hvs - art science of hotel valuation in an economic downturn[1]

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TheArt&ScienceofHotelValuationinanEconomicDownturn

Following the significant and continuing impact of the global financial andeconomic crisis on the hotel industry, HVSs valuation assumptions andmethodologyhaveevolvedtomoreaccuratelyreflecttheactionsoftypicalbuyersand sellers in the market place who have modified their valuation proceduresbasedonthecurrentfinancingenvironment.Europeanhotelvalueshavecomeundersignificantpressureinthepasttwoandahalfyearsowingtothecreditandoperatingconstraintsofthecurrentmarket.Inthis context, we have adapted our valuation assumptions and methodology toensure that we consider current and mediumterm operating and lendingconditions toprovidea fair estimateofMarketValue rather thanavaluewhichoveremphasisestheeffectsoffinancialand/oroperationaldistress.In thisarticlewedemonstratehowdistressedvaluesareat least1520% lowerthanMarketValues.Hence,theimportanceofmakingsurethatthevaluedoesntpenalise the medium and longerterm performance of the asset by assumingcurrentlydepressedinvestmentparametersandoperatingconditionsthroughouttheentireholdingperiod.Havingobservedsomeofthestrategiesputinplacebycurrently active buyers, we propose a more flexible, realistic and transparentroutetoMarketValuesinuncertaintimes.Theproposedmethodologyconsiderscurrentcreditmarketconditionsintheshorttermandarefinancingeventinthemediumterm,basedonimprovedbusinesscashflowsandthesubsequentreturnofinvestorsandlendersconfidence.Themainpurposeofthismethodologyistorepresentmorecloselybothdebtandequityinvestorssentimentandbehaviourinthecurrentmarketmakingsurethatthe true earning potential of the asset is reflected in our conclusion of MarketValue, whilst at all times complying with the strict requirements of the RoyalInstitutionofCharteredSurveyers(RICS)RedBook.

HVSLondon TheArt&ScienceofHotelValuationinAnEconomicDownturn2

Themain challenges to hotel valuation during the current crisis have been thelack of transactions, the limited availability of finance, the depressed operatingreturnsandtheunknownrecoverytimetable.Morethanever,itisimportantthatthe valuer has a specialist understanding of the industry and the specific hotelmarkets to be able to accurately assess the hotels earning potential.Moreover,theprofessionalvaluershouldbeconsciousofthebenefitsandlimitationsofthedifferent property valuationmethods available and systematically adopt two orthreevaluationmethodsascrosschecks.A tenyear leveraged discounted cash flow is the most accurate method ofvaluation,providingthatthereistransparencyforthevaluertoprovethesourceof all market assumptions and investment parameters. This valuation methodconsists of forecasting the hotels future earnings and discounting them to thepresent value based on the typical investment parameters and returnrequirementsthatdriveequityanddebtmarketparticipants.Investors and lenders appetite for prime hotels and riskfree deals with fixedleaseincomeand/orguaranteeshascontinuedandevenincreasedthroughoutthecrisis. In contrast, most other type of hotel deals have been very difficult tofinanceowingtothevolatilityofhotelearningsatthisstageoftheeconomiccycleand lenders more conservative and riskaverse approach. However, as thegeneral economy and hotel earnings recover and there is less default risk, it islikelythatbetterfinancingtermswillbecomeavailable.Therefore, if we were to simply adopt the assumptions and investmentparametersofthecurrentmarketandrollthemforwardthroughoutthetenyearsprojected,wewouldbepurely reporting adistressedvalue, not allowing for animprovement in the hotels operating cash flows, debt coverage and creditmarketsinthemediumterm.Historically,thispotentialupsidehasbeenreflectedbymerging the investmentparametersavailable todaywith those fromastablemarket. However, inessenceall thatdoes is touse investmentparameters thatareeitheroverlyaggressiveforthecurrentmarketortooconservativeforastablemarket.Torepresentmarketwide investmentparametersat all stages,wehaveadaptedour normal tenyear leveraged cash flow method of valuation and builtin arefinancingscenariowhichconsidersboththecurrentandtheimprovedmarketconditions and reflects the likelihood of refinancing in a few years time undermorefavourablelendingconditions.Thisscenarioassumesthattheloantovalueratiowill improve, and investorswill look to release someof theirequitywhenadditional finance and/or better terms are available. We have reviewed thisassumptionwithmany experienced hotel lenders and investors,most ofwhomhave confirmed the validity of our approach as it reflects their investment andlendingrationale.

