anything with your investors.
Investor relations starts with good communication. A financial model that provides for potential real-life scenarios will help you appropriately craft that message.
Know your target investors and craft your offer accordingly.
Build a reserve and adjust distributions accordingly if you know that your investors are interested in consistent cash flows. This will impact time-based investment returns, like IRR, so don’t skip this step.
Seasonality is a significant reason that investors avoid some markets.
It creates uncertainty and risk that few people are willing and capable of managing effectively. Thin markets with the right business plan create exceptional opportunities. These factors combine for you to target outsized returns and reduced risk.
Seek to neutralize seasonality on the front end.
Start with thoughtful underwriting, a comprehensive financial model, and well-informed stakeholders. This combination will allow you to penetrate difficult markets and reduce the cost of capital. Beyond that, astute asset and property management will lead to long-term success in this field.