SHA563 Transcripts · 2015. 5. 29. ·...

SHA563: Valuing Hotel Investments Through Effective Forecasting School of Hotel Administration, Cornell University

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SHA563 Transcripts

Transcript: Course Introduction Hotel investors face a myriad of unknowns such as: how much is my hotel worth today? How much will it be worth in five years? What's the impact of a new competitor on my rate and occupancy? How might the lose of a major demand generator impact my profitability and hence the value of my hotel? The analysis of hotel investments is both a science and an art. Good science requires good tools: they must be accurate, precise and well-‐designed. Good artists require creativity and insight. In this course, you'll acquire a set of tools designed to assist in the evaluation of hotel investments. These tools will help you complete a market study, forecast occupancy, forecast average daily rate, forecast cash flows and produce an estimate of the value of any prospective hotel. You will also consider the art of hotel investment analysis, taking a look at how good analyst uses their creativity to develop assumptions and use their insight to support the data and their conclusions. Welcome to the course. Transcript: The Market Study As a hotel investor, you have a new project, either an acquisition or a newly built property to be developed in the market. How do you make an investment decision? As we've seen, the decision relies on our old friends net present value (NPV) and internal rate of return (IRR). These are both very data-‐driven metrics. Determining either the NPV or the IRR requires a series of inputs, including occupancy, revenues, expenses, cash flows, and the selling price of the asset at the end of the holding period. Until now we have simply made assumptions about these inputs, but now it is time to learn how to derive them. In this course, you learn how to develop sound estimates of the assumptions used in the investment analysis. You learn how to forecast future occupancy while specifically considering changes in demand and supply over the projection period. This is known as a market study. You then learn how to prepare a forecast of revenues and expenses that explicitly reflects the occupancy forecast and market study. This forecast produces reliable estimates of cash flows.



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Lastly, we used the cash flow forecast, along with the market data and required rates of returns to debt and equity, to produce a market value estimate for the property. Using this methodical approach, you can now answer with confidence and clarity the big investment question: "Is the value of the property greater than the cost to acquire or the cost to build?" Transcript: The Built Up Approach to Estimating Demand Here we use the built-‐up approach to quantify existing room night demand. The built-‐up approach is based on an analysis of lodging activity, and utilizes the premise that existing hotel demand can be quantified by totaling the number of hotel rooms actually occupied in the market. This entails surveying local lodging facilities and determining their room count, their percentage of occupancy, and their market segmentation. This total is then adjusted for latent demand, which is comprised of unaccommodated and induced demand. When we talk of the primary and secondary competitive lodging facilities within a market area, we are talking about hotels catering to overnight visitors. Primary competitors are hotels similar to the subject property with respect to the class and type of facilities offered. These hotels compete for the same type of visitors as the subject hotel. Secondary competition consists of lodging facilities that would not normally attract the same type of visitor, but because of special circumstances (such as location), they become competitive. So let's identify the primary and secondary competition. A survey of the subject property's market area found 20 hotels containing 2,762 rooms; however, only 15 hotels were deemed to be competitive with the subject. Of those 20 hotels, 9 were judged to represent primary competition (1,604 rooms). Six were considered secondarily competitive (743 rooms). These include the budget hotels and the market's one luxury hotel. Based on competitive criteria, we assigned competitive weighting factors to each secondary hotel. This helps account for the competitive differences between the Sheraton and, say, a Microtel on the one hand or a Four Seasons on the other. When used in the supply and demand computer program (the Room Night Analysis), the competitive weighting factor reduces that hotel's room count, producing an "effective" room count that looks like this.



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Here we see the first indication that, though the Room Night Analysis Program is very accurate, it is only as good as the quality of its inputs. Appraisers play a crucial role in the process in instances such as this, assigning competitive weights based on their knowledge of the qualities and characteristics of both national brands and local properties. Once we have our weighted competitive set, we can estimate the occupancies for all the competitive lodging facilities in the market area. The occupancy estimate for each of the primary and secondary competitive hotels is the key ingredient in the built-‐up approach. Here we look only at the primary competition. The estimate of competitive occupancies should cover the most recent past year so that the analyst is using the actual, achieved results from the competitive properties. Next, we examine market segmentation. In the case study, we break the market into three segments: commercial, meeting and convention, and leisure. Because each market segment has unique characteristics, you need to allocate the market's overall room night demand into individual segments. This is typically done by estimating the percentage of room night demand in each market segment. Now we make an adjustment to occupancy by considering the historic average room count. For most properties, this is the same as the occupancy. But consider the 124-‐room Courtyard by Marriott. It opened on July 1, Year 0, midway between the base year period that extends from January 1, Year 0, to December 31, Year 0. Since the Courtyard only operated for six months, its historic average room count is 62 rooms (50% x 124 rooms = 62). The historic average room count equates to the hotel's room count multiplied by the percentage of the base year that the property is actually open. In addition to weighting the impact of new hotels on the market, historic average room count can be used for seasonal properties that may close for a portion of the year, or existing hotels that add new rooms during the base year.



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The process is similar for the secondary competition, with one important difference. The effective historic average room count must be adjusted for the competitive weighting of each hotel. For example, the Red Roof Inn has 110 rooms. Its competitive weighting is 50%, making the effective historic average room count 55. To make the analysis easier as we proceed, we will eventually combine the secondary competition into one generic hotel. Here we can see what this looks like. The program takes the data from each of the secondary hotels and comes up with a generic hotel. We can see the effective historic average room count of 389, the commercial segment percentage of 61.08%, the meeting and convention segment percentage of 16.88%, and the leisure segment percentage of 21.93%. Finally, we have the occupancy rate of 75.10%, and the average rate of $95.80 for our generic secondary competition.

