Hotel Underwriting Tips and Pitfalls
As the owner of a hotel appraisal and advisory company, I get the opportunity to review hundreds of hotel appraisals, feasibility studies, investment pitch books, and offering memoranda each year. One of the things I’ve learned over the past two decades is that a few small changes in underwriting assumptions can greatly affect how hotel deals looks to investors. If these underwriting assumptions are not carefully considered, then they can represent big pitfalls for investors, appraisers, and others involved in the underwriting process.
The following is a list of several issues and pitfalls I encounter frequently. This is not intended to be a comprehensive list. But the items on this list often lead to significant flaws in hotel underwriting.
- New Supply – One of the biggest risks for hotel owners and investors is new supply. Yet, in my experience, this factor is often overlooked or underestimated by hotel underwriters. If new supply is not adequately addressed in the investor’s underwriting, then occupancy projections could end up being way off the mark.
- Ramp-Up Periods – Most hotels ramp up very quickly in the first one or two years after opening or being renovated. But I have reviewed numerous offering memoranda that show occupancies ramping up for four or five years after an anticipated sale. This can create the illusion that no big changes are assumed in the underwriting. However, it can lead to cash flow projections that are unrealistically high in later years.
- Declining Expense Projections – Underwriters should carefully review each expense line item they are projecting and compare them to historical expenses. While there can be legitimate reasons to project declines in certain expense line items, this can also sometimes be a red flag for overly optimistic underwriting. If expenses are projected to be lower in the future than they have been in the past, then there needs to be a convincing explanation for why this would happen.
- Sudden Revenue Growth – When showing a big jump in projected revenues from one year to the next, underwriters should support such projections with specific reasons. I’ve reviewed countless financial projections that show revenue bumps in excess of 20 percent for a new owner, often with the only explanation being that the new owner is going to have better management. While this may be true in some cases, a good analyst should dig deeper. Are there specific problems with current management and has the new management team identified specific strategies that are likely to produce significant revenue growth?
- Temporary vs. Stabilized Labor – Hotel underwriters should investigate whether recent financial statements reflect a fully staffed hotel. In a tight labor market, it can be difficult to keep certain hotel positions filled, especially if they are vacated without much notice. From an owner’s perspective, this can be a good thing in the short-run, as the reduced expenses from having unfilled positions can increase the hotel’s bottom line. However, if extended too long, such strategies can eventually catch up with a property and result in reduced guest scores, poor reviews, or declining morale among staff. Therefore, it is important for underwriters to understand whether there are any temporarily vacant positions that may be causing historical financials to appear artificially better than one should expect during a stabilized year.
- One-Time Expenses – On the other hand, one-time operating expenses can occasionally make historical financials appear artificially worse than a stabilized year. So, underwriters also need to research whether any of the expenses shown in historical financial statements are unusually high and temporary.
- Defining the Competitive Set – When underwriting proposed new hotels, it is important to consider which existing hotels are defined as the proposed hotel’s competitive set. If you are building an upper-midscale hotel and all the hotels in your competitive set are in the upscale chain scale, then underwriters need to factor this into how they position the projected average daily rate (ADR) for the subject hotel relative to the competitive set. Don’t automatically assume that a new hotel will achieve ADR levels in line with existing competitors, especially if the competitive set generally represents a higher or lower chain scale.
- Holding Period – When underwriting a stabilized hotel, tinkering with the holding period assumption should not affect the projected investment returns. In practice, sometimes analysts adjust the holding period without making appropriate adjustments to other valuation parameters, such as the assumed terminal capitalization rate. This erroneous procedure could produce changes in the calculated returns. If substantial changes in a hotel’s value result from changing the holding period assumption, then this could be a red flag.
- Reversion Assumptions – Seemingly small adjustments to the terminal capitalization rate and inflation assumptions can sometimes have big effects on valuations. Since most hotel cap rate surveys and most inflation surveys exhibit wide ranges of projections, there can be a lot of wiggle room for underwriters, while still remaining inside the ranges shown in national surveys. My advice to hotel analysts and underwriters is to consider the selection of all your assumed valuation parameters in aggregate and make sure they make sense together. For example, if EBITDA projections are on the aggressive end of the reasonable range, then discount rates or cap rates should reflect the riskiness of such projections.
- Capital Deductions – Many hotel acquisitions are planned in conjunction with a property improvement plan (PIP). Even when rebranding is not part of the strategy, hotel companies often require a PIP simply to maintain the existing flag. Underestimating the cost of these PIPs, or other necessary renovations, is one of the biggest potential pitfalls for investors considering a hotel acquisition.
- Change of Ownership PIPs – A related pitfall concerns the distinction between a regular PIP for a hotel and a change of ownership PIP when a hotel is being sold. An owner’s PIP and a change of ownership PIP are two very different things. When a hotel is sold, this typically causes the termination of its license or franchise agreement. For the buyer to maintain the same flag, the franchisor will typically require a new license or franchise agreement to be approved. This involves paying a new application fee as well as complying with a change of ownership PIP. Since the franchisor has significant leverage at this juncture, change of ownership PIPs can be extensive and expensive. In summary, PIP estimates from sellers can differ from change of ownership PIPs by millions of dollars. Therefore, a buyer should not assume a PIP estimate from the seller will be applicable for hotel underwriting purposes involving a change of ownership.
- Replacement Reserves – Hotel owners account for replacement reserves in varying ways. The Uniform System of Accounts for the Lodging Industry (USALI) provides that hotel operators should include a Replacement Reserve expense line item to reflect operating income, known as EBITDA Less Replacement Reserve. Most hotel cap rate surveys assume a replacement reserve, so this is a relevant application when relying on these hotel cap rates or similar hotel valuation parameters. Additionally, most hotel financial projections assume stabilized performance; so, ongoing capital improvements and renovations will be needed to achieve such stabilized performance. As such, hotel underwriters should reflect appropriate expenses for replacement reserves, regardless of whether this expense has been recorded in historical financial statements.
- Management Fees – Similarly, some hotels may not record management fees, especially owner-operated hotels. However, most hotel cap rate surveys assume professional, third-party hotel management. As such, hotel underwriters should reflect appropriate expenses for management fees, regardless of whether this expense has been recorded in historical financial statements.
- Franchise Term – Strong branding and reservation systems often contribute to a hotel’s success. Therefore, it is important to understand the length and terms of a hotel’s franchise agreement. Some investors are reluctant to acquire hotels with fewer than 10 years left on a popular franchise agreement. If a hotel’s franchise agreement expires and cannot be renewed, an owner may be limited to inferior branding options that will negatively affect future revenue and earnings. Therefore, if underwriters don’t accurately account for a hotel’s franchise term, then their EBITDA and reversion estimates could be seriously flawed.
Hotel appraisers, investors, and underwriters typically must make decisions about dozens or hundreds of assumptions throughout the course of analyzing a single hotel deal. The preceding tips are intended to invite additional attention to certain assumptions and topics that frequently lead to flawed analyses. The author welcomes comments and feedback. This report is intended for discussion purposes only and is not intended to be construed as investment advice.