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**By Stephen Rushmore, CHA, MAl, eRE, and
**

jan deRoos, Ph.D.

Stephen Rushmore, eHA, MAl, CRE, is President and Founder of HVS International, a global hospitality consulting organizp.tion with offices in New York (Mineola), San Francisco, Miami, Boulder, Vancouver; London, New Delhi, Singapore, and Mexico City. He directs the worldwide operation of HVS International and is responsible for future office expansion and new product development. Mr. Rushmore has pr0vided consultation services for more than 5,000 hotels throughout the world during his 30-year career and specializes in complex issues involving hotel feasibility, valuations, and financing. He was one of the creators of the Microtel concept, and has written numerous books and articles on hotel feasibility studies, appraisals, and other aspects of hotel investing.

Jan deRoos, Ph.D., is an Assistant Professor in the School of Hotel Administration at Cornell University. He has devoted his career to hospitality real estate, with afocus on the valuation, development, fi7Ulncing, and operation of lodging assets. Areas of teaching expertise include hospitality real estate fi7Ulnce,lodging property valuation, hotel development and construction, and hospitality industry environmental (eco) management. Prior to his teaching career;Dr. deRoos worked extensively in the hospitality industry and was responsible for the construction of new properties and the renovation and facility management of existing hotels. He is one of the primary researchers responsible for producing the Lodging Property Index, a quarterly publication that reports on the total returns to lodging property.

HIS CHAPTER on hotel valuation presents three traditional income approaches that are used to estimate the market value of individual hotel assets. In addition, an after-tax model that estimates investment value, two income capitalization techniques used to value hotels owned by publicly traded lodging companies, and two rules of thumb for valuing hotels will be demonstrated. Each technique is illustrated by means of a unified case study that allows for a meaningful comparison of the techniques. We will conclude with a summary that briefly compares all of the techniques.

T

Three Approaches to Hotel Valuation -------In valuing hotels, there are three approaches from which to select: the income capitalization, sales comparison, and cost approach. Although all three valuation

approaches are generally given consideration, the inherent strengths of each approach and the nature of the hotel in question must be evaluated to determine which approach will provide supportable value estimates. Since hotel investors typically give more weight to it, the income capitalization approach will be emphasized in this chapter.

Income Capitalization

Approach

The income capitalization approach is based on the principle that the value of a property is indicated by its net return, or what is known as the "present worth of future benefits." The future benefits of income-producing properties, such as hotels, are the net income estimated by a forecast of income and expense along with the anticipated proceeds from a future sale. These benefits can be converted into an indication of market value through a capitalization process and discounted cash flow analysis. The forecast of income and expense is expressed in current dollars for each year. The stabilized year is intended to reflect the anticipated operating results of the property over its remaining economic life, given any or all applicable stages of build-up, plateau, and decline in the life cycle of a hotel. Thus, income and expense estimates from the stabilized year forward exclude from consideration any abnormal relationship between supply and demand, as well as any nonrecurring conditions that may result in unusual revenues or expenses. As stated in the textbook entitled Hotels and Motels: A Guide to Mar/ret Analysis, Investment Analysis, and Valuations, "Of the three valuation approaches available to the appraiser, the income capitalization approach generally provides the most persuasive and supportable conclusions when valuing a lodging facility"! The text goes on to state that using a ten-year forecast and an equity yield rate "most accurately reflects the actions of typical hotel buyers, who purchase properties based on their leveraged discounted cash flow."2 The simpler procedure of using a ten-year forecast and a discount rate (total property yield) is "less reliable because the derivation of the discount rate has little support. Moreover, it is difficult to adjust the discount rate for changes in the cost of capital."> A third income valuation technique is the "band of investment using one stabilized year." This technique is appropriate when the local hotel market is not expected to experience any Significant changes in supply and demand so it can be assumed that the subject property's net income has stabilized.

