Appraisal of Limited Service Hotels – A Preamble to Valuation of Intangibles

Bwembya Chikolwa - PTAD Kevin Katsuda - Bexar CAD Mike Swenson - Bexar CAD

David Oehler - Gillespie CAD

PTI Conference University of Texas at Austin, TX

December 11 – 12, 2012

The statements made or opinions expressed by the authors/presenters in this presentation or related materials do not necessarily represent a policy position of the entities they work for.

As such, the material presented should not be quoted without prior consent of the authors/presenters.

2

1. Rationale for adjustment of intangibles

2. Texas Property Tax Code

3. General valuation model

4. Valuation methods

5. Valuation of technology and software

6. Valuation of trademarks, patents, copyrights & licenses

7. Valuation of name, reputation & flag

8. Valuation of assembled workforce

9. Adjustment for working capital

10. Controversies in valuation of hotel intangibles & open discussion

3

As an investment, a hotel fundamentally is a hospitality business whose largest capital asset is real estate but whose important operating asset is a collection of business resources and relationships that are classified as “intangible assets.”

Source: Business Enterprise Value Anthology, Appraisal Institute, pp. 139

Although the need to distinguish between tangible & intangible hotel value has been well documented, there is no general agreement regarding how to do so.

Source: O'Neill, J.W. & E.E. Belfrage (2005), A Strategy for Estimating Identified Intangible Asset Value: Hotel Affiliation Contribution, Appraisal Journal, pp. 78-86.

Broadly, in order to be subject to financial valuation, an intangible asset must be capable of being owned, is transferable and subject to legal existence and protection.

Source: Royal Institution of Chartered Surveyors (2006), Valuation of Intangible Assets, pp. 5.

4

The Texas Property Tax Code, Section 1.04 states intangible personal property:

Means a claim, interest (other than an interest in tangible property), right, or other thing that has value but cannot be seen, felt, weighed, measured, or otherwise perceived by the senses, although its existence may be evidenced by a document. It includes a stock, bond, note or account receivable, franchise, license or permit, demand or time deposit, certificate of deposit, share account share certificate account, share deposit account, insurance policy, annuity, pension, cause of action, contract, and goodwill.

Section 11.02 states:

(a) Except as provided by Subsection (b) of this section, intangible personal

property is not taxable.

5

General model for arriving at the “value of real property” for hotel properties:

6

Business Value Enterprise or Going Concern Value

Less Furniture, Fixtures & Equipment (FF&E)

Less Profit Centres:

-Food & Beverage

-Telephone & Internet

-Business Centre

-Conferences/Seminars/Workshops

-Athletic Club

Less Intangibles:

-Workforce (if applicable)

-Name, Reputation & Flag*

-Software & Technology*

-Trademark/Tradename, Patents & Licenses

-Working Capital

Value of Real Property

*Customer relationships/goodwill, advance reservations & past

customer lists may be included in either one of these.

There are three internationally accepted, fundamental approaches used in valuation:

Cost Approach: -Estimation of the cost to replace or recreate.

Market Approach: -Study of the market to create or discover guidelines. There must be

sufficient quantity of comparable or guide intangible transaction data.

Income Approach: -Valuation of earnings/income expected from exploitation of the subject

property. Income can be either ‘operating income’ or ‘ownership income’.

7

Criteria for selection of valuation method: - Quantity & quality of data. - Access to available data. - Supply of relevant transaction data. - Type & nature of the subject asset. - The particular bundle of rights represented in subject intangible asset. - Statutory, judicial, contractual, and administrative requirements and

considerations. - Informational needs of the particular audience for the valuation opinion. - Purpose and objective of the appraisal. - Compliance with professional standards. - Professional judgment and technical expertise.

Source: Reilly, R.F. & R.P. Schweihs (1999), Valuing Intangible Assets, McGraw-Hill, London.

8

The cost approach is commonly used. The income approach can be used if an identifiable income stream is available. Market transaction data is needed for the market approach.

Cost approach model:

9

Replacement Cost New (RCN):

-Direct costs (materials & supplies)

-Indirect costs (engineering & design expenses, legal fees, etc.)

-Intangible asset devlper's profit

-Opportunity cost/enterpreneurial incentive

Less Physical Deterioration¹

Less Incurable Fuctional & Technological Obsolescence²

Less Economic Obsolescence³

Intangible Asset Value

Notes:

1 Unlikely for intangible assets.

2 Functional: inability to perform function.

3 Incurable, uncontrolable external economic effects, events or conditions:

-Locational

-Economic (inability to earn fair rate of return on ROI)

Technological: Design or engineering technology of new asset produces a greater

standardized measure of util ity production.

Cost approach based “Software Engineering” estimation models are popular for valuing software:

- Constructive Cost Model (or COCOMO) Amount of development effort required to recreate subject software,

taking into account size, characteristics and environment in which program was developed.

