When hotel markets evolve as they have lately, the highest and best use of a particular hotel may change. Highest and best use is an economic concept that identifies the use of real estate that will generate the greatest return to the owner. When a piece of real property is developed to its highest and best use, the result is the greatest possible market value of the real estate.

The highest and best use concept is important not only because the highest and best use provides the owner with the greatest possible return, but also because when a real estate appraiser estimates value of real property like a hotel, the appraiser should determine the property’s highest and best use early on during the appraisal engagement. In fact, it’s required by law.

While the highest and best use for an existing hotel is usually to continue operations as a hotel, sometimes it’s not. It’s not unusual in today’s market to see a hotel with functional obsolescence where the highest and best use is no longer as a hotel. In some cases, the hotel should be converted to an alternative use, such as a residential property, but in other cases the hotel should be demolished.

To determine whether a hotel should be demolished, it’s first necessary to figure out whether there is an alternative use for the land that will provide a superior return to the land owner. A couple years ago, it was not unusual to find land being sold for hotel development to be transferring at higher prices than for any other anticipated use. In a few markets I’ve studied lately, I’ve found other proposed uses, such as national and regional drug stores and gas stations/convenience stores, to net higher land prices per square foot for the land owners. In other words, to figure out whether there may be an alternative highest and best use for land, it’s important to analyze area land sales. An appraiser should then estimate the value of the subject land minus the cost to demolish the hotel, as well as any lost profit between the point in time the hotel is closed and the point a new use generates cash flow (or the point the land is sold).

For example, I recently appraised an exterior-corridor hotel that originally opened as a Holiday Inn in 1961 and is located at the edge of the downtown of a mid-sized city. It later operated as a Ramada Inn and most recently was an unaffiliated hotel with significant obsolescence. The hotel had not been profitable since a new chain-affiliated hotel opened downtown a few years ago. The most recent land sales in the area were for gas stations/convenience stores, drug stores and a hospital expansion. The hotel was located along a primary artery with high traffic counts in a busy, commercial neighborhood.

In the end, the hotel was unlikely to be profitable in the foreseeable future, and its value was calculated as the value of its highly desirable land less the cost to demolish the very undesirable improvements, i.e., the hotel.

An alternative consideration to the drastic decision to demolish a hotel is that the highest and best use of the property may be renovation and/or re-branding. Again, it’s necessary to estimate the cost of the renovation/re-branding, any temporary lost profit and the return on the investment. As previously presented in this column, lost profit usually occurs during the first year after a brand change, with profit improvements typically beginning in the second year.

The Penn State Index
The Penn State Index of U.S. hotel values econometric model currently projects overall hotel values will decline 3.1 percent this year. With an approximate $13,000 per-room decrease in value, luxury hotels can be expected to have the largest value decreases for 2010. Economy hotels are expected to register the largest percentage drop in value, with a 5.7-percent decline.

John W. O’Neill, MAI, CHE, Ph.D., is managing director of Hospitality Advisory Services, LLC, and Associate Professor in the School of Hospitality Management at The Pennsylvania State University. Reach him at jwo3@psu.edu or 814-863-8984.