As the last step in this section, we add the summary of the secondary competition, our "generic" secondary competitor, into our first spreadsheet. It should now look like this. We have data for our primary and generic secondary competition, and are ready to move on to calculating the accommodated room night demand.



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Transcript: Continuing the Built Up Approach In your previous calculations, you quantified the area's current accommodated room night demand. Because this demand is based on actual hotel occupancies, the accommodated demand accounts for only those hotel rooms that have been utilized by guests. It does not take into account other types of demand that may have been present in the market, but for one reason or another have not been accommodated in the area's current supply of lodging facilities. This additional demand is called latent demand. It is composed of unaccommodated demand and induced demand. Unaccommodated demand arises when transient travelers who seek accommodations within a market area must defer their trips, settle for a less desirable hotel outside the competitive set, or stay outside of the market area, because the competitive set is filled. Because this type of



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demand is not actually accommodated by the area's lodging facilities, we haven't yet accounted for it in the calculations we've made. It isn't part of the room nights we've quantified. When quantifying current hotel room night demand, unaccommodated demand can only be added to the market when the number of competitive rooms in the market is expanding. As the supply of rooms increases, more of the unaccommodated demand can be accommodated during periods of peak visitation. Guests formerly excluded from the market can now find rooms; this allows demand to grow with supply to meet the unaccommodated demand that already exists. Because of this, it is important to quantify the number of unaccommodated visitors currently attempting to use lodging facilities in the area. Adding new hotel rooms to the supply brings unaccommodated demand into the market analysis as accommodated demand; these new rooms are available to absorb this form of latent demand. Care must be taken to make sure that the amount of unaccommodated demand converted into accommodated demand is justified by the number of new rooms opening in the market. The amount of capacity (new rooms) available to convert unaccommodated demand into accommodated demand is called the accommodatable latent demand. The second type of latent demand is called induced demand. Induced demand is additional room nights that will be newly attracted to the market area over the analysis period. Some examples include: The opening of new hotels that offer previously unsupplied amenities, such as extensive meeting and convention space or specialized recreational amenities such as golf or skiing. Aggressive marketing efforts by individual properties. Some of the major hotel chains can bring new room nights into the market as a direct result of the marketing performed by other properties they operate. Or, the opening of new demand generators such as a convention center, a commercial enterprise, a retail complex, a transportation facility such as an airport or port, or a recreational attraction. So, returning to our case study, the analysis of the Sheraton's market area indicates a presence of latent hotel demand composed of both unaccommodated and induced room night demand. To show the true depth of demand in the market, the amount of latent demand must be quantified. Based on analysis of the market, here are the base year unaccommodated demand estimates for the subject's market area, shown both as a percentage of accommodated demand and as a number of room nights.



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The opening of the proposed Sheraton is expected to create induced demand in the meeting and convention segment. Based on discussions with the operator, it is anticipated that the operator will be able to refer approximately 15,000 room nights of additional demand per year to this new Sheraton. This induced demand will be attracted to the Sheraton over the first three years of its operation, based on a phase-‐in schedule. Here we can see the inputs for latent demand in the RNA program, under the Latent tab. If the market contains induced demand, the number of total induced room nights is entered adjacent to the appropriate market segment in column C. The phase-‐in percentage is entered under the appropriate year, adjacent to the appropriate market segment. Because the proposed Sheraton does not open until projection Year 3, the phase-‐in starts at that point with 20% entered in projection Year 3, 60% in projection Year 4, and 100% in projection Year 5. Unless a percentage is entered in the phase-‐in section, the RNA program assumes that none of the induced demand will be utilized. If the market contains unaccommodated demand, you enter these percentages in column B. For the Sheraton, you enter 8% for the commercial segment, 5% for the meeting and convention segment, and 3% for the leisure segment.



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The Room Night Analysis Program handles all of the calculations necessary to deal with both unaccommodated and induced demand, including the adjustment for new supply, which we will see in a future module. Now that we have forecasts of accommodated and unaccommodated demand, we are ready to take the next step, which will be to forecast room night demand into the future. Transcript: Quantifying Total Usable Demand We are now ready for the fifth step in our analysis, where we quantify the area's total guestroom supply, the total room nights available, the accommodatable latent demand, and the total usable demand. Once we have done all this, we can take the sixth step and calculate the area-‐wide occupancy. Let's begin. The total guestroom supply consists of the existing hotels (primary and secondary competition) previously identified, plus any facilities currently under construction, or proposed projects likely to be completed. Of course, that doesn't account for growth that can be expected in the market in years to come. To address this, the RNA program provides the option of growing the supply in accordance with historical growth patterns in those years when no identifiable supply is added.

The appraiser must decide what to do with each proposed hotel within the market area. Each hotel may be included, disregarded entirely, or assigned a probability factor based on its estimated chance of ultimately being developed. For example, a proposed 200-‐room hotel is announced for a site within the market area. Based on discussions with the building



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department and developer, the appraiser estimates that the project has only a 50% chance of being built. When totaling the size of the competitive supply, the appraiser includes this project, but considers it to be a 100-‐room rather than a 200-‐room hotel, utilizing the 50% probability factor. Once adjustments are made, the RNA program calculates the total room nights available by multiplying the total guestroom supply for each projection year by 365.

The RNA program also produces accurate estimates of accommodatable and unaccomodatable latent demand if latent demand is present. You determine accommodatable latent demand for each projection year as follows: Calculate the number of new room nights available per year by multiplying the number of new hotel rooms that have opened since the base year by 365. Calculate the accommodatable latent demand by multiplying the number of new room nights available by the estimated areawide occupancy for that year.

