Hotel Underwriting

Agreed with @SHB & @Link_REDev – you’re underwriting the operating business that has a much higher level of volatility than a traditional CRE asset with long term leases in place. In a sense, think of it like the hotel reverts to 0% occupancy each day, and guests are signing one night leases. Over the course of a year this tends to follow a more predictable pattern than you may think. (2020 excluded). Ultimately you are working towards estimating NOI just like you would in any other asset class, it just takes a bit longer to get there.

If this is for work (not school) and the deal is probable, one of your first tasks should be to create a relevant competitive set and order a STR (Smith Travel Research) Trend report. You will want to select similar hotels (i.e. don’t put a 400-room full-service Marriott in the set if your subject hotel is a 120-room select-service Courtyard) in the immediate vicinity that would have comparable rates for your subject hotel. This can get tricky in tertiary markets due to STR’s brand requirements and potential lack of supply. If the subject hotel is in a somewhat populated MSA you shouldn’t have any problem selecting an accurate competitive set that meets STR’s brand guidelines.

STR Guidelines used to be something along the lines of:

• Minimum of four hotels included in set (don’t include subject)
• No single property can account for more than 50% of the set’s total number of rooms
• No single brand (Courtyard, Hilton Garden Inn) can account for more than 50% of the set’s total number of rooms
• No single Parent Company (Marriott, Hilton, Hyatt) can account for more than 70% of the set’s total number of rooms

**These rules may have changed slightly due to Marriott’s Starwood acquisition because they now represent nearly half of the brands available in the market**

This report will give you aggregated data on:

1. Occupancy
2. ADR (Average Daily Rate)
3. RevPAR (Revenue Per Available Room) (Occ X ADR)
4. Supply (Amount of rooms in the set X # of nights open [365 when open entire year])
5. Demand (Room nights sold) (Occ % X Supply)
6. Revenue (RevPAR x Supply)

When focusing on occupancy – pay attention to comp set data, population trends & overall market growth. Sophisticated municipalities with good visitors & convention bureaus will often have an overall market STR report to shoot your way if you ask correctly.

When focusing on ADR – pay attention to comp set data, amenities and age of the hotels that would be deemed immediately competitive. Are the competitors tired and in need of a PIP (renovation)? Will your location be worthy of a rate premium over the rest of the set? Do you have a rooftop bar that is unique to the area?

• Another less accurate way to estimate ADR is to pick 3-4 dates (include at least 1 weekday & 1 weekend) and record asking rates for the each of the competitive hotels for the applicable dates.

New supply coming to the subject market is a crucial component to your evaluation. If there are hotels that are under construction / proposed in the subject market that would be directly competitive, you ADR & Occupancy assumptions need to reflect the new competitor(s) coming online.

It’s important to understand the relationship between ADR & Occupancy when evaluating hotel operations. It is very much a balancing act to find the sweet spot of both. This is counterintuitive to other CRE assets, but 100% occupancy is very rarely 1) the most optimal way to run a hotel; 2) plausible.

• By increasing ADR to a level that would allow you to run 75-80% (totally depending on market, I’m speaking in generalities) you will more often than not be able to keep revenues consistent and decrease expenses that would be associated with 100% occupancy (think housekeeping hours)

This is all done in the attempt to get to an accurate RevPAR assumption for your subject hotel. Once you feel comfortable with your topline assumptions, you need to start thinking through the operating expenses. If this is an acquisition you should have at least 2-3 years of P&L’s that will make this process much easier. Experienced hotel operators will often be able to streamline expenses from previous management through an existing presence in the market & expense sharing between regional hotels that may be able to share employees / shuttles / marketing efforts, etc. (i.e. Having a regional Director of Sales that knows the market and oversees a cluster of hotels rather than just one is a good way to split a salary between the applicable hotels and add a quick ~30k to your bottom line.) That being said, if you have existing expenses available, that is a perfectly fine baseline to plug into your proforma.

If this is a development deal and you need to estimate expenses from scratch, look into USALI – (Uniform System of Accounts for the Lodging Industry). This will give you the correct breakdown of a hotel P&L and at least give you a good starting framework.

Depending on how sophisticated you’re looking to make your model, it’s a good idea to build out a staffing schedule as well. This is tricky to do without any existing hotel data to benchmark against, but there are reports available for purchase (Wage Watch) to give data on market rates for GMs, DOS, Engineers, Housekeepers, Front Desk Associates, etc.

Once you have worked your way down to an accurate assumption of EBITDA Less Replacement Reserves, you can apply a market-relevant cap rate (I know CBRE used to publish a quarterly hotel cap rate survey for all major MSA’s) to calculate value. (in addition, it’s important to look at sales comps in the market, and cost approach if you have the available data). People will also refer to Revenue Multiples & Price per Key when discussing value (especially when evaluating limited service hotels), but these are less sophisticated and can be easily skewed due to a myriad of factors.

Once you have your cash flows modeled and an estimated value, you’ll input your debt assumptions and evaluate return metrics just like any other asset. (Some investors are more focused on IRR, while some will be more concerned with cash on cash / equity multiples etc.)

Here’s a quick back of the napkin numerical example and then I’ll shut up:

Hotel ABC

• Rooms: 125
• ADR: $100
• Occ: 80%
• RevPAR: $80
• Revenue: $3,650,000 (125 rooms x 365 nights x RevPAR)
• Expenses: $2,555,000 (70%)
• EBITDA Less RR: $1,095,000
• Cap Rate: 8%
• Value: $13,687,500
• Room Rev Multiple: 3.75x
• PPK: $109,500/key

Useful Links:

• https://str.com/data-solutions/industry-trend-report (download sample to see how the data is laid out)
• https://www.hvs.com/indepth/
• https://www.cbre.us/research-and-reports/US-Hotel-Cap-Rate-Survey-H2-2019