Finance tesa Rinences, I Rates of Return on Hotel Investments In developing capitalization rates for hotel properties, there are many factors to consider depending on the equity investor and required rates of return by Daniel H. Lesser and Karen Rubin WE HAVE NOTICED over the years that the real-estate market in general and hotel real estate in particular are not efficient. When real estate is compared with, say, the stock exchange, we wonder: Where is the up-to-the-minute information on price-earnings ratios? Across whose computer terminal does the most recent sales price of a particular property flash? What daily newspaper 1889, Cornell University JUNE 1993 prints lists of the latest prices for real property and the indicated capitalization rates? And, what exactly is that “thing” that we call “capitalization rate?” That last problem is particu- larly significant because there are so many variations of eapitaliza- tion rates and no consensus on the kind of capitalization rate that should be used. Obviously, the purpose of any capitalization rate is to reflect the relationship between a property's value (or price) and its income. However, there are many ways of expressing that relationship. So when we are 83 asked about capitalization rates for hotels, our first question is: What rate are you talking about? Daniel H. Lesser, CRE., CHA. MALL, is a senior vice president and director of consulting and valuation services with Hospitality Valuation Services (HVS). Karen Rubin, CRE, CHA, is also an HVS senior vice president. This article first appeared in the American Society of Real Estate Counselors's magazine, Real Estate Issues, 17, No. 2 (Fall-Winter 1992), pp. 43-51, and is excerpted here with permission.EXHIBIT 1 Hotel mortgage-interest rates, 1991 Quester 2 Seo tm Tora, Fixed rate, fixed term Number of loans 1 5 5 30 39 ‘Amount committed (000s) $4,890 $25,980 $29,814 $91,995 $152,679 Contract interest rate "10.75% 10.03% 10.49% 10.51% Other special features: Number of loans = = 1 1 2 Amount committed (000s) — = + $a.400 $12,426 Contract interest rate = = ' * ¢ Total Number of loans 1 ¢ 6 a at ‘Amount committed (000s) $4,890 $25,980 $32,840 $101,395 $165,105, Contract interest rate + 40.75% 10.00% 10.40% 10.44% “Data not available *Data not shown for limited number of loans ‘Source: American Council of Lie Insurance Capitalization Rates An investor may formulate a capitalization rate that can be applied to various net-income levels. For example, direct capitali- zation rates can be developed based on historical net income, forecasted first-year net income, or forecasted stabilized net income deflated to current dollars. To add to the confusion, investors ean capitalize different levels of net income, including before or after a reserve for replacement for furnishings, fixtures, and equipment and before or after an incentive-management fee. ‘The same confusion arises when discount rates are discussed, The term “discount rate” is equivalent to yield or internal rate of return. ‘Some investors segment their analysis of returns between debt and equity yields over an assumed holding period. Others focus on the total property yield or the unlever- aged return. Again, a discounted- cash-flow analysis can be predi- cated on a multitude of net-income levels. At bottom we define capitaliza- tion rate as a rate of return that an investment entity seeks when purchasing real estate. For ex- ample, if an income-producing piece of real estate is forecasted to generate $1 million in cash flow, and an investment entity wants a 10-pereent return, then the pur- chase price can't be more than $10 million. ‘To establish an appropriate rate of return, an investor must con- sider the risk inherent in the investment and the returns that may be achieved by alternative investments. Although risk is identifiable, it is difficult to quan- tify. Therefore we believe that the preferred method for quantifying capitalization rates involves the realization that a capitalization rate is merely the weighted cost of the capital utilized to aequire an investment. Hotel real-estate transactions typically involve a capital structure that includes debt and equity funds. Although there is a notable scarcity of available third-party debt funding insofar as hotels are concerned, we find that the great majority of hotel transactions currently taking place are being financed, one way or another. 