But not all the latent demand may be accommodated. The number of new rooms entering the market determines the exact amount. The portion left over is called the unaccommodatable latent demand. Unaccommodatable latent demand arises because the supply of hotel rooms is



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insufficient to accommodate total latent demand. It is simply what is left over when you subtract accomodatable latent demand from total latent demand. The RNA program automatically handles these calculations and produces accurate estimates of both accommodatable and unaccommodatable latent demand; the program uses these estimates to produce properly adjusted occupancy rates.

Let's look at the example. In addition to the 250-‐room proposed Sheraton, which is scheduled to open in three years, there are two other hotels on the horizon. A 140-‐room Best Western Hotel is scheduled to open next year, and a 200-‐unit Marriott Suite Hotel is scheduled to open in two years. Each of these hotels is considered fully competitive with the proposed Sheraton.

Looking at the Supply Addition sheet of the RNA, we can see how to handle these increases in supply. We have our 1,931 existing rooms. To that we add the 250-‐room Sheraton in row 5 of the year the Sheraton opens; if the subject hotel is an addition to the market, it is always entered in row 5. We also add the 200-‐room Marriott Suites in the year prior to the Sheraton opening. The 140-‐room Best Western, on the other hand, is opening in October of the year prior to the Marriott. We add 35 rooms in that year to account for it being open only one quarter of the year. For each subsequent year we enter it as 140 rooms. Finally, we add in the long-‐term supply growth. In our Demand Inputs sheet, we previously calculated an annual growth of 2.92%. A 2.92% compound supply growth yields these increases in room supply.



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We now have the total room nights available, and thus the market occupancy. But we are not through. We must adjust for the accommodatable latent demand and the total usable latent demand. We do this on the Demand Calculations sheet.

To see how this is done, let's look at the calculation for Year 1. During the first year, the Best Western opens with 140 rooms, which represents effectively 35 rooms because it is open for only one quarter. In addition, the 124-‐room Courtyard by Marriott was open for the first full year.

The previous year the Courtyard was open for only six months and thus counted as 62 rooms. This year we count it at its full room count when calculating the accommodatable latent demand.

Thus, we have 97 new rooms added to the supply for Year 1.

We determine the accommodatable latent demand for Year 1 by first multiplying the number of new rooms that opened subsequent to the base year times 365, yielding the total number of new rooms available per year. So the 97 rooms we just calculated times 365 is 35,405 rooms.

Next, enter the unadjusted area-‐wide occupancy for Year 1. The result of this calculation is 75.68%, taken from the "Supply Addition" sheet.

Next, the accommodatable latent room nights are calculated by multiplying the total number of new rooms available per year by the estimated area-‐wide occupancy—in this case, 35,405 times 75.68% is 26,796.

The total latent demand for Year 1 is 33,602 room nights, taken from the top of the "Demand Calculations" sheet. The unaccommodatable latent demand is the difference between the total latent demand and the accommodatable latent demand; for Year 1, this calculation is 33,602 – 26,796, or 6,806.



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The unaccommodatable latent demand is allocated to the three market segments based on the percentage relationship of each segment's demand to the market's total demand. The program divides the segmented demand by the total demand on an annual basis. Here we see the calculation. The unaccommodatable latent demand is allocated to each segment according to that segment's percentage of the total business.

We deduct the unaccommodatable portion of the latent demand from the total demand to produce the adjusted total market demand. With the opening of the 200-‐room Marriott Suite hotel and the full operation of the Best Western hotel in Year 2, there are 402 new rooms in the market since the base year. This is more than enough to accommodate all the latent demand.

Thus, the unaccommodatable demand calculations show zeros in Year 2 and beyond.

We are now ready for step 6: Calculate the area-‐wide occupancy. The area-‐wide, or market, occupancy for any given year is calculated by dividing the projected room night demand, consisting of both the accommodated demand and the usable latent demand, by the total room nights available. For example, in Year 1, we had a total room night demand of 533,427 (drawn from cell C73 of the Demand Calculations sheet). This is divided by the total room nights available, 740,220. The result? An adjusted market occupancy of 74.77%. It was a lot of work, but we now have a strong and accurate estimate of market occupancy.



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Transcript: Evaluating Competitors We now turn to step 7, where we evaluate the relative competitiveness of area hotels. Obviously, any market study must take into account the competitive strengths and weaknesses of the other hotels in the market. The relative competitiveness of the existing hotels must be quantified. We do this through penetration factors. The penetration factor expresses the hotel's relative competitiveness as a percentage of its fair share. Remember, the fair share is based solely on the hotel’s number of rooms relative to the market. It says nothing about its competitiveness. Conceptually, we calculate the penetration factor as the market share divided by the fair share.

A penetration factor greater than 100% indicates the hotel obtains more than its fair share. It is doing well in the market, with the actual percentage suggesting how well. A penetration of



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104% means the hotel has slightly more than its fair share. A penetration of 150%, on the other hand, suggests it dominates the market. Conversely, a penetration factor of less than 100% indicates the hotel obtains less than its fair share.

Consider a market containing only Hotels A and B, with three market segments: commercial, meeting, and leisure. Here we see the percentage of business within each market segment, and the resulting penetration factors for each market segment at the two hotels, as well as the overall market penetration.

The first thing to note is that each hotel has a fair share based on its room count as a percentage of the market total. For example, Hotel A has a fair share of 40% because it contains 200 of the 500 rooms in the market.



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Second, the overall penetration factor for each hotel is the ratio of each hotel's occupancy to the market occupancy. For example, let's calculate Hotel A's overall penetration factor. It is Hotel A's occupancy of 80% divided by the market occupancy of 68%. The result? An overall penetration of 118%.

We calculate the market segment penetration factors the same way, just broken down for the commercial, meeting and convention, and leisure segments.

Consider the commercial market segment penetration factor of 129% for Hotel A. That figure is calculated as the actual commercial rooms sold, 35,040, divided by the fair share (40% of 67,890 or 27,156).