**Sales Comparison Approach
**

While hotel investors are interested in the information contained in the sales comparison approach, they usually do not employ this approach in reaching their final purchase decisions. Factors such as the lack of recent sales data, the numerous insupportable adjustments that are necessary, and the general inability to determine the true financial terms and human motivations of comparable transactions often make the results of this technique questionable. The sales comparison approach is most useful in providing a range of values indicated by prior sales;

however, reliance on this method beyond the establishment of broad parameters is rarely justified by the quality of the sales data. The market-derived capitalization rates sometimes used by appraisers are susceptible to the same shortcomings inherent in the sales comparison approach.

Cost Approach

The cost approach may provide a reliable estimate of value in the case of new properties, but as buildings and other improvements grow older and begin to deteriorate, the resultant loss in value becomes increasingly difficult to quantify accurately. Most knowledgeable hotel buyers base their purchase decisions on economic factors such as projected net income and return on investment. Because the cost approach does not reflect these income-related considerations and requires a number of highly subjective depreciation estimates, this approach is given minimal weight in the hotel valuation process. Since the cost approach is seldom appropriate for valuing hotels, it will not be covered in this chapter.

Case Study Example and Valuation Techniques ---The fictiona1300-roorn Eldridge Hotel is an upscale property in an urban market catering to the needs of business travelers and moderate-size groups. The Eldridge was constructed in 1990 in a growing area of a major city located in the southern half of the United States. The property has a restaurant and deli with 200 seats, and a club and lobby bar with 120 combined seats. Meeting space totals 20,000 square feet and includes a grand ballroom, two executive boardrooms, and several breakout rooms. Recreational facilities include an indoor/outdoor pool with whirlpool, an exercise room, stearn rooms, and a locker facility. The property is the newest hotel in its competitive set. The property was constructed using superior materials and workmanship and has been maintained in above-average condition. The property was recently renovated and shows no signs of distress or deferred maintenance. The Eldridge has traditionally been an average competitor, achieving average daily rates and occupancy virtually in the middle of its competitive set. Given the slow but steady growth in demand and the lack of new competition in the past nine years, recent occupancy rates have been very strong. However, one new hotel and a conversion from a mid-price to an upscale hotel are expected to open in 1999, increasing the number of rooms in the upscale sub-market by 10 percent. In addition, one new project is rumored to be ready to break ground. These factors combine to produce an outlook for a near-term drop in market occupancy as the new properties gain their fair share of the upscale market. The occupancy situation is expected to improve in five years, as demand grows to catch the supply.

**Pro-Forma Financial Projections
**

Exhibit 1 presents a historical statement of income and expense for 1998 for the Eldridge Hotel, as well as projections for 1999 through 2001. The current date is

415 3.467 3.2 22.0 41.8 17. Departmental Income Undistributed Operating expenses Income Before Fixed Charges Fixed Charges Net Income 5.032 10.0 59.139 10.384 1.99 76. c.800 16. .6 58.Exhibit 1 Statement of Revenues and Expenses for the Fictional 1998 .2 58.1 17.165 4.140 5.008 %of Gross $per Room 17.633 33.690 15.0 41.665 29.969 31.797 33.00 85.650 $per Room $(000) Gross Total Revenues Departmental .6 58.125 $per Room 72% $139.047 100. and "Other. Insurance.Year 2 Occupancy Average Rate Rooms Occupied 78% $125.797 12.530 7.230 5.245 10.950 4.0 27. Telephone.139 7.150 33.902 %of Gross $(000) 17.833 16. Marketing.722 100.340 100.Year 3 1999 .947 4. and a 4 percent Capital Expenditure Reseive.xjJ~nses .rgesincludes Property Taxes.13 78.033 24.824 30.790 23.310 5.Historical 300-Room Eldridge Hotel 2001 . Property Operation and direct expenses of Rooms.717 13.5 57.410 7.993 31. Franchise Fees. Management Maintenance.385 ·1.390 10. Fees.840 $per Aoom 70% $143.337 7.50 82.Year 1 2000 . and Energy Costs.263 1.740 100.814 %of Gross $(000) 17.4 29.2 57.1 17.2 22. Departmental Expenses includesthe & Beverage.747 5. Notes: Total Revenues includes Rooms.107 4.410 %of 75% $132.8 17.5 8.440 33." Undistributed Operating Expenses includes A&G. Food & Beverage..993 16. d.8 27.4 - a. and "other" revenues.640 13. Food b.130 23.0 8.4 20.3 8.132 1.8 28.217 23.433 24.439 3.2 8.693 i.107 4.543 4. $(000) 17.8 57.0 42. Fixed Cha.890 12.1 58. Telephone.0 41.392 3. .198 4.

