These are challenging times for hotel appraisers. Transactions are occurring infrequently, and when they do, many times the price represents liquidation value or a forced sale rather than market value. Hotel financing is almost impossible to obtain, so many transactions are structured using all equity instead of the normal debt and equity. Projected net income is generally lower than historic net income so derived capitalization rates are unreliable. Simply, all the traditional hotel valuation approaches don’t work in today’s market.

HVS is frequently called upon to value hotels in today’s uncertain market. Even if there are no transactions occurring or active buyers in the marketplace, hotels do have value and we must still derive what this is based on the limited data. It became obvious about six months ago that neither the traditional cap rate approach nor the 10-year discounted cash flow technique would work. We had to mirror the actions of typical hotel buyers and reflect how they would structure their acquisitions. Based on our extensive research, HVS developed a totally new approach to valuing hotels, which has produced highly accurate values even when there is little or no market data.

The basis for the HVS Hotel Valuation Approach is a standard 10-year discounted cash flow (DCF) using a mortgage/equity weighted cost of capital rate of return. However, unlike the traditional 10-year DCF where the underlying financing is assumed to continue throughout the full 10 years, the HVS approach assumes the initial (unfavorable) financing is replaced after three to five years with new debt obtained at more favorable terms. It is this refinancing assumption that truly reflects the current market environment because a typical buyer today would be lucky to obtain any amount of debt financing. Most likely, a buyer will initially have to use all equity.

Let’s go through an example to demonstrate how the HVS Hotel Valuation Approach works.

Assumptions:

Net Income Before Debt Service (per room):

Using the standard 10-year DCF and the assumed 50-percent financing, the initial value of the hotel would be $73,000 per room. The initial mortgage would be $36,000 per room. The resulting debt service is $3,225 per room. In 2012, the hotel is refinanced with the following mortgage:

The value of the hotel in 2012 using this new financing structure would be $108,000 per room. The replacement mortgage would be $76,000 per room. The resulting debt service is $6,442 room. The owner receives $41,000 per room in refinancing proceeds.

The HVS Hotel Valuation Approach combines these two financing structures in the following manner:

Here is how this structure works. Each year the hotel is expected to produce the Net Income Available for Debt Service (Column 2). From those amounts the owner has to pay debt service (Column 3) based on the initial mortgage financing and the new financing as of 2012. Column 4 shows the financing proceeds that occur in 2012 and the sales proceeds in 2018. The cash flow to equity is totaled in Column 5. The 19-percent equity discount rate is in Column 6 and the discounted cash flow is Column 7. The total of the discounted cash flow of $44,619 represents the total value of the equity on a per room basis. The initial mortgage of $36,369 is added to the equity amount to produce a total property value of approximately $81,000 per room.

The value of $81,000 per room assumes the typical buyer would be able to obtain a 50-percent mortgage to purchase the hotel. It is more likely a buyer today would have to purchase the hotel using all equity and the value would decline to $70,000 per room because the initial 50-percent debt financing would be eliminated. Appraisers who use the traditional DCF and assume an all-equity structure over the 10-year projection period would produce a value of $55,000 per room, which grossly understates the true market value of this hotel.

The HVS Hotel Valuation Approach produces an estimate of market value, which assumes a willing seller and sufficient time to complete a transaction. Under the assumption of a forced sale or an unwilling seller facing foreclosure, our estimate of market value needs to be reduced by 20 percent to 50 percent and represents what is know as “liquidation” value. Most of the transactions that will occur over the next six to 12 months probably represent liquidation value, not market value.

Suzanne Mellen, who heads up the San Francisco office of HVS, has written a detailed report on the new Hotel Valuation Approach. If you would like a copy, send Suzanne an e-mail at smellen@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 at srushmore@hvs.com or 516 248-8828 ext. 204.