Using penetration factors, the appraiser can state in simple terms that Hotel A has an overall penetration factor of 118%, meaning that it captures 118% of its fair share of business in the market.

Further, Hotel A captures 129% of its fair share of commercial business, only 57% of its fair share of meeting business, and 143% of its fair share of leisure business.

Once we have these penetration factors, we can make some defensible comparisons of each hotel's relative competitiveness. For example, compare Hotel A with Hotel B. Hotel A is 50% more competitive than Hotel B in the commercial market. Hotel B is more than twice as competitive as Hotel A in the meeting market. Hotel A is twice as competitive in the leisure segment as Hotel B. We can surmise that Hotel A is the stronger of the two hotels, though it probably lacks the meeting facilities to compete with Hotel B for this segment.



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Returning to our case study, we can now compare the relative competitiveness of the existing area hotels using the market penetration approach we've just discussed. Remember, we have already calculated the market penetrations for each hotel in the market in the base year; they are contained in the Demand-‐Base Year sheet. Here we see the overall penetration for each hotel. And we have the market segment penetration for each hotel. Now that we have measured the relative competitiveness of the hotels in the market area, we have most of the data we need to complete the market study. In the next topic we complete the study by fitting each new hotel into the market based on its expected competitiveness.



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Transcript: Fit Each Hotel into the Market Analysis

We are now ready for the eighth of our nine steps, fitting each hotel into the market based on its expected competitiveness. At a minimum, we must now assign market penetration indexes to each new lodging facility as it enters the market. In addition, if we expect the relative competitiveness of any existing area hotel to change, we need to adjust its market penetration. Remember, we have already determined market penetrations for our competition on the Demand Base Year Sheet of the Room Night Analysis. The process of assigning or adjusting competitive indexes is largely judgmental, utilizing the indices of similar hotels operating within the market as a basis for the analysis.

Once penetration information for all existing and proposed hotels has been assembled, we can enter it into the Market Penetrations sheet of the Room Night Analysis program. For most hotels in the market, we expect the present market penetrations to continue at similar levels into the future. Let's look at three examples: Embassy Suites, The Hilton Inn, and the Ramada Inn.



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Embassy Suites is a relatively new commercially oriented hotel that currently operates at its stabilized occupancy level. The property is well located and its facilities are up-‐to-‐date and well maintained. Management operates the property in a competent manner and frequent travelers recognize the Embassy Suites identification well. We expect the Embassy Suites market penetrations to continue in the future.

The Hilton Inn was constructed ten years ago as a convention-‐oriented hotel, and it is currently the largest hotel in the market. Its extensive meeting and banquet space, along with aggressive group marketing and skilled management, makes this property the most competitive in the meeting and convention market. The Hilton is also the area's least competitive hotel in the commercial market. Essentially, most of the Hilton's commercial demand has been purposely displaced by meeting and convention patronage. We expect the Hilton Inn's current market penetrations to continue into the future. A recent renovation has brought this property up to first-‐class condition, and it should remain the meeting and convention leader into the future.



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The Ramada Inn is a 17-‐year-‐old property that suffers from some deferred maintenance and a second-‐rate location in an older industrial park. It seeks to compete across market segments, but it does not capture as much meeting and convention or leisure business as other hotels in the market. The neighborhood surrounding the Ramada consists of warehouses and industrial buildings, which is not conducive to either meeting or leisure demand. We expect the Ramada's market penetrations to continue at similar levels into the future. Ownership has renovated the property on a regular basis, so we don't expect its competitive position to deteriorate.



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We perform similar analyses for all of the primary hotels. Now let's look at a hotel whose penetration levels we expect to change. The Island Inn is the oldest hotel in the market, having been constructed in 1975. Frequent changes in ownership and indifferent management have adversely affected the operating results of this property over the past five years. The Island Inn lost its franchise four years ago. Without a national identification, reservation system, or sufficient revenue to maintain this property at an attractive level, the Island Inn's competitive position is likely to decline over the coming years. We expect the present market penetrations to decline. We anticipate declines in competitiveness in all three market segments.



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Now let's look at the new properties entering the market. The Courtyard by Marriott achieved an immediate penetration of all market segments upon opening, with particular strength in the commercial and leisure markets. Its excellent location and strong management should make the Courtyard one of the occupancy leaders in the area. With only six months of operating history, the Courtyard has not yet achieved a stabilized level of competitiveness. We expect gains in all three market segments. The market mix of the Courtyard is expected to be similar to that of the Embassy Suites (i.e., strong commercial, minimal meeting and convention, and good leisure). It should undercut the Embassy Suites in room rate, capturing the more price-‐sensitive travelers, particularly in the leisure market. On the other hand, the suite concept seems to be uniformly more competitive in the commercial segment. Here are the penetration numbers for the Courtyard. It should be more competitive in the leisure segment, somewhat more competitive in the meeting and convention segment, and almost as competitive as the Embassy Suites in the commercial segment.



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We also need to analyze the two properties under construction, and our proposed Sheraton. We expect the Best Western hotel to open in October of Year 1. Its facilities will be oriented toward the rate-‐sensitive commercial traveler and weekend leisure patronage. Meeting space will be limited, so we expect its competitiveness in this segment to be minimal. The Best Western has building plans that look attractive, but the property will have an inferior location near the interstate. Here are the market penetrations for the Best Western. It should be slightly less competitive than the nearby Days Hotel for highway-‐oriented leisure patrons. Its competitiveness in the commercial segment is expected to be just below that of the Quality Inn, which is also a new property with limited meeting space.



