Investing in hotels is an exercise in balancing risks with rewards. An attractive hotel acquisition would offer low risk coupled with high returns. Let’s look at ways hotel investors can evaluate the risk/reward relationship.

Investment risk represents the likeliness that a certain return will be achieved. Examples of low-risk investments are U.S. government backed securities that guarantee a certain rate of return. High-risk investments include junk bonds where the guarantor has a low credit rating and the repayment could be uncertain.

Hotels are subject to all types of risks that impact the certainty of achieving specific levels of return. Examples of risks include potential for oversupply (too many new hotels), a decline in demand (recession), incompetent management, functional and external obsolescence, poor brand recognition, over leverage and natural and man-made disasters (oil spills). Each one of these risks translates into either lower than anticipated revenues and/or higher operating expenses, which results in a lower bottom-line profit (return). With so many different types of risks, quantifying the overall risk of a hotel investment is difficult.

The return portion of the risk/return equations represents the annual cash flow or profit from the hotel plus the value appreciation during the period of ownership. Determining the historic investment return of hotel ownership is a simple calculation that is expressed as an internal rate of return (IRR). Estimating a future rate of return is difficult because it is affected by the various risks cited above.

One of the key risk factors affecting hotel investments is the risk associated with changes in asset value over time. The industry is often characterized as being cyclical. Occupancy, rate, RevPAR, profits and hotel asset values tend to move up and down based on changes in the underlying economy. At this point in time the U.S. hotel industry has reached the bottom of a cycle that peaked in 2007 and should start to trend upwards beginning the last half of this year.

Each hotel market tracks its own cycle, which may or may not be similar to the national cycle. What is interesting about these cycles is the wide variety of volatility exhibited by different markets. From an asset value perspective, some hotel markets are highly volatile with annual asset values rising rapidly to new heights and then falling quickly to new lows. Other markets have low volatility where movement in asset value is relatively subdued.

Investors often equate volatility with risk. A highly volatile investment is thought to be more risky than a less volatile investment. However, going back to the risk/reward equation, part of the investment return is the value appreciation realized during ownership, which can only be achieved in markets exhibiting value growth and those tend to be the most volatile. The key is to identify markets that show strong growth, but are not highly volatile.

Each year HVS tracks hotel values in 52 U.S. markets. Our data goes back to 1987 and is projected out to 2015, which covers several major cycles. Based on this extensive source of hotel value data we have been able to quantify the volatility and long-term asset value growth of each market. With this information, you can identify the markets that are projected to experience relatively high asset growth coupled with low volatility and markets that will have low asset growth and high volatility.

We measure hotel value volatility by calculating the standard deviation of the annual change in value divided by the average value over the same period. This result is then indexed to the volatility of a typical hotel in the U.S. The Volatility Index shows the percentage relationship of the value volatility of a specific market to the value volatility of the U.S. For example, Miami has a Volatility Index of 82 percent, which means hotel values are 82 percent more volatile than a typical hotel value in the U.S.

The accompanying table shows the relationship between volatility with projected asset growth. The 52 hotel markets are arranged by their Volatility Index with Cincinnati being the least volatile (-50%) and New York the most volatile (131%). The Volatility Index for the U.S. is zero. The last column is the projected total change in value per room of a typical hotel in each market from 2009 to 2010. The comparison base is the projected per room change in value for a typical hotel in the U.S., which is $75,000 per room.

Using this table, I have identified the markets (in green) that have a Volatility Index of less than zero, but a projected value growth of more than $75,000/per room. These markets represent volatility lower than that of the U.S., but value growth expectations higher than the U.S. These markets include: Orlando, New Orleans, Seattle, Tucson and Minneapolis.

The markets with a Volatility Index of more than zero coupled with a projected growth of less than $75,000/per room have been identified in orange. These markets represent volatility higher than that of the U.S., but value growth expectations below the U.S. These markets include: Detroit, Philadelphia, Houston, Denver, Charlotte, Jacksonville, Austin, Omaha and Anaheim.

While hotel value volatility is not the only measure of investment risk and the projected change in value is not the only measure of investment return, they are both important factors to consider when making a hotel investment particularly in today’s uncertain market. Irrespective of its incredibly high volatility, I still like the $401,000 projected value growth for a hotel in New York City.

If you are a hotel investor looking to maximize the percentage change in value (rather than the per room change shown in the table), the results are somewhat different and can be obtained by e-mailing me at srushmore@hvs.com. Stephen Rushmore is president and founder of HVS, a global hospitality consulting organization with offices around the world. Steve has provided consultation services for more than 12,000 hotels throughout the world during his 35-year career and specializes in complex issues involving hotel feasibility, valuations and financing. He can be reached 516 248-8828 ext. 204.