The projection shows a rapid decline in occupancy as new supply comes into the market.824 million is used+ Basis of Projections. It is thought that long-term stabilized occupancy will average 72 percent.5% 15. a decline of 8. This combination produces a net income that gradually declines over the projection period.0% 7. and 3. For years 4 through 11 (not shown in Exhibit 1). The operating expenses for the property include all charges normally associated with the operation of the property.0% 39% 20% 39 years 60% of value and 30% of reserve for replacement 7 years 20% of value and 70% of reserve for replacement 20% of value (land is not depreciated) Equity Parameters Before Tax Equity Dividend Rate Before Tax Equity Yield After-Tax Equity Dividend Rate After-Tax Equity Yield Ordinary Income Tax Rate Capital Gains Income Tax Rate Building Life Building Basis FF&E Life FF&EBasis Land Basis Tax Considerations for Investment Value Estimates Depreciation Parameters (straight line assumed) . provide an equity dividend.66 million.5 percent between 2000 and 2001. In 1998. Thus.7548% 9.99 million. it is assumed that room revenue will increase by 3.3 percent over the four years. the net income figure represents the cash available to service debt.090639 19. the Eldridge obtained a net income of $3.assumed to be January 1. and pay income taxes. 5 percent between 1999 and 2000. The average room rate of the fictional Eldridge Hotel is projected to increase by 6 percent between 1998 and 1999. it is projected that in 2001 the Eldridge will see a net income of $3. The projections account for an increase in the room supply and any changes in the relative competitive position of the Eldridge. including a management fee and a capital expenditure reserve.75% 0. all other revenues and expenses are assumed to increase by 3 percent per year. Other assumptions used in the valuation techniques that will be discussed in the following sections are: Debt Parameters Loan-to-Value Ratios Amortization Mortgage Interest Yearly Mortgage Constants Percent of Loan Paid in 10 Years6 70% 25 years 7.5% 18. All expenses are projected to increase by 3 percent per year. Hence a stabilized net income of $3.5 percent per year. with average daily rate increases moderating over the projection period. 1999.

0% 3. The band of investment.824.090639 70% 9. As just mentioned. The calculations which follow show how the band of investment using one stabilized year technique is used to estimate the value of the fictional Eldridge Hotel: Mortgage Finance Terms: Mortgage Interest Rate: Mortgage Amortization: Mortgage Constant: Loan-to.5% 1.0% (For both REITs and C-Corporations) 40% (Giving a 60% Equity to Value Ratio) 5.0 Other Valuation Parameters Terminal Capitalization Rate Total Property Yield Selling Expenses (Broker & Legal) 10. the stabilized net income for the fictional Eldridge Hotel is estimated to be $3. The proper rate of return for the equity component is the equity dividend rate. average rate. The appropriate overall capitalization rate is therefore the weighted average cost of capital from these two sources. Beta C-Corporation Tax Rate REIT Share FFO Multiple 7. The stabilized net income estimate is intended to reflect a representative year for the subject property in terms of occupancy. also known as the "weighted average cost of capital.5% 4. Both of these capital sources are seeking a specific rate of return on their invested capital as well as the return of their invested capital. stabilized estimate of net income can be capitalized at an appropriate rate.Public Company Infonnation Cost of Debt Debt to Total Value Ratio C-Corporation Equity Parameters Risk Free Rate Equity Market Premium C-Corp.000.75% 25 years 0. a single. The next step in evaluating the Eldridge using the "band of investment using one stabilized year" technique is to develop a rate to capitalize the stabilized net income into an estimate of value.Value Ratio: Equity Dividend Rate (Before Tax) 7. and net income. which combines the return on capital (interest rate) with the return of capital (sinking fund factor) into a single rate.0% of selling price Valuation Technique 1: Band of Investment Using One Stabilized Year Instead of projecting net income over an extended period of time.5% . is based on the premise that most hotel investors purchase their properties using a combination of debt and equity capital." or WACC. The appropriate rate for the debt component is called the mortgage constant.25 35% 11.0% 12.