- SPR Knowledge PLAN (or KPLAN) Amount of development effort associated with a particular software

based on various parameters including: project classification, complexity, size, language, & other attributes.

Both models arrive at a “full absorption cost per person-month,” used in

arriving at RCN. Fair market value = RCN - Depreciation

10

Some sources of data: - 10K Wizard: Search engine of terms, e.g., brand, trademark ™, etc. - Royalty Stat: Database of royalty rates & license agreements.

Valuation: - Profits generated by ™, Patents, © & Licenses captured by licensor &

licensee. - Royalty rates charged to third parties for ™, Patents, © & Licenses , e.g.

2.5% - 4% of sales, to determine value accrued to licensor. - Adjusting royalty rates to determine value accrual to licensee, e.g. “rule of

thumb”: licensor 1/3 & licensee 2/3. - Multiplying royalty rate by projected revenues & then determining ATCF

using marginal tax rate (35%). The value of IP rights is the PV of the CF derived from the “Relief from Royalty

Approach” via the DCF methodology.

11

Name recognition, good reputation for high quality service & brand/flag affiliating can add as much as 20% - 25% to going concern value of a successful operating hotel.

Source: O'Neill, J.W. & E.E. Belfrage (2005), A Strategy for Estimating Identified Intangible Asset Value:

Hotel Affiliation Contribution, Appraisal Journal, pp. 78-86.

REVPAR = Average Percent Occupancy (APO) X ADR - Reflection/measure of both management effectiveness & appeal of

hotel name, reputation & flag. Requirements for customer relationships to be an intangible: - Relationship between customer & vendor - Data & documentation regarding relationship that would be useful to

the buyer (or the user). Components of goodwill: - Existence of excess income. - Expectation of future events not directly related to current

operations; a positive NPV of income associated with future events.

12

An example for determining the value of name, reputation & flag:

13

Subject Property: 2008 2009 2010 2011 2012

(a) Room revenues ($000) $14,621 $14,864 $16,488 $17,266 $18,767

(b) Avg. daily rate ($) $113.77 $115.98 $121.30 $125.51 $124.61

(c') = (a)/(b) $128,514 $128,160 $135,927 $137,567 $150,606

(d) Occupancy (%) 60.20% 61.00% 64.80% 64.00% 71.60%

(f) = (a)/(b)/(c') Base figure $213,478 $210,098 $209,765 $214,948 $210,343

Local Submarket:

(g) Occupancy (%) 68.70% 66.70% 71.80% 71.50% 74.50%

(h) = (f)*(g) $146,659 $140,136 $150,611 $153,688 $156,706

(i) Avg. daily rate ($) $96.87 $98.99 $101.34 $105.58 $112.58

(j) = (h)*(i) $14,207 $13,872 $15,263 $16,226 $17,642

Value of Name,

Reputation &

Flag

(k) = (a) - (J) Rev, Differential ($000) $414 $992 $1,225 $1,040 $1,125

(l) Cap Rate 20% 20% 20% 20% 20%

(m) = (k)/(l) Value $2,070 $4,960 $6,125 $5,200 $5,625

Source: Adapted from Kinnard, W.N., et.al (2001), Intangible Assets in an Operating First-Class Downtown

Hotel, Appraisal Journal, pp. 68-83.

14

An Example for Extraction of Intangible Asset Capitalization Rate

Position Percent of Value Capitalization

Rate

Product

Real estate 70% 8.5%¹ 5.95%

Personal property (TPP) 10% 15% 1.50%

Intangibles (IA) 20% (X) 3.50%

Total Rate (TAB) 100% 11.00%²

Solving for IA Cap Rate (X):

X = (R₀ - (RERE X %RE) - (RTPP x %TPP))/%IA

X = (11.0% - (8.5% x 70%) - (15% x 10%))/20%

X = (11.0% - (5.95%) - (1.5%))/20%

X = (11.0% - 7.45%)/20%

X = 3.55%/20%

X = 17.75%

X = 18.00% (rounded)

Notes:

1. Real Estate R₀ (Korpacz Real Estate Survey - Apartments).

2. Hotel R₀ (Korpacz Real Estate Survey - Full service hotels).

Source: O'Neill, J.W. & E.E. Belfrage (2005), A Strategy for Estimating Identified

Intangible Asset Value: Hotel Affil iation Contribution, Appraisal Journal, pp. 78-86.

Assembled workforce (WF), which is typically classified as part of goodwill, is normally attributable to the cost that the company would incur should it have to recruit, hire, and train new employees and the corresponding lost productivity in learning a new job.

The corresponding return to the company must ultimately be greater than the cost of the employees in order to be consider an intangible.

Although WF may not be separable from brand, often the brand is sold without WF, & the WF can be valued as a separate asset.

An assembled WF possesses expertise & knowledge specific to a company & is important in sustaining the profitability & continued growth of the company.