Current Challenges


The following example will help to illustrate the impact of the refinancingassumptionsontheMarketValueofaspecifichotelproperty.

THEHOTELWepresent thevaluationofahypothetical250room full servicehotelaffiliatedwith an international brand. This hotel enjoys a very good location, in a mainEuropeanbusinessandleisuredestination,andwasrefurbishedin2007/08.Themarkethashighbarriers toentry, and therefore supplyhasbeen relativelystableoverthepastdecade;supplyisexpectedtoincreasebyapproximately5%from2010to2012.The hotel has historically generated an annual net operating income of nearly4,000,000 per year. However, the hotels operating income shrank by nearly40%in2009.From our forecast of occupancy, average rate, food and beverage revenue,banqueting revenue, other income and operating, undistributed and fixedexpenses for the hotel, we have projected the resulting tenyear net operatingincomecashflows,whicharepresentedinTable1.The debt service coverage ratio (DSCR) decreased to 1.05 in 2009 due to thereduced level of earnings. We observe that this is below the 1.31.5 minimumDSCRtypicallyrequiredbylendersandisnotexpectedtoexceedthatleveluntil2012.

Table1 TenYearNetOperatingIncomeCashFlowHistoryandProjections(000s)

Net ExistingYear IncomeDebtService DSCR2007 4,000 2,100 1.902008 3,700 2,100 1.762009 2,200 2,100 1.05

2010 2,400 2,100 1.142011 2,800 2,100 1.332012 3,700 2,100 1.762013 3,900 2,100 1.862014 3,960 2,100 1.892015 4,020 2,100 1.912016 4,080 2,100 1.942017 4,140 2,100 1.972018 4,200 2,100 2.002019 4,260 2,100 2.03

Historical

Projected

Our projections consider the gradual recovery of the trading performance from2010 onwards, a similar revenue and cost structure to the historical, a 4.0%reserveforreplacementtofundreinvestmentinthehotelthroughouttheholdingperiodandinflationarygrowthfromthestabilisedyear(2013)onwards.

The Science in Practice


THEVALUATIONTheMarketValueofthehotelisestimatedviathecapitalisationoftheprojectednet operating income cash flows through a tenyear leveraged discounted cashflowanalysis.We consider two valuation scenarios. Scenario One considers a theoreticalpurchase of the hotel assuming investment parameters in line with thoseavailable in themarket as of today, and no refinancing. Scenario Two assumescurrent investment parameters butwith a refinancing at the end of year three,undermorefavourablelendingterms,aspresentedinTable2.

Table2 ValuationParametersScenariosOneandTwoValuationParameters Scenario1 Scenario2StabilisedInflation: 1.5% 1.5%InitialLoan/Value: 50% 50%RefinancingLTV none 70%Amortisation(years): 20 20InterestRate: 6.0% 6.0%TerminalCapRate: 8.0% 7.0%Transaction/RefinancingCosts: 1.5% 1.5%EquityYield: 18.5% 17.5%OverallDiscountRate: 13.7% 12.2%

Wehave used our forecast of net operating income for the hotel, deducted thecorrespondingdebtserviceandaddedthenetsaleproceedsfromdisposingofthehotel at the end of an assumed ten year holding period to obtain the net cashflowstoequityanddebtcoverageratiobasedoncurrentoperatingandavailablelendingconditions,asshowninTable3.

Table3 NetCashFlowstoEquity()NetIncome Plus:Availablefor TotalAnnual NetSale TotalCashFlow

Year DebtService DebtService Proceeds toEquity DSCR

2010 2,400,000 1,441,000 + 0 = 959,000 1.672011 2,800,000 1,441,000 + 0 = 1,359,000 1.942012 3,700,000 1,441,000 + 0 = 2,259,000 2.572013 3,900,000 1,441,000 + 0 = 2,459,000 2.712014 3,960,000 1,441,000 + 0 = 2,519,000 2.752015 4,020,000 1,441,000 + 0 = 2,579,000 2.792016 4,080,000 1,441,000 + 0 = 2,639,000 2.832017 4,140,000 1,441,000 + 0 = 2,699,000 2.872018 4,200,000 1,441,000 + 0 = 2,759,000 2.912019 4,260,000 1,441,000 + 42,370,000 = 45,189,000 2.96