84 Reliable sources tell us that. mortgages are being put in place on hotel deals. Debt-Return Requirements One source of reliable hotel- mortgage data is the American Council of Life Insuranee. The ACLI’s Investment Bulletin surveys commercial-mortgage commitments quarterly and publishes the results by property type. For most of 1990, 1991, and 1992, the companies reporting to this survey accounted for roughly ‘two-thirds of commercial mort- gages held by U.S. life-insurance companies. Thus, to a large extent, the data in the Investment Bulle- tin are from the best sources. Although many recent quarters have had insufficient data on hotel loans, published data for 1991 encompassed 41 hotel loans representing over $165 million in commitments (Exhibit 1). As one would expect, the contract interest rates for hotel mortgages substantially exceeded those reported for other property types. The average hotel contract interest rate for all types of ‘mortgages (including fixed-rate, fixed-term, participation, joint- venture, and other special fea- tures) was 104 basis points above the rate for industrial properties (for which over $876 million had been reported as committed), 96 basis points above the rate for office buildings (for which over $1.4 billion was reported commit- ted) and 78 basis points above the rate for apartments (for which over $6.2 billion was reported as committed). Obviously, the low amount committed for hotels, combined with the higher interest rates, tells the real story about the current desirability of financing hotels. Nonetheless the ACLT provides hard data that clearly indicate return requirements for ‘THE CORNELL H.R.A. QUARTERLY‘the debt component of the capitalization rate. ‘Another source of published data is the Hotel and Motel Bro- kkers of America (HMBA). Its new publication, Transactions by -HMBA, lists many types of finan- ial criteria relative to hotel sales. For 1991 the HMBA’s average listed first-mortgage loan-to-value ratio was 73.7 percent, the average interest rate was 9.8 percent, the average amortization period was 21.5 years, and the average term was 12.5 years. Another way to quantify return requirements for hotel debt is by looking at individual deals as they ‘occur as well as the terms offered by sellers who provide financing for hotels. Here are some of the recent deals that we know about. + Ata major auction held in late 1991, the Federal Deposit Insurance Corporation offered purchase-money mortgages for first mortgages on hotels at up to 75 percent of the value (or the price). Interest rates were 150 to 200 basis points over seven-year treasury notes (8.35 to 8.85 percent), the amortization period was 30 years, and the term was seven years. It was nonrecourse, nonassumable debt with a 1.25-percent origination fee. Other terms included a prepayment penalty of 3 percent during the first three years and 2 percent during years four and five, + An Asian lender placed third- party financing on a midwestern airport hotel at the end of the third quarter of 1991. A first mortgage in the $10-$15 million range reflected the full purchase price of the property. As it was interest-only, at 250 basis points over prime (about 9 percent as of March 1992), and the original term was only 1.5 years, it was probably intended as bridge financing. However, by January JUNE 1993 the term had been extended to six years with a 30-year amorti- zation schedule. But lest that sound too good to be true, close to $8 million was either guaran- teed or pledged by the borrower in the form of a security interest in other nonrealty assets, and the borrowing entity included the property’s management. Another third-party-financing deal was provided by the same Asian lender in early 1992. The property was a mid-class chain- affiliated hotel in another midwestern market. The deal was for a nonrecourse first ‘mortgage in the $5-$10 million range at a 76.5 percent loan-to- value ratio. The interest rate ‘was 300 basis points over prime, and the term was five years, interest-only for the first two years and with a 25-year amorti- ‘zation schedule thereafter. In late 1991 a quasi-governmen- tal arm of the Resolution Trust Corporation took back a pur- chase-money mortgage on a mid- class chain-affiliated hotel in a depressed area of the Northeast. The loan-to-value ratio was 70 percent, with interest at. 200 basis points over prime. The mortgage was in the $5-$10 million range. We were unable to ascertain the amortization schedule but estimate that it was based on a 30-year sched- ule; the term was seven years. ‘A major USS. insurance company took back a purchase-money mortgage on a first-class, chain- affiliated (franchised) hotel in the South at the end of 1990. ‘The mortgage was in the $15— $20 million range, and there was a commitment for a $5-$7 million second mortgage from an Asian lender. The term of the first mortgage was for five years; fixed interest was set at increas- ing rates during the term, starting at 7.5 pereent and 85 The great majority of hotel transactions currently taking place are being financed, one way or another.EXHIBIT 2 Total-property and equity yields for hotels sold Yean oF we Lecarion sate Midscale Binghamton, NY 1985 Luury—BeverlyHils, CA 1987 Lowry Carsbad, CA 41967 Midscale Boston, MA 1988 Luxury Boston’ MA 1988 First-class Chicago,IL 1988 First-class Denver, CO 1988 Midseale Kingston, NY 1908 Midscale Mfc, CT 1988 Midscale Philadelphia, PA 1988 Midscale San Francisco, CA 1988, Midscale San Francisco, CA 1088, First-class Wilmington, DE 1988 First-class Annapolis, MD 1989 First-class Boston, MA 1980 Midscale Concord, CA 1989 Midscale