15

16

Replacement Cost New

Assembled

Worforce

Employee

Component

No. of

Emp.'s

Avg Salary Other

Costs

Factor

Full

Absorpot

ion (FA)

Cost

Recruit

Empl.

Hire

Empl.

Train

Empl.

% of FA

Cost to

Replace

Empl.

Avg. RCN

Compo.

Total RCN

Compo.

Top Mgt 10 $180,000 1.6 $288,000 20% 20% 40% 80% 230,400 $2,304,000

Chefs 20 $60,000 1.5 $90,000 10% 50% 30% 50% 45,000 $900,000

Others 20 $40,000 1.4 $56,000 10% 40% 25% 40% 22,400 $448,000

Total Empl.'s 50

Total direct & indirect cost components $3,652,000

Add

Dvlper's profit cost component

Devlper's profit margin 10%

Devlper's profit cost component $365,200

Total direct & indirect cost components + Devlper's profit $4,017,200

Add

Enterpreneurial incentive

Est. total WF replacement period 6 weeks (6/52 weeks or 11.5%)

Est. avg. WF replacement cost (i.e., $4,017,000 total cost * 11.5%) $461,978

Req'd annual return on investment 16%

Req'd annual return on investment for 6 weeks replacement period 1.84%

Entrepreneurial incentive (i.e., $461,978 * 1.84%) $8,500 $8,500

Total replacement cost new $4,025,700

Source: Adapted from Holloway, B.P. & R.F. Reilly (2012), Intangible Asset Valuation Approcahes and Methods, Insights

magazine, pp. 13-33.

% of Total (FA) Cost

Reqd to

17

Total replacement cost new 4,034,201

Physical Deteroration

Assembled

Worforce

Employee

Component

No. of

Emp.'s

Avg.

direct &

indirect

RCN

Dvlper's

profit &

Enterpre

neurial

Incentive

Compon

ents

Total

RCN

% Dep. Accum.

Dep.

Chefs 2 $45,000 $13,000 $103,000 100% $90,000

Others 1 $22,400 $3,200 $25,600 100% $22,400

Total $16,200 $128,600 $112,400 $128,600

Functional Obsolescence

Assembled

Worforce

Employee

Component

No. of

Emp.'s

Excess

Direct &

Indirect

RCN

Excess

Dvlper's

profit &

Enterpre

neurial

Incentive

Compon

ents

Total

Excess

RCN

Function

al

Obsolesc

ence

Chefs 18 $7,500 $1,100 $8,600 $154,800

Others 2 $22,400 $3,200 $25,600 $51,200

Total $206,000

RCN less total physical & functional obsolescence $3,699,601

20% $739,920

Assembled workforce value $2,959,681

Source: Adapted from Holloway, B.P. & R.F. Reilly (2012), Intangible Asset Valuation Approcahes

and Methods, Insights magazine, pp. 13-33.

Less Selected economic obsolescence (20%)

18

Economic Obsolescence Data

Item LTM

Ended

12/31/12

Benchmark

Measure

LTM %

Shortfall

1 Average collected revenue per chef $340,000 $420,000 19%

2 No. of support staff per chef 4 3.2 25%

3 Annual growth rate in cafeteria revenue 3.50% 4.50% 22%

4 Return on the average assets 10% 12.50% 20%

5 Return on the average equity 20% 25% 20%

LTM % shortfall indications

Mean 21%

Median 20%

Mode 20%

Economc obsolescence indication 20%

Actual subject average 2008-2014

Source: Adapted from Holloway, B.P. & R.F. Reilly (2012), Intangible Asset Valuation Approcahes and Methods, Insights magazine, pp. 13-

33.

Financial or Operational Performance

Metric

Benchmark Comparison Reference

Source

2012 Local submarket average

2012 Local submarket average

Actual subject average 2008-2012

Actual subject average 2008-2013

Working Capital (WC) is capital required in the short term to run the business: - Current ratio: Current Assets/Current Liabilities - DCF Valuation: ATCF considers change in WC

WC adjustment practices: - “1/8 Rule” or 45 days of O&M account (used by utility regulators in

consideration of the allowable rate of return) - Cash & temporary cash investment accounts - Accounts receivables WC is required for an operating hotel’s continued operation/liquidity and

solvency. - e.g. two weeks of total revenue suggested for hotels

19

Some controversies and points of discussion:

- If franchise fees are the sole basis for estimating a hotel’s intangible value, are they the most appropriate technique?

- Are advanced telephone reservation systems & established reputation

for high quality fully captured in the franchise fee? - Should assembled workforce and customer relationships (e.g.

rewards/loyalty programs) be assessed as separate intangible assets? - What are the appropriate items to deduct as working capital? - What is the appropriate methodology for determining the cap rate for

intangible assets? - If detailed information is difficult to obtain or model, is a rule of the thumb

such as “20% of BEV being attributable to intangibles” appropriate? - Do locational attributes and selection of local comparables counter the need

for intangible value adjustment?

20