Note:Figureshavebeenroundedforpresentationpurposes Theannualdebtservicepaymenthasbeencalculatedbasedontheloantovalueratio assumed and the mortgage constant, which reflects the periodic cost of

Scenario One


financing as a percentage of the total loan amount.We note that the projectedearningsallowforahealthycoverageofdebtservice.Thenetsalesproceedsresultfromcapitalisingthe11thyearnetoperatingincomeinto perpetuity at the terminal capitalisation rate and deducting the typicaltransactioncostsbornebythesellerandtheremainingmortgagebalanceat theendoftheholdingperiod.Wehavethendiscountedtheannualcash flowstoequityat theassumedequityyieldwhichreflectsthereturnrequirementsofequityparticipantsinthecurrentmarket. This results in the value of the equity component (16,765,000), asshowninTable4.

Table4 DiscountedCashFlowAnalysisScenarioOneBaseValue()NetIncome Discount Discounted

Year ToEquity Factor CashFlow

2010 959,000 18.5% x 0.84388 = 809,0002011 1,359,000 18.5% x 0.71214 = 968,0002012 2,259,000 18.5% x 0.60096 = 1,358,0002013 2,459,000 18.5% x 0.50714 = 1,247,0002014 2,519,000 18.5% x 0.42796 = 1,078,0002015 2,579,000 18.5% x 0.36115 = 931,0002016 2,639,000 18.5% x 0.30477 = 804,0002017 2,699,000 18.5% x 0.25719 = 694,0002018 2,759,000 18.5% x 0.21704 = 599,0002019 45,189,000 18.5% x 0.18315 = 8,277,000

ValueofEquityComponent: 16,765,000Plus:ValueoftheMortgage: 16,765,000

Less:CapitalDeduction: 0TotalPropertyValue: 33,530,000

RoundedTo: 33,500,000Value

perRoom: 134,000PropertyYield: 13.66%

Note:Figureshavebeenroundedforpresentationpurposes

EquityDiscount

Thevalueofthemortgageisbasedonthevalueoftheequitycomponentandtheequitytovalue(ETV)andloantovalueratios(LTV).

TotalValue=ETV+LTV100%=ETV+50%ETV=100%50%=50%Thus,LTV=16,765,000

We have assumed no additional capital deduction in our analysis, beyond thealreadyforecastreserveforreplacement.As illustrated in Table 4, our tenyear leveraged discounted cash flow analysisindicatesaMarketValue for thehotelof approximately33,500,000 (134,000perroom).


However,weconsiderthatpresentlendingconditionsarenotrepresentativeofanormal investmentenvironment.Therefore,theriskisthatbyonlyconsideringtheseconditions,asshowninTable4,thehoteliseffectivelybeingundervalued.So if wewere to take into consideration the very likely event that an investorwouldexpecttorefinancethisinvestmentwhenoperatingandlendingconditionsimprove, and we adopt the Scenario Two valuation parameters, the picturechangessubstantially.ToderivethetotalcashflowtoequityunderScenarioTwowehaveusedthesameforecast of income and expense, deducted the corresponding debt service andaddedthenetproceedsofrefinancingthehotelattheendofyearthree.Uponrefinancing,thehotelhasbeenvaluedusingatenyeardiscountedcashflowanalysisbasedonpostrefinancingcashflowsfrom2014onwardsandimprovedinvestmentparametersinordertoderivethequantityoftheloanandtherevisedannual debt service. The inputs and outputs of this analysis are summarised inTable5.

Table5 ValueBasedonPostRefinancingYearCashFlowsandNewMortgageSize()

YearofValue: 2013 Value:* 47,900,000Inflation: 1.5% ValuePerRoom: 191,600

Loan/Value: 70% OverallDiscountRate: 10.8%mortisation(years): 20 CapRateHistoricalNOI: 8.1%

Term: 10 CapRate1stYearNOI: 8.3%InterestRate: 6.0% [email protected]%LTV: 33,549,000

TerminalCapRate: 7.0% MortgagePerRoom: 134,196TransactionCosts: 1.5% AnnualDebtService: 2,884,000

EquityYield: 17.5% DSCRRefi.Year: 1.37

*Beforecapitaldeduction,ifany

ValuationInput ValuationOutput

Thenetproceedsofrefinancinghavebeencalculatedbasedonthesizeofthenewmortgage less the outstandingmortgage balance of the initialmortgage and anassumed1.5%costofrefinancingasafeetothelender,asshowninTable6.