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The Marriott Suites hotel will be the second Marriott in the marketplace. It will open in January of Year 2, and will cater to a more upscale traveler than the Courtyard, and thereby achieve a higher average room rate. Based on the following analysis, here are the market penetrations for the Marriott Suites hotel. Plans call for limited meeting space similar to the Embassy Suites, but the property will have a more upscale overall décor. With a projected room rate somewhat higher than that of the Embassy Suites, the Marriott Suites should be slightly less competitive in the commercial and leisure segments as far as occupancy is concerned, but it should achieve a higher overall room rate. Marriott's strength in marketing to meeting planners is anticipated to make this property more competitive than the Embassy in the meeting and convention segment.



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The proposed Sheraton hotel has been designed as a convention-‐oriented hotel with approximately the same amount of meeting space as the Radisson Hotel. It plans to go after both the meeting and convention and commercial segments in a manner that will maximize room revenue by not displacing as much of the higher-‐rated commercial demand with lower-‐priced meeting and convention patronage. Here are the market penetrations for the proposed Sheraton Hotel. The new facilities offered by the Sheraton, along with its excellent location, should make it highly competitive in the local market. We expect its market penetrations in all three segments to stabilize at a level somewhat above those experienced by the Radisson.



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We have now estimated changes in penetration levels, and can account for them in the Room Night Analysis. Note that penetration levels must be entered for every hotel in the competitive set. The Demand-‐Base Year sheet contains the market segment penetration levels for each hotel. The same numbers are entered in the Market Penetrations sheet. Here we will look at the commercial segment. When we begin, the program implicitly assumes that the historical market penetration will continue in the future. The number in the base year continues in each subsequent year. Your task is to modify the market penetration data to reflect the anticipated changes we have made.



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For the existing supply, all market penetrations are expected to hold constant, with the exception of the Courtyard by Marriott and the Island Inn. To change these two hotels, enter the commercial penetration data for the Island Inn; it is projected to have a penetration of 87% in Year 1, 84% in Year 2, and 80% thereafter. For the Courtyard, we enter a penetration of 117% in Year 1, 134% in Year 2, and 140% thereafter.

You also enter data for the new supply: the proposed Sheraton, the Marriott Suites, and the Best Western. The data come from the tables developed earlier. The same process works for the meeting and convention segment of the Market Penetrations sheet, shown here, and the leisure segment.

Transcript: Final Calculations We have now reached the final step on our nine-‐step list. Here we calculate the subject's market share, the room nights captured, the occupancy percentage, and the stabilized occupancy. The market penetrations we have already used form the basis for calculating the market share of each hotel within the market. Once we know the market share, we can determine the projected room nights captured, which then leads to an estimate of occupancy. The RNA program performs these calculations automatically, but we will take a look at where they come from.



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We determine market share on a year-‐by-‐year basis, in the following manner: First, we perform fair-‐share calculations to determine the fair share for each hotel in the market. Since the room count for the competitive set changes annually due to changes in the historic annual room count and additions to supply, we must perform fair-‐share calculations for each year of the projection period. Second, for each hotel, we multiply the market penetration by its appropriate fair share, resulting in a factor called the market share adjuster. You then divide the market share adjuster for each property by the total of all the market share adjusters for the area's competitive hotels. This calculation results in each property's market share percentage. Third, you determine the actual room nights captured by each hotel in each market segment. You do this by multiplying the market share percentages by the total market demand. This can be found on the Demand Calculations sheet. Fourth, sum the room nights captured by segment to obtain the total room night capture for each hotel. Fifth, determine each property's percentage of occupancy by dividing the total room nights captured by the hotel's number of available rooms per year (room count x 365). The Occupancy Calculations sheet contains the portion of the RNA program where the previously entered market penetrations are used to calculate each hotel's market share adjuster, market share percentage, room nights captured, total room nights captured, and percentage of occupancy. Here we have the Fair Share tab. Note that fair shares for each hotel decrease over time as additional supply hits the market. For example, the Embassy Suites has a 2001 fair share of 9.86%. That number drops to 8.57% in '02, 7.74% in '03, and so on. You calculate market share adjusters for each segment as follows: market share adjuster = market penetration x fair share. As an example, consider the Embassy Suites hotel. Its market penetration in the commercial segment is 150%, which when multiplied by its fair share of 9.86% results in a market share adjuster of 14.79%. Perform identical calculations for each hotel, in each market segment. Calculate market share percentages for each market segment as follows: market share percentage = market share adjuster for a given property, divided by the total market share for all properties. As an example of the market share percentages calculation, consider the Year 1 figure for the Embassy Suites hotel. Its market share adjuster in the commercial segment is 14.79%. The total of all market share adjusters is 99.82%. Thus, the market share percentage for the Embassy Suites is 14.79% ÷ 99.82% = 14.82%. Perform identical calculations for each hotel, in each market segment.



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Calculate room nights captured for each market segment as follows: room nights captured = market share percentage x adjusted market demand for the segment. As an example of the room nights captured calculation, consider the Year 1 figure for the Embassy Suites hotel. Its market share percentage in the commercial segment is 14.82%. The adjusted market demand in the commercial segment is 327,861 (this is from cell C68 on the Demand Calculations sheet). Thus, the room nights captured for the Embassy Suites is 14.82% x 327,861 = 48,587. Perform identical calculations for each hotel, in each market segment. Calculate total room nights captured for each market segment by summing the room nights captured for each market segment. As an example of how we calculate the total room nights captured, we again consider the Year 1 result for the Embassy Suites hotel. This hotel captured 48,587 room nights in the commercial segment, 2,960 room nights in the meeting and convention segment, and 8,494 room nights in the leisure segment. The three segments sum to 60,041. Perform identical calculations for each hotel. The occupancy section of the Occupancy Calculations sheet contains the yearly percentage of occupancy calculations for each hotel, as well as an overall market occupancy in row 36. Calculate occupancy as follows: occupancy percentage = total room nights captured by a given property ÷ annual available room nights. Annual available room nights are simply the room count x 365. As an example of how to calculate occupancy, consider the Year 1 figure for the Embassy Suites hotel. Its total room nights captured is 60,041. The available room nights are 200 x 365 = 73,000. Thus the Embassy Suites’ occupancy is 60,041 ÷ 73,000, or 82.25%. We can now look at the final outputs screen, which contains detailed information on one hotel in the market and our Sheraton Hotel. We will focus on the Sheraton. The Room Nights Analysis Program forecasts occupancy percentages of 54.17%, 62.53%, and 68.92% over the first three years. Based on the commercial and meeting and convention orientation of the property, we expect the Sheraton's occupancy to stabilize in the third year at a level of 68%. The final output sheet then calculates additional comparison data relative to the subject property's occupancy estimate: market share, fair share, and occupancy penetration. We have now completed our market study and produced a strong forecast of the Sheraton's occupancy. Transcript: Overview of Forecast Production This is a quick overview of how we will forecast revenues and expenses, a preview of what we will be doing in this module. First, we establish a base year forecast. Conceptualize the base year this way: there is a long-‐term equilibrium situation. Given equilibrium occupancy and