Corning, NY 1989 Luxury Los Angeles, CA 1989 First-class Mission Valey. CA 1969) Firstciass New Orleans,LA 1989 Luxury San Francisco, CA 1989 Midscale Walnut Crook, CA 1989 First-class Buckhead, GA 1900 Economy Easton, MD 1900 Midscale ester City, CA 1990 First-class Newport Beach, CA 1990 Lowry Palm Springs. CA 1990, First-class San Francisco, CA 1990 Economy Bridgeton, MO 1991 Micscale Bratton Woods, NH 1991 Torat- Snuxpmce —Ovenaur pnoventy — Eaury $52,200 104% 146% 20.3% 265957 149197 52.0 518,672 79 8756 $206 «108 1532 141058 0113277 124,734 90 «123165. S10 11943184 e172 07h 01 = 1081420 4a971 98 4502S 43,702 87 05128 560% 861221739 60114119985 11220018573 102374 120160282 60060 ©6502 355 443145020971 meee 47185382 wos7e 1418088 9706119 17.1 28 agess = 103187197 4920 © 121180203 412 102138196 2750 145 e238 75.210 8 98 aa 88757 120 17.0280 191.163 140837 105263 1014725 422187161208 2006 17726 “Direct capitalization rate based on stabilized year deflated to cuent dollars ‘Source: Hospitality Valuation Services ‘on a package of seven domesti hotels (roughly 1,300 rooms). ‘The mortgage was in the $30— $50 million range at a stated loan-to-value ratio of 65 percent. The interest rate was LIBOR plus 190 basis points, with a seven-year term and a 28-year amortization schedule. It was a takeout of an original note held by another lender. ‘A domestic savings and loan provided a first mortgage on a budget hotel in Texas during the first quarter of 1992. The loan was in the $1-$5 million range, with interest at 100 basis points over prime. The loan-to-value ratio was estimated at 40 percent, based on a sale price in the first half of 1991 and an estimated $1 million in renova- tion costs. The term of the loan was seven years, with a 30-year amortization schedule. From the deals we have seen consummated and from published data, we believe that required returns for the debt portion of a hotel investment are identifiable, despite the scarcity of third-party financing for hotels. Our conclusion is that loan-to-value ratios of 40 to 76 percent generally reflect the escalating to 9.59 percent. We were unable to ascertain the amortization schedule. Another major U.S, insurance ‘company took back a purchase- money mortgage on a mixed-use (hotel and office) asset in Texas in the third quarter of 1991 Interestingly, the hotel was not a chain-affiliated property. The Joan was in the $5-$10 million range, but a letter of credit for over $1 million was provided as additional security. The loan-to- value ratio was about 71 per- cent, with a fixed-interest rate of 10 percent, a seven-year term, and a 25-year amortization schedule. ‘In the fourth quarter of 1991 a European lender took a first ‘mortgage on a small, indepen- dent Manhattan hotel property. This was a takeout of previous financing, so the property was not actually sold. The new loan- to-value ratio was represented to be 60 percent of the appraised value. The loan was in the $30- $50 million range, with interest at 150 basis points over LIBOR (London Interbank Offering Rate). We were unable to ascertain either the term or the amortization schedule. In the fourth quarter of 1991 an Asian lender provided third party, first-mortgage financing 86 market, such as itis, with fixed interest rates of 9.5 to 10.5 percent. Although floating interest rates begin at levels that are materially lower, there is no way of knowing where they will end up. Amortiza- tion schedules are 25 to 30 years, and terms are 5 to 10 years. ‘While some third-party finane- ‘ng appears to be coming from Asian and European lenders, some domestic lenders are providing financing in the form of purchase- money mortgages. Although loan- to-value ratios are down from the late 1980s, when levels of percent and above were standard, debt is still a significant portion of a capitalization rate and can be well supported. However, because ‘THE CORNELL H.R.A. QUARTERLYequity-return requirements are supposed to reflect the expectations of the investor rather than docu- mented interest rates, they are ‘more difficult to quantify. Equity-Return Requirements ‘The portion of the hotel investment not funded by debt in the form of a first mortgage typically comes from an equity investor. The rate of return the equity investor expects over a ten-year holding period is, known as equity yield. Unlike the equity dividend, which is a short- term rate of return, equity yield considers a longer holding period, annual inflation-adjusted eash flows, property appreciation, ‘mortgage amortization, and pro- ceeds from a sale at the end of the holding period. Its difficult to quantify the rate of return required by equity inves- tors who seek to purchase hotel properties. To establish an appro- priate equity yield rate, a hotel analyst may consult several sources of data. First, one may analyze recent sales and extract rates based on historical and forecasted net- income figures. Second, one may refer to numerous published sourees of data. Finally, one may determine anticipated yield rates, through