Table6 CalculationofNetRefinancingProceedstoEquity()RefinancingYearValue: 47,900,000NewLoan/ValueRatio: 70%

NewMortgage: 33,549,000Less:

OutstandingBalanceofInitialMortgage: 14,801,[email protected]%: 503,000NetRefinancingProceeds 18,200,000

Table 7 shows the calculation of net cash flows to equity according to theassumptionsofScenarioTwo.Weassumeasaleofthepropertyattheendoftheholdingperiod.

Scenario Two


Table7 ScenarioTwoNetCashFlowstoEquity()NetIncome Plus:Availablefor TotalAnnual Refi./Sale TotalCashFlow DSCR

Year DebtService DebtService Proceeds toEquity Ratio

2010 2,400,000 1,441,000 + 0 = 959,000 1.672011 2,800,000 1,441,000 + 0 = 1,359,000 1.942012 3,700,000 1,441,000 + 0 = 2,259,000 2.572013 3,900,000 1,441,000 + 18,200,000 = 20,659,000 2.712014 3,960,000 2,884,000 + 0 = 1,076,000 1.372015 4,020,000 2,884,000 + 0 = 1,136,000 1.392016 4,080,000 2,884,000 + 0 = 1,196,000 1.412017 4,140,000 2,884,000 + 0 = 1,256,000 1.442018 4,200,000 2,884,000 + 0 = 1,316,000 1.462019 4,260,000 2,884,000 + 33,569,000 = 34,945,000 1.48


Followingtherefinancingevent,thebuyertakesadvantageofadditionalfinancebased on improved level of earnings and general financing conditions and thisresults in larger annual debt service payments. We note that the DSCR uponrefinancingisstillwithinthe1.31.5minimumrangetypicallyrequiredbylendersinthestabilisedyear.Theresultingcashflowstoequityarethendiscountedattheequityyield(initially18.5%andthen17.5%afterrefinancing,giventhereductioninequityneededtofund the project, less operating risk and the higher returns on the existinginvestmentfromtherefinancingproceeds).Thisresultsinthevalueoftheequitycomponent(22,531,000).This valuation methodology considers the upside potential of refinancing thecurrent loan when the property is stabilised and more favourable lendingconditions are available on the return to the equity participant and the currentlendingconditionsonthereturntothedebtparticipant.Thus,toobtainthehotelsMarketValue,weaddthevalueoftheoriginalmortgagetothevalueoftheequitycomponentundertherefinancingassumption.We have assumed no capital deduction in our analysis, beyond the alreadyforecastreserveforreplacement.


Table8 DiscountedCashFlowAnalysisScenarioTwoMarketValue()NetIncome Discount Discounted

Year ToEquity Factor CashFlow2010 959,000 18.5% x 0.84388 = 809,0002011 1,359,000 18.5% x 0.71214 = 968,0002012 2,259,000 18.5% x 0.60096 = 1,358,0002013 20,659,000 18.5% x 0.50714 = 10,477,0002014 1,076,000 17.5% x 0.44649 = 480,0002015 1,136,000 17.5% x 0.37999 = 432,0002016 1,196,000 17.5% x 0.32340 = 387,0002017 1,256,000 17.5% x 0.27523 = 346,0002018 1,316,000 17.5% x 0.23424 = 308,0002019 34,945,000 17.5% x 0.19935 = 6,966,000

ValueofEquityComponent: 22,531,000Plus:ValueofInitialMortgage: 16,765,000

Less:CapitalDeduction: 0TotalPropertyValue: 39,296,000

RoundedTo: 39,300,000Value

perRoom: 157,000PropertyYield: 12.2%


EquityDiscount

ThisresultsinaMarketValueofthehotelof39,300,000(157,000perroom)whichinourviewmoreappropriatelyreflectstherequirementsofanexperiencedandknowledgeablehotelinvestoractinginthecurrenteconomicenvironment.Agraphicillustrationoftheprocesswouldbeasfollows.

