ABCs of Cap Rates

Investors often estimate hotel values based on capitalization rates, or cap rates. A cap rate is a rate of return calculated as the hotel's annual bottom-line profit expressed as net operating income, or NOI, divided by a hotel's sale price. In other words, a hotel with annual NOI of $1 million that sold for $10 million sold at a cap rate of 10 percent ($1,000,000 divided by $10,000,000). Stated alternatively, applying a ten-percent cap rate to a hotel's $1 million NOI results in an estimated value of $10 million ($1,000,000 divided by .10).

A problem with cap rates may be obvious: If a hotel hasn't sold, a cap rate can't be calculated because there's no sale price. As a result, investors seeking to figure out the value of an existing hotel usually use a round-about approach to estimate an appropriate cap rate: they derive cap rates from comparable hotels that have recently sold and based on that research, apply a cap rate to the hotel in question to estimate its value.

The “solution” of using cap rates from comparable hotel sales to estimate a given hotel's value is not without its problems. Sometimes, for example, no truly similar hotels have sold, or comparable information simply isn't available. Also, sometimes the information that's available is difficult to analyze. For example, in today's market, I've seen hotels sell at cap rates as low as five percent and as high as 12 percent. That's quite a range, and it can be difficult to come up with an unbiased estimate of an applicable cap rate for a given hotel within such a range.

Although it's logical to assume that applying cap rates is a reasonable method for estimating a hotel's value, another issue that comes up with cap rates is whether the market of hotel buyers and sellers actually uses them to arrive at a price upon which both a buyer and seller agree and a hotel ultimately sells. This issue is relevant because while cap rates are based on a hotel's NOI, i.e., bottom line, some market participants indicate that hotel sale prices are actually based on hotels' top lines. A hotel's top line, or at least the room revenue part, is a function of a property's occupancy and average daily rate, or ADR.

To try to get to the bottom of this issue, I queried a number of hotel owners and investors attending the New York University International Hospitality Industry Investment Conference in New York in June. Specifically, I asked them how they really determine hotel sale prices. Though most discussed cap rates, they all talked about considering top-line indicators. A few suggested that in today's sellers' market, i.e., more willing buyers than sellers, buyers who neglect to consider a hotel's top line are frequently outbid by buyers giving the top-line consideration.

While such qualitative research is interesting, and maybe even valuable, it doesn't really answer the question of what is more important to the hotel sale transaction market, i.e., top- or bottom-line performance. That's why I undertook quantitative research to evaluate the question. Looking back at hundreds of hotel sale transactions over the past 10 years, I found there are consistently three factors that most directly correlate with hotel sale prices. Specifically those three vital factors (in order of statistical significance) are: ADR, NOI and occupancy. In all cases, ADR, NOI and occupancy are based on hotels' twelve months of operation prior to an actual sale transaction taking place.

The statistical methodology used to arrive at these conclusions was hierarchical, multiple, linear regression analysis. Without going in-depth into this methodology, the point is that the top-line indicator of ADR has been a more important factor in determining hotel sale prices than the bottom-line indicator of NOI (though both factors appear to be more important than occupancy, even though occupancy is statistically significant, as well).

The bottom line, so to speak, is that a hotel's top line is extremely important in determining value, and this conclusion is not only confirmed by discussions with hotel investors, but is bolstered by statistical methodology as well. So, while cap rates (based on NOI) may be relevant, top-line indicators (particularly based on ADR) should not be ignored.

Now, on to the Penn State Index of Hotel Values. The Penn State Index projects that overall hotel values are expected to increase 10.9 percent this year, slightly higher than the 10.6-percent value increase last year.

John W. O'Neill, MAI, CHE, Ph.D., is a professor in the School of Hospitality Management at The Pennsylvania State University and a licensed real estate appraiser. He previously held unit-level, regional-level and corporate-level management positions with Hyatt and Marriott. He can be reached at or 814-863-8984.

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