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average daily rate, what other revenues are expected and what expense levels are expected? This is fairly easy to produce for one single static year. Next, the exercise proceeds by adjusting the base year for changes in occupancy and rate obtained from the market study. The forecast must respect the fact that many of the revenues and much of the cost of the hotel are fixed. Otherwise, we will overestimate cash flows with low occupancy and underestimate cash flows with a high occupancy. In addition, the forecast must properly account for inflation. In the software, we can adjust inflation every year for every line item. With these calculations, we can produce reliable estimates of revenues, expenses, and cash flows, adjusted for the fact that much of the cost basis is fixed and adjusted for expected inflation. We have a much more reliable estimate than our static projection. Once complete, we have another key piece of the information needed to value the property. Transcript: Forecasting ADR for the Emphatic Hotel

Here we will take a look at how average daily rate, or ADR, is projected for a hotel property. Consider the Emphatic Hotel, an existing all-‐suite hotel. We have historical data for the property, and data for its competitive set. How do we project ADR for the coming years?

First, we will analyze the Emphatic's historical data, looking at the monthly average rate to determine trends that may continue to influence operating performance.

Second, we will use the competitive positioning model, considering the historical average rate for competitive properties to determine whether the Emphatic's rates reflect market conditions, management competence, and buyer's expectations.

Next, we analyze factors that may influence future average rate increases, and estimate future growth rates. These include comparisons with the competitive set, and a review of macroeconomic factors.

Finally, we project the Emphatic's average rate based on these growth estimates.

Here we see the Emphatic Hotel's monthly average rate over a six-‐year period. Note that on a monthly basis, the Emphatic achieved its highest average rate during the summer months. Average rate decreased in the winter months of December and January, then gradually increased to its peak in June and July.



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In our second step, we project the Emphatic's average rate using the competitive positioning model. Compare the Emphatic's average rate to those of the hotels most similar to it in terms of size, quality, facilities, amenities, market orientation, location, management, image, and affiliation. Make adjustments to reflect any relevant differences. Here we have the average rates achieved by the Emphatic and its competitors, the Majesty, the Ardent, the Stalwart, and the Resolute. These rates establish a range that reflects certain characteristics of the specific market, such as price sensitivity, demand orientation, and occupancy.



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The Emphatic achieved an average room rate of $122.61, significantly higher than the competitive set average of $111.04 and the highest of any hotel in the market. We can attribute this to the all-‐suite configuration of the Emphatic and the overall condition of the property. You can expect the Emphatic to maintain its position as the average rate leader in the future. Though it does not appear in the table, you also know that a new Herculean Hotel will open in Year 8, and you must consider it in the analysis.

We are now ready to estimate future growth rates. Obviously, inflation rates would have a clear impact on ADR increases. Although we take the inflation rate into account, it is important to note that room rates do not necessarily move in tandem with inflation. A number of other factors also influence a hotel’s ability to raise rates. First, supply and demand relationships can influence rate. Strong markets where lodging demand is increasing faster than supply often have rate increases that outpace inflation. On the other hand, markets that are overbuilt or suffering from declining demand are unlikely to show any significant rate increases.

Let's look at the Emphatic. It is in a market that is entering a period of strong performance. The local economy has traditionally been strong, and it is attracting new businesses due to the quality of the workforce, the quality of life, and the quality of the area's transportation infrastructure. In addition, the city has been noted as one of the top medium-‐sized cities in the U.S., attracting a growing and diverse population of seniors, which further strengthens the economy.



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Given the strength of the economy and the fact that we expect limited competition over the near term, the analyst projects that next year's room rates will grow faster than the economy, which is expected to grow 4.5% annually over the next few years. In Year 8, with the opening of the Herculean Hotel, rate growth will moderate as this hotel adds to the supply.

Another factor that can drive rate increases is an improvement in the competitive standard in a market. When a new lodging facility enters a mature market, its rates may be set higher than the market-‐wide average. This may allow other hotels to achieve corresponding gains by pushing the market rate higher.

Finally, property-‐specific improvements, such as an expansion, renovation, upgrade, or the introduction of new facilities, may justify an increase in rate.

The Emphatic is already the market rate leader, so there is no "story" that will allow the ADRs at the Emphatic to increase the relative spread between the market average and the Emphatic's rates.

In determining average rate projections, you can generally attribute changes that occur before occupancy stabilizes to property-‐ and market-‐specific factors. After the hotel achieves its stabilized occupancy, you can generally assume that room rates increase at the underlying inflation rate through the remainder of the projection period, unless any of the factors just described are clearly at work.

In the case of the Emphatic Hotel, the ADR growth rates incorporate an expected inflation rate of 3.0%. If inflation increases above this level, the Emphatic should be able to include this unexpected inflation in the room rates.