investor interviews. Each year our firm appraises more than 400 hotels, including properties in most major national markets. Most of the appraisals use a mortgage-equity approach by which income is projected and then discounted to a current value at rates reflecting the cost of debt and equity capital. In the case of hotels that were sold after our valuations, wwe were able to determine an appropriate equity yield rate by excluding ineentive-management, fees from the projection of income and expense, inserting the projec- tion into a valuation model, and adjusting the appraised value to reflect the actual sale price. JUNE 1993 Exhibit 2 presents a representa- tive sample of hotels sold shortly after we appraised them. It should be noted that the rates of return assume a specific type of financial structure and may not represent the actual expectations of the buy- ers. They do illustrate, however, what a typical investor may expect when acquiring one of these hotels, Published Sources ‘Many real-estate firms and organi- zations publish newsletters and summaries of investor surveys and hotel-real-estate sales. A review of some of the more recent newslet- ters illustrates that anticipated total property yield rates employed by hotel investors in their analysis range from 12.0 to 18.6 percent. Anticipated equity-yield rates range from 15.0 to 28.0 percent, Going-in capitalization rates range from 10.0 to 14.0 percent, and terminal capitalization rates range from 9.0 to 14.0 percent. The typi- cal holding periods reported by the surveys range from 5 to 15 years. ‘Anew source of data on hotel- investment returns is the publica- tion Transactions by HMBA. Although it does not consider yield data, it contains interesting data on direct capitalization rates. During 1991 the HMBA sold 170 hotels, about 25 percent of all reported nonjudicial U.S. hotel sales. The size of the lodging facilities is typically up to 400 The publication has data on operating performance at the time of sale, including average daily room rate and room revenue per room; statisties on hotel-sales transactions, including selling price per room, room-revenue multiplier, net operating income multiplier, and capitalization rate; and information on financing attained at the time of sale, includ- ing first mortgage loan-to-value ratio, amortization period, loan 87 While some financing appears to be coming from overseas, ‘some domestic lenders are providing financing in the form of purchase-money mortgages.EXHIBIT 3 Equity-yield requirements Source oF Eoury Eoury Yieto Reounewen Individual syndicator 20 to 24% Institution 18 10 22%. ‘Source: Hospitality Valuation Services EXHIBIT 4 Analysis of capitalization and yield rates, Sale 1 Hotel type: Luxury high-rise Location: South-central United States Sales price per room: $121,000 Direct capitalization rates: Foot yea Stasis ean Lever meow Hisroncar __prouto1to_seriaren v0 conn § NOI alter reserve for replacement 85% 9.5% 9.6% NOI’ before reserve for replacement 10.3% 117% 118% Ten-year DCF yield rates: Levensoeo 47 65% Levene ar 50% ALL cass Tom. Tora. Tora. Pnorenry Eaury Prorenry Eoury Propenry Eouny NOI! after reserve for replacement 13.6% 18.0% 13.5% 161% 193.5% 19.5% NOI before reserve for replacement 17.1% 25.7% 17.1% 22.2% 171% 17.1% “Net operating income ‘Discounted cash flow EXHIBIT 5 Analysis of capitalization and yield rates, Sale 2 Hotel type: First-class mig-rise Location: South-central United States Sales price per room: $41,000 Renovation cost per room: $14,000 Total acquisition cost per room: $55,000 Direct capitalization rates: Fest year Stanuzen vean Levet oF meowe Histomca PROJECTED _O&FLATED TO CMMENT § NOI’ after reserve for replacement 2.8% 6.7% 12.1% NOI before reserve forreplacement. §— 5.2%. 85% 14.1% Ten-year DCFt yield rates: Levensceo ar 60% Levensceo Ar 50% AU cass Tora, Tora. Tora. Proverry Eoury Provemry Eoury Proremty Eourry NOI’ ater reserve for replacement 15.1% 20.0% 15.1% 18.8% 15.1% 15.1% NOI" before reserve for replacement 18.1% 25.5% 18.1% 232% 18.1% 18.1% “Net operating income Discounted cash flow term, and debt-coverage ratio. Of the 170 HMBA hotel, sales tracked during 1991, 94 were conventional sales, and 76 were real-estate owned (REO) sales. For the 94 conventional sales, the average capitalization rate was 11.9 percent; for the 70 sales of properties with fewer than 75 rooms, it was 12.5 percent; and for the 24 sales of properties with greater than 75 rooms, it was 9.8 percent. Investor Interviews As hotel-real-estate eounse- lors we are in constant contact with many institu- tional and individual hotel investors. Their return requirements are often expressed as an equity yield rate based on a 10-year projection of net income before ineentive management fees but after debt service (see Exhibit 3). ‘Three recent examples. Asa final foray into the world of hotel capitalization rates, we analyzed three recent hotel transactions to illustrate current return rates. The three properties vary significantly in