I have a hotel construction financing opportunity that came in that I was asked to start underwriting. I haven't had any experience in UW hotels yet. I'm totally unfamiliar with how to look at franchise fees and management fees and how to judge my analysis on what information is provided in the broker package. The subject opportunity is a full-service hotel.
Additionally, the market this deal is in is a huge market for tourism so there's a lot of other hotels near the subject ranging from limited, select, and full-service. I'm unfamiliar with the reputation and profitability of a lot of the different brands and sub-brands and what kind of customers they attract. I don't know how to structure my commentary on the risks and strengths of this deal relatively to the existing comp set and what hotels are currently under construction.
Can anyone point me in some directions?
Easily my weakest asset class. Would love to hear from others.
Take a look at the supply and demand dynamics of the specific market, first from a historic standpoint. Take a look at the recent trends in occupancy levels and compare them to the supply addition of the corresponding year. Do the occ levels swing dramatically due to increases in supply? If so, how heavily? In addition to the supply increases, how did the pre-existing hotels react to the additions? Were there large amounts of capital infusions within the market in order to keep up with the new product? If not, how did they market share shift? Were rates diluted?
Then take a forward-looking approach. How many projects are currently in the pipeline? What stage are they currently in? What class do they fall into (select service, full service, etc. as well as upscale, upper-upscale, luxury, etc.)? - This will all be part of your market risk commentary. Aside from their chain scale and market classifications, you also need to be wary of additional factors such as meeting space, F&B outlets, etc., all of which could have an impact on the segmentation mix (group vs. transient business) at your hotel.
In regards to the comp set, create some sort of matrix that lists all of the key components of each hotel; (i) number of rooms. (ii) location relative to key demand generators, (iii) food & beverage outlets, (iv) amenities such as business center, pool, spa, fitness center, etc., (v) meeting space (overall and relative to the key count), (vi) when was the hotel last renovated (how much was spent, what areas were touched). Then figure out how the subject property stacks up in comparison to their competitive set. If there are specific areas in which the hotel is weaker, how would you propose the hotel can combat those issues.
Make sure you either obtain or build some sort of database that reflects recent trades within the market.
This is all very top-line and relates solely to the market dynamics. You'll then of course need to underwrite the actual hotel itself.
These are all great qualitative points to consider in your analysis.
When it comes to the numbers, start with step 1: the most important thing to U/W the proforma is a STR report. PKF is great to have as well (this will give you an overview of those historical and projected market dynamics factoring in all of those major market considerations the poster above pointed out).
TLDR: If they don't have a STR report don't even waste your time.
Thanks for your awesome response. STR report looks excellent. Steady 3-4% growth in ADR, Occupancy has never been below 80%, demand has steadily increased while comp supply has been totally flat. I've found I need to have commentary on the surrounding office market (business travel) ad walkability and drive ability for leisure travelers. I had a interesting question after going back and forth with another deal team member. Has Uber/Lyft impacted the lodging industry in a positive way? Is there any research out there that supports this?
I don't know if there is any research on this, but speaking from personal experience I feel that they did. I've booked nicer hotels a few times now that are a little further off the beaten path but are much better value and used uber to get to where I need to be. In the end, I still came out saving a decent chunk.
I've underwritten several hotels. Enough to understand the importance of a few basic due diligence items you'll need to get started including:
1) for starters, how experienced is the sponsor/developer? Hotels are a management-intensive real estate asset class with leases that expire daily. DO NOT get involved with a group that has never owned/operated a hotel before in any circumstance!
2) "flagged" hotels are the best, easiest, most liquid properties to underwrite. Now that Marriott has bought Starwood, their market share is even larger than it was pre-merger. Marriott flags include Marriott, Courtyard, Fairfield and now the W and Westin brands. Hilton flags (Hilton, HGI, Hampton etc.) would be right after that. After those two there's the Hyatt and Intercontinental brands which are much smaller, but are viewed positively by investors/lenders.
A flag will bring you easily 50% of your room nights b/c of their reservation systems and loyalty programs. Brand-new non-flagged hotels are exceptionally difficult to underwrite. Existing non-flagged hotels with well-known reputations and 5-star service like the Beverly Hills Hotel, are the only types of non-flagged hotels that can really get investor attention and decent financing.
3) You need a good feasibility study that describes the demand drivers and can create a decent penetration analysis of where the demand will come from (ie. leisure, group, or business travelers)
4) You should at the very least get a Smith Travel Research (STR pronounced "star") report of the comp set for this hotel. This will give you a good reference point for estimating the top line room revenue.
5) If you can, find a copy of the Smith Travel Research HOST report or a PKF Trends report that breaks down expense line items line by line on a % of revenue or a cost per occupied room basis. Ask an appraiser who you trust and do business with. If you can't find one, they cost $350-500 bucks. Hopefully you can expense it. Compare these assumptions to the developer's proforma. If something seems out of line, ask how they came up with their numbers. There might be a good reason, there might not be.
A couple of other "rules of thumb" to follow:
1) is that full-service hotels should have higher expense ratios (b/c of food and banquet costs) most likely in the 40% range on stabilized income. Limited service hotels w/o food service should be in the 35% range on stabilized income.
2) If the developer assumes that they'll be more than 80% occupancy into perpetuity, ask yourself how much do they really know about the hotel market. If it takes more than 65-70% average occupancy to service the debt, you're over-leveraged. On stabilized NOI numbers, you should shoot for 11.5% or 12% Debt Yield for a construction loan that will take 3-4 yrs from the beginning of construction to the stabilization date.
3) Replacement Reserves should be ~4% of Total Revenue b/c brands will require FF&E refreshes about every 7 years or so. So don't use .20/SF for roof and HVAC repairs like its an office building.
4) This rule doesn't apply as much as it used to but it used to be a good back of the napkin estimate that for every $100,000/room cost they should be able to get $100 in ADR (room rate). So if the project costs $300,000/room to build then they can hopefully average $300 in ADR. That doesn't hold up as much in today's low cap rate world we live in.
Good points, I would break out margins by service line, for ex if full service F&B margins are usually 15%, room margins are in the 60% and event margins (meeting hall, etc) is around 30% as a rule of thumb.
Also focus on your debt assumptions, if you're not a flag and the debt is non-recourse, your pricing will be much higher than traditional construction financing for other RE assets in today's market. Also, if the market is particularly in high demand for certain flags, they could be willing to contribute key money for the development of the hotel, although that too is rare in today's market, in fact I've only seen key money in 2 deals I've ever done with hotel investments.
In terms of your HMA assumptions, those are fairly standard, speaking to a few hotel property brokers should get you into a good range of fees.
Also, don't forget the initial WK that will go into your total budget to figure out the capital stack to get to stabilzied occupancy post C/O of the building to a fully operating property...
PM me and I can send you the BIWS model
PM me. Our investment group has acquired 26 hotels in the past and I've personally underwritten at least 5 in the last two years.
Threads like this are why I love WSO. Great info here, even for me just casually reading. SB's and thanks guys.
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