So let's look at the Emphatic. According to Smith Travel Research, over a ten-‐year period average rate increased by 4.8%. Based on this information, and assuming an inflation rate of 3%, here we have the average rate forecast for the Emphatic.

We estimate the Emphatic's average rate will increase by 5.5% in Year 8, 2.0% in Year 9, and then grow in Year 10 slightly faster than the inflation rate, so we assume a 4.0% growth rate. Basically, we can expect the solid growth rates of the Emphatic to continue, with a dip in Year 9 to account for the opening of the Herculean Hotel.



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We now have a defensible forecast of rate increases for the Emphatic Hotel for the next three years. With a forecasted occupancy and forecasted rate, we can forecast rooms revenue. We have the tools to proceed with our forecast of revenues and expenses.

Transcript: Implementation Once we have projected the subject's occupancy rate via the Room Night Analysis Program, developed the property's base income and expense statement, and formulated the future inflation assumptions, we are ready to enter data into the fixed and variable income and expense forecasting model, the FixVar program. This will produce our forecasts of revenues and expenses for the proposed Sheraton Hotel. We click the Inputs sheet to begin. The Inputs sheet consists of four sections. First we have the Project Information and Base Year Room Inputs. This portion is very straightforward. The base year data from the Sheraton room inputs come from the base financial statement. We have the year, the number of rooms, the number of days the hotel is open annually, the base year occupancy, and the base year average room rate. The occupancy comes from the analysis of comparable hotels; recall that the comparable property had an occupancy of 68%; thus, the base year is prepared under the assumption that the Sheraton is running a 68% occupancy for comparability. We also assume a base year average room rate of $130.00, which comes from a competitive positioning of the Sheraton relative to the competitive set. Next we move down to the Revenue and Expense Inputs. This is the heart of the FixVar program. We have produced a base year set of benchmarks for the Sheraton, based on the revenues and expenses for a comparable property. (We consider in detail the benchmarking of revenues and expenses, which you need to produce these estimates, in another course in this series, Achieving Hotel Asset Management Objectives.) We take the base year data and enter it into the Revenue and Expense Inputs.



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We begin with Revenues. Here we have the headings that describe the various categories comprising the base statement of income and expense. (These are arranged in accordance with the Uniform System of Accounts, 9th edition.) We have four different ways of entering data for each item, depending on which metric we have the most confidence in. In column D is the amount in total dollars, expressed in thousands. Next, in column E, we can enter items as a percentage of a defined revenue. Then, in column F, we can enter data as dollars per available room per year. Finally, in column G, we can enter data as dollars per occupied room per day. Note that for each line, you enter data pertaining to only one of these four metrics. For example, for food revenue, you could enter the amount in dollars as a percentage of rooms revenue, as the amount per available room, or as the amount per occupied room. Any one, but only one, of these will suffice. Lastly, we need to make an entry in row I, the percentage of Revenue (or Expense) Fixed to complete each line item. In the case of the Sheraton, we expect the food revenue to be 40% fixed, with 60% variable, depending on occupancy. We expect beverage revenues to be totally dependent on food revenues, so we need to enter a 0 in cell I25 to reflect this. Note the other percentages in this column. We base the default values from the template on the averages for many hotels. Note that we calculate all revenues input as percentages as a percentage of rooms revenue. The index of variability for all these items is occupancy. The one exception is beverage revenue, which we calculate as a percentage of food revenue; its index of variability is also food revenue. For expenses, we calculate rooms expenses as a percentage of rooms revenue. We calculate food and beverage expenses as a percentage of combined F&B revenues. We calculate all other departmental expenses as a percentage of the departmental revenue. Finally, we calculate all undistributed operating expenses and fixed expenses as a percentage of total revenues. The only exception is franchise fees, which we calculate as a percentage of rooms revenue. We make decisions about the data at every step of the process. Take administrative and general expenses, for example. In our Sheraton example, we use the dollar amount for A&G expenses, entering $1,150,000 into the proper cell. In other circumstances, however, it may make better sense to express A&G as a percentage of revenues or as dollars per available room. This would enable us to make better comparisons across markets with different average rates



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and wage scales. The $1,150,000 would mean different things in, say, Chicago than it would in, say, Des Moines, Iowa. On the other hand, dollars per available room makes more sense if you are comparing 200-‐room properties with 250-‐room properties. Good analysts must be aware of such nuances in choosing their data. The third section of the Inputs sheet contains inflation estimates. The program is set up so that entering an expected inflation rate in cell E63 inserts the identical rate for all revenues and expenses. We can manually enter different inflation rates for different items. For example, let's assume we believe that room rate inflation will be 6% in Year 1, and that it will slowly decline to 3% by Year 4 and stabilize at 3%. We need to enter the 3% only in cell E64 (food revenues) to have the 3% inflation assumption appear for all other line items in all years. You should experiment on your own with adding different inflation levels for different items. The third section of the Inputs sheet contains inflation estimates. The program is set up so that entering an expected inflation rate in cell E63 inserts the identical rate for all revenues and expenses. We can manually enter different inflation rates for different items. For example, let's assume we believe that room rate inflation will be 6% in Year 1, and that it will slowly decline to 3% by Year 4 and stabilize at 3%. We need to enter the 3% only in cell E64 (food revenues) to have the 3% inflation assumption appear for all other line items in all years. You should experiment on your own with adding different inflation levels for different items. The bottom portion of the Inputs sheet contains the Occupancy and Average Rate inputs. The occupancy initially appears as 68%, the number that was entered above in the project information section (cell D14). Once entered, this number appears in every year. We will need to adjust it, however, to reflect the projections from the Room Night Analysis Program. The average rate projections already reflect the adjustments for inflation, but we need to adjust them for the discounting of rates likely to occur in the hotel's opening years, as management tries to build occupancy. Once the date entry is completed, we have important estimates for the proposed Sheraton Hotel. We have projected occupancy and projected average rate. We also have projected revenues and expenses for the hotel over the ten-‐year projection period. Transcript: Estimate Overall Property Value We now have the data needed to use the Hotel Capitalization Software and produce an estimate of market value for the Sheraton Hotel. To begin, we enter the data we have developed into the Input section of the spreadsheet. The first section contains cells for project information.