Table 9 Illustration of the Current and Changing Circumstances and Refinancing Scenario

1,500,000

3,000,000

5,000,000

15,000,000

17,000,000

31,000,000

33,000,000

35,000,000

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

NetIncomeDebtService

NetDebtDrawdown

NetSaleProceeds

NetRefinancingProceeds

MortgageUponRefinancing

Initial Mortgage

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AbouttheAuthorsAnaCamposBlancoisanAssociatewithHVSsLondonoffice,specialisingin hotel valuation and consultancy. She joined HVS in 2007 aftercompletingadiplomainTourismManagementattheCEUUniversity,SpainandanMBAat IMHI(ESSECBusinessSchool,Paris,France).Since joiningHVS, shehasprovided investment advice andworkedonhotel feasibilitystudiesandvaluationsacrossEuropeandNorthernAfrica.Sheiscurrentlypursuing aMSc in Property Investment from the CEM (College of EstateManagement,Reading)andisexpectingtograduatein2012.

Sophie Perret is an Associate Director with HVSs London office. Shejoined HVS in 2003 and has ten years operational experience in thehospitalityindustryinSouthAmericaandEurope.OriginallyfromBuenosAires, Sophie speaks English, Spanish and French. She holds a Bachelorsdegree inHotelManagement fromAteneodeEstudiosTerciarios, and anMBA from IMHI (Essec Business School, France, and Cornell University,USA). Since joining HVS, she has advised on a wide range of hotelinvestment projects and related assignments. Sophie is responsible fordevelopingHVSsworkinFrance,Italy,andAfrica.Forfurtherinformation,pleasecontactAnaCamposBlancoorSophiePerret.AnaCamposBlancoAssociateEmail:[email protected]:+442078787762SophiePerretAssociateDirectorEmail:[email protected]:+442078787722710ChandosStreetCavendishSquareLondonW1G9DQTel:+442078787700Fax:+442078787799Orvisitwww.hvs.com

HVS2010


About HVS

HVSistheworldsleadingconsultingandservicesorganisationfocusedonthehotel,restaurant,sharedownership, gaming and leisure industries. Established in 1980, the company offers a comprehensivescopeofservicesandspecialisedindustryexpertisetohelpyouenhancetheeconomicreturnsandvalueofyourhospitalityassets.Because hotels represent both real property and operating businesses, the founding partners of HVSdecided to develop the first comprehensive valuation methodology for appraising these specialisedassets.Their initial textbookonthis topicentitledTheValuationofHotelsandMotels,publishedbytheAppraisalInstitute,createdtheindustrystandardforvaluinghotelsandisnowusedbyvirtuallyeveryappraiseraroundtheworld.HVScontinuestobeattheforefrontofhotelvaluationmethodology,havingpublishedsixtextbooksandhundredsofarticlesonthissubject,whichareusedinappraisalcoursesandseminarsandatleadinghotelschoolssuchasLausanne,IMHIandCornell.HVSassociatesareconstantlycalled upon to teach this methodology to hotel owners, lenders and operators and to participate atindustry conferences. HVS principals literally wrote the book on hotel valuation, which significantlyenhancesthecredibilityandreliabilityofourconclusions.Over the past three decades, HVS has expanded both its range of services and its geographicalboundaries. The companys global reach, through a network of 30 offices staffed by 400 seasonedindustry professionals, gives you access to an unparalleled range of complementary services for thehospitalityindustry:

Consulting&Valuation Convention,Sports&EntertainmentFacilitiesInvestmentBanking InteriorDesignAssetManagement&Advisory Sales&MarketingServicesSharedOwnershipServices HotelManagement(USonly)GolfServices EcoServicesExecutiveSearch Food&BeverageServicesRiskManagement GamingServicesPropertyTaxServices HotelParkingConsulting

Our clients include prominent hotel owners, lending institutions, international hotel companies,managemententities,governmentalagencies,andlawandaccountingfirmsfromNorthAmerica,Europe,Asia,LatinAmericaandtheCaribbean.HVSprincipalsareregardedastheleadingprofessionalsintheirrespectiveregionsoftheglobe.Weareclientdriven,entrepreneurialanddedicatedtoprovidingthebestadviceandservicesinatimelyandcostefficientmanner.HVSemployeescontinuetobeindustryleaders,consistently generating a wide variety of articles, studies, and publications on all aspects of thehospitalityindustry.HVSistheindustrysprimarysourceofhotelownershipdata.Our2,000+assignmentseachyearkeepusat the forefront of trends and knowledge regarding information on financial operating results,management contracts, franchise agreements, compensation programmes, financing structures andtransactions.Withaccesstoourindustryintelligenceanddata,youwillhavethemosttimelyinformationandthebesttoolsavailabletomakecriticaldecisionsaboutyourhospitalityassets.For further information regarding our expertise and specifics about our services, please visitwww.hvs.com.