size, location, and quality. Sale 1 was of a high-rise, luxury-class, chain-affiliated hotel of under 500 rooms in the south-central United States, purchased with cash during the past year for about $120,000 a room. It hhad a successful operating history. Occupancies were in the high 70-percent range, and average room rates were about $100 (with an upward trend) in 1990 and 1991. The overseas buyer was expected to finance part of the pur- 88 ‘THE CORNELL H.R.A. QUARTERLYchase with offshore funds and back the mortgage with a corporate guarantee, Because the anticipated debt was not a pure real-estate mortgage, we factored into our analysis several assumed structures EXHIBIT 6 Analysis of capitalization and yield rates, Sale 3 Hotel type: Old, midrate hotel (to be converted to budget property Location: Sales price per room: $13,000 Renovation cost per room: $7,000 Total acquisition cost per room: $20,000 North-midwestern United States for debt financing from third | "26t eaprtalization rates: Fs s Parties or sellers (Exhibit 4. | eye or mcoue Heronea. paren oar ro cone § Sale 2 was of a midrate : | Nort ator reserve for placement 6.0% 7.0% 15.7% eon chain-affiliated NOI" before reserve for replacement 8.5%. 9.6% 18.0% tel in the south-central | Th ear pcr yl rates, United States, The property Levenseo 47 60% Levensoeoar45% Au ca was sold by a U.S. lending = oe fa institution during the past Proven Eaurr Provenry Eoumy Phovesry Eourr year to an overseas hotel NOI after reserve for replacement 18.8% 27.0% 18.8% 237% 188% 18.8% operator with cash for about | NO}" before reserve for replacement 21.6% 32.4% 21.6% 28.0% 21.6% 21.6% $41,000 a room. We were unable to ascertain whether “Net operating income *Discounted cash flow the buyer was interested in financing a portion of the in- vestment. The purchaser was reportedly planning to renovate and rename the property at a cost of about $14,000 a room. We analyzed the transaction on an all- cash basis and with several as- sumed debt structures (Exhibit 5). Sale 3 involved a midprice, standard-class, chain-affiliated lodging facility in the northern ‘Midwest, constructed in the late 1960s. The facility had operated with 100 to 200 rooms. Its histori- cal occupancies were in the 50-60 percent range, but since 1989 room rates had been declining from a high of about $65. The purchaser intended to reposition the property to the upper end of the budget segment, eliminate the restaurant and lounge facilities while retain ing some function space, and change the property's chain affilia- tion to one more suited to a budget- type operation. ‘The property had been fore- closed and sold out of foreclosure in mid-1992 for about $13,000 a room; however, the buyer committed to ‘spending about $7,000 more per room in renovations. The total investment was therefore $20,000 room, As reported to us by the JUNE 1993 lender, third-party financing was obtained at a stated 60 percent loan-to-value ratio. If based on the purchase price alone, however (that is, without considering the renova- tion costs), the actual loan-to- purchase price ratio was closer to 70 percent. Based on the purchase price plus the renovation cost, the loan-to-value ratio was about 45 percent. ‘The interest rate on the mort- ‘gage floated with the prime rate; however, the interest rate was reported to be artificially low owing, to the strong guarantees put in place by an entity that was known to the lender. The loan had a three- year balloon and was amortized on fa 15-year schedule, Because the anticipated debt did not reflect a pure real-estate mortgage, we factored in to our analysis several assumed structures for hotel debt financing from third parties or the seller (Exhibit 6) Conclusion: Hopeful Signs While third-party financing on hotel properties is scarce, hotel deals are being made, and the sales are being financed. That hotels are being bought and sold with equity and debt financing supports the 89 consideration of mortgage and. ‘equity-return requirements in developing today’s capitalization rates. Despite the large number of seller-financed deals, purchase- ‘money mortgages, and loans backed by corporate credit, debt terms for hotels are ascertainable, although the range of loan-to-value ratios is broader now than in the past. On the equity side the market is fragmented, with no apparent consensus on the required equity returns. Clearly the quality, age, and class of the property, the strength of its operating and financial history, its historieal and potential position in the market- place, and the magnitude of any required renovation or reposition- ing strongly influence the type of. equity investor who will be at- tracted and the equity portion of the required return on investment, In developing capitalization rrates for any hotel property, it is important to recognize those factors, interpret them in light of the kind of equity investor who would be attracted to the property, and understand their effect on the required rates of return to the equity component. ca