CREM – Hotel Model vF

CREM – Hotel Template Guidelines

Key Steps in Valuing and Underwriting a Hotel:

1) Conduct Market Research and Analysis

Before delving into financials, it’s essential to understand the broader market dynamics. This will include:

• Location Analysis: Analyze the market and the specific location of the hotel (e.g., proximity to attractions, business centers, transportation hubs). High-traffic areas with tourist destinations or business demand generally result in higher hotel occupancy rates and higher average daily rates (ADR).
• Demand and Supply Assessment: Investigate the demand drivers (tourism trends, conventions, business travel, etc.) and supply (competition, new hotels in the area). This helps forecast future hotel occupancy levels.
• Competitor Comparison: Identify and analyze similar hotels (competitors) in the area. Key metrics include Average Daily Rate (ADR), Revenue Per Available Room (RevPAR), and Occupancy Rate. This will provide a benchmark for assessing the hotel’s financial performance.

2) Understand the Hotel’s Financial Performance

The financial performance of a hotel is significantly impacted by its operational management. Key performance metrics include:

• Revenue Metrics:

  • Room Revenue: Based on the number of rooms, occupancy, and ADR.
  • Other Operating Revenue: This includes food and beverage sales, event hosting, spa services, parking fees, and other ancillary services.
  • Total Revenue per Available Room (TRevPAR): This metric considers all sources of hotel revenue (not just room revenue) and helps to understand the overall earning potential of the hotel.

• Cost Metrics:

  • Operating Expenses: These can be broken down into:
    • Fixed Expenses: Costs that do not vary with occupancy, such as management salaries, property taxes, and insurance.
    • Variable Expenses: These costs fluctuate with hotel occupancy, such as housekeeping, utilities, and guest services.
  • Cost per Occupied Room (CPOR): Measures the total operating costs for each room sold.

The goal is to analyze the hotel’s Net Operating Income (NOI), which is the revenue minus operating expenses, to determine how much income the hotel generates before accounting for debt service, taxes, and depreciation.

3) Establish Unlevered Cash Flow and NOI

Start by projecting Unlevered Cash Flow (UCFC) for the hotel. This is the hotel’s income from operations, excluding the effects of debt financing. Here’s the process:

• Revenue Projections:

  • Project room revenue based on occupancy rates and ADR (considering historical trends, competitive landscape, and market conditions).
  • Estimate ancillary revenue from services such as food and beverage, parking, and events.

• Operating Expense Projections:

  • Estimate the Operating Expenses, which typically range from 60% to 80% of total revenue for a hotel, depending on the property’s quality and brand.
  • Include fixed and variable costs in your projections, with attention to seasonality (e.g., higher costs in peak season).

• NOI Calculation:

  • NOI = Total Revenue – Operating Expenses

This NOI will be used to assess the profitability of the hotel, providing a baseline for the discounted cash flow (DCF) model.

4) Debt Financing and Leverage Considerations

Hotels typically involve significant debt financing, making it important to model both levered and unlevered cash flows. When underwriting, consider:

• Debt Structure: Hotels often have floating-rate loans and are more sensitive to interest rate changes. Loan terms typically involve higher Loan-to-Value (LTV) ratios (e.g., 70-80%), but this will vary depending on the risk profile of the property.
• Debt Service: Model debt service payments based on the interest rate, loan amount, and amortization schedule.
• Impact of Leverage: The use of leverage increases the return on equity but also increases risk. The calculation of levered free cash flow (LFCF) will be after accounting for debt service (both interest and principal payments).

The difference between unlevered and levered cash flow will show you how much equity investors will receive after servicing debt.

5) Apply the Discounted Cash Flow (DCF) Method

The Discounted Cash Flow (DCF) method is widely used for valuing hotels, as it allows you to account for future cash flows and the time value of money. The key steps are:

• Project Cash Flows: Using the unlevered and levered cash flow projections, forecast the hotel’s income over a typical investment horizon (e.g., 5-10 years).

• Terminal Value (TV): After projecting the annual cash flows, estimate the terminal value of the hotel. This is typically done by applying an exit cap rate to the projected Year 10 NOI. The exit cap rate is typically derived from market comparables and reflects the long-term growth prospects of the hotel.

  • Terminal Value = Year 10 NOI / Exit Cap Rate

• Discount Rate (WACC): The appropriate Weighted Average Cost of Capital (WACC) should be used to discount the cash flows and terminal value to the present day. WACC reflects the cost of debt and equity financing weighted by their respective proportions in the capital structure.

• Net Present Value (NPV): Discount the projected cash flows and terminal value to calculate the NPV. This will give you the hotel’s value based on the expected cash flows.

• Internal Rate of Return (IRR): Calculate the IRR to determine the rate of return on equity investment. A higher IRR indicates a more attractive investment, assuming the risk is acceptable.

6) Consider Sensitivity and Risk Analysis

A critical component of hotel underwriting is understanding the risks and volatility of the property’s performance. Given that hotel performance can fluctuate with seasonality, economic cycles, and competition, sensitivity analysis should be performed on key variables, such as:

• ADR
• Occupancy Rate
• Exit Cap Rate
• Operating Expenses

This helps you understand how sensitive the hotel’s value is to changes in key assumptions, allowing you to assess the potential risks and rewards under different scenarios.

7) Exit Strategy and Market Liquidity

Hotels have shorter investment horizons compared to other real estate assets (e.g., office buildings or multifamily properties), and the exit strategy plays a key role in the valuation process. Consider factors such as:

• Market Liquidity: Hotel properties are more illiquid than other types of real estate, so it’s essential to assess the potential for finding a buyer or refinancing the property at the end of the investment horizon.
• Exit Cap Rate: The exit cap rate should be consistent with the market’s expectations at the time of sale and reflect the hotel’s future income potential.

8) Final Valuation and Considerations

When all factors are considered, the final hotel valuation will be the sum of:

• The NPV of unlevered cash flows (to value the property on a pure operational basis).
• The NPV of levered cash flows (to determine the equity investor’s return).
• The terminal value, reflecting the exit value of the hotel based on projected income and market conditions.

Conclusion

Valuing and underwriting a hotel investment involves a thorough understanding of both the real estate and business operations aspects of the property. By combining market research, financial modelling (including DCF), sensitivity analysis, and risk considerations, investors can make informed decisions about the potential profitability and viability of a hotel investment.