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In the second section we enter information pertaining to the mortgage and equity terms. We also enter the projected cash flows, or NOIs. Finally, we have two additional cells. Values need to be added here if we are interested in using the debt coverage ratio to calculate a value. Here we insert the debt coverage ratio of 1.3 on Year 2 cash flows that we determined were appropriate when we estimated the mortgage terms. Let's take a closer look at the cash flows. These are drawn from the Net Income line on the output of the FixVar program. Note that the cash flows are only available through Year 9. We will need to project two additional years, Year 10 for the discounted cash flow analysis, and Year 11 to determine the residual value of the property. One of the first things the program does is calculate the cash flows to be used for the valuation. For the Sheraton, we assume the cash flow stabilizes in Year 3 of operation and grows 3% after this point. So the program reads the stabilized year, and calculates an inflated net income for every year thereafter. The result appears in the Calcs sheet, where we see the program has also calculated our missing Year 10 and Year 11 net incomes. Note that if you do NOT wish to use the adjusted net income, you MUST enter net income in all 11 years of the Input sheet, AND set the stabilized year in cell D19 to 11. The final section of the Input sheet contains Calculated Information. This includes the yearly mortgage constant, which is the percentage of the mortgage that is paid each year. Thus, annual debt service equals the yearly mortgage constant times the mortgage amount. Next, % of Mortgage paid in Year 10—we use this to calculate the remaining mortgage balance in the 10th year. In the case of the Sheraton, 18.2% of the mortgage is paid during the first 10 years, leaving 81.8% remaining to be paid. Then, the equity reversion in Year 10—this is the dollar amount that the equity participant will receive in Year 10. Note that this is not the terminal selling price. Finally, the Going-‐In Cap Rates. Two are presented, Year 1 and the stabilized year. We use these as a check on the reasonableness of the terminal cap rate, as well as the overall valuation. The program then takes step 4 in our valuation process, using an algebraic process to solve for value. The Calcs sheet contains the calculation “engine” used to calculate value. We calculate two values. The first uses the loan-‐to-‐value ratio, arriving at a value for the property. The second uses the debt coverage ratio, and again arrives at a value for the property. We’ll look at these values in detail on the Output page. The remainder of the Calcs page includes the Income Calculations viewed previously.



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The Output sheet contains formatted output with the valuations and the proofs of value. It demonstrates the results of step 5, where the program calculates values, and step 6, where the program performs a proof of value. The Output sheet is divided into two sections. The top section contains the valuation based on the loan-‐to-‐value ratio; the bottom section contains the valuation based on the debt coverage ratio. The value of the property, using the loan-‐to-‐value ratio to size the mortgage, is $31,666,000. Thus, the value of the mortgage component is $20,583,000, or 65% of total value. The value of the equity component is $11,083,000, or 35% of total value. The IRR for the total property, or total property yield, calculates to 12.78%. We perform the same process to calculate the IRR for the mortgage component. It is comforting to know that the IRR is 8.5%, which is the mortgage interest rate specified on the Input sheet. Similarly, the equity IRR or equity yield calculates to 18%. Here we have the cash flows used in the IRR calculations. The Year 10 flows include both the annual cash flow and the reversion to each component of value. This reversion for each component is shown under Reversion Calculations for Proof. We also have the Debt Coverage Ratio for each year of the holding period. The remaining portion of the loan-‐to-‐value section contains three tables that prove the yield calculations by showing the actual cash flow to each component—the total property, the mortgage, and the equity—discounted at the appropriate yield rate. The sum of the annual discounted cash flows plus the discounted residual value should equal the value of that particular component. Here we have the proof of value for the total property yield. The next table proves the IRR of the mortgage component. Note that the interest rate used is 8.43%, not the 8.5% mortgage interest rate. The reason this rate differs from the mortgage interest rate is due to the difference between the monthly payments used to calculate the mortgage payments and the yearly discounting used in the proof of value. The annual payment is assumed to be 12 times the monthly payment, which needs to be discounted at a slightly lower rate of interest to obtain the correct answer. Be assured that the software is correctly handling this situation. The last table proves the equity yield of 18%. These three tables prove the calculations of the Hotel Capitalization Software. They demonstrate that a total property value of $31,666,000 is the only value that would fulfill the requirements and assumptions set forth above, based on the cash flow projections for the



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proposed Sheraton Hotel, the yield requirements of the debt and equity components, and the reversionary sale assumptions. Finally, we have the value of the property using the debt coverage ratio to size the mortgage. The value is $32,418,000, rounded to $32,400,000. Compare this to the $31,600,000 value obtained using the loan-‐to-‐value valuation. Here we face one final decision: which valuation to use? We should give more weight to the value that contains the lending criteria most likely to be used at the time of the appraisal.

Transcript: Thank You and Farewell Hi, this is Jan deRoos again. We now have the tools necessary to perform a market study and produce highly accurate estimates of hotel occupancy. We can likewise produce accurate estimates of average daily rate, and of cash flows. And finally, we can put it all together to produce an overall valuation for a prospective hotel. These are essential tools for hotel appraisal work and the starting point for the thorough and defensible analysis of hotel investments. I trust they will serve you well.

SHA563 Transcripts · 2015. 5. 29. ·...

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Transcript of SHA563 Transcripts · 2015. 5. 29. ·...