824.000) by the anticipated equity return (.091947 x x 0.000 These calculations show that the $41. say $41.000 .090639 0.639.185.028500 0.000 $41. The terms of typical hotel financing are set forth.095).590. rate.090639). The annual debt service plus the equity dividend equals the stabilized net income of $3..to ten-year time frame. and net income has not stabilized.095000 The stabilized net income is divided by the capitalization rate to calculate the capitalized value: $3.589. The process is described as follows: 1. including interest rate. using the pro-jected stabilized net income to calculate the value that will meet the demands of both the debt and equity investors.477.000 $1. consisting of interest and amortization. hotel investors use a ten-year projection period.639.000. Traditionally.0. The equity dividend is established by multiplying the equity investment ($12.000.000 The value can be supported with the following calculations: 70% Mortgage 30% Equity Total $29.000 $12.477. and loan-to-value ratio.590.000 $3. Valuation Technique 2A: 10-Year Discounted Cash Flow Using Mortgage and Equity Rates of Return Valuation technique 2A is appropriate in dynamic hotel markets where supply and demand is constantly changing and the subject property's occupancy. is calculated by multiplying the original mortgage balance ($29. The yearly mortgage payment.000) by the mortgage constant (0.113.824.477.091947 = $41. .000. which yields $1..113.113.000.000 and an equity portion of $12. To convert the projected income stream into an estimate of value.090639 0. the band-of-investment technique works backward. amortization term. the anticipated net income is allocated to the mortgage and equity components based on market rates of return and loan-to-value ratios (similar to the band-of-investment). The projection of income and expenses reflect changing market conditions and extends over a five..095000 = $2.000 value can be divided into a mortgage portion of $29.000 x x 0. Essentially.824.063447 0. which results in an annual debt service of $2.000. The total of the mortgage component and the equity component equals the value of the property.185.Weighted Average Cost of Capital Calculation: Percent Of Value Mortgage 70% Equity 30% Overall Capitalization Rate Rate of Return Weighted Average 0.590.

Many hotel buyers base their equity investments on a desired IO-year equity yield rate. since the loan-to-value ratio was determined in Step 1. This technique was developed by Suzanne R. the equity residual is discounted back. This is the classic simultaneous valuation conundrum. This rate takes into account ownership benefits such as periodic cash-flow distributions. to the date of value at the equity yield rate." 3. and various non-financial considerations such as status and prestige. The value is proven by allocating the total property value between the mortgage and equity components and verifying that the rates of return set forth in Steps 1 and 2 can be met from the projected net income. residual sale or refinancing distributions that return any property appreciation and mortgage amortization. The sum of these discounted values equates to the value of the equity component. The mortgage and the debt service amounts are unknown because they depend on the value of the property. The equity yield is also known as the "internal rate of return on equity. An equity yield rate of return is established.2. MAl. The value of the equity component is calculated by first deducting the annual debt service from the projected net income before debt service. After deducting the mortgage balance at the end of the tenth year and the typical brokerage and legal costs. leaving the net income to equity for each year. The net income as of the 11th year is capitalized into a reversionary value. the preceding calculation can be solved through an iterative process or by use of an algebraic equation that solves for the total property value using a tenyear mortgage and equity technique. The net income to equity for each of the ten projection years is also discounted to the present value. This process can be expressed in two algebraic equations that set forth the mathematical relationships between the known and unknown variables using the following symbols: V NI M = = = = = = f n de dr b p Value Net income before (or available for) debt service Mortgage interest rate Loan-to-value ratio Annual debt service constant Number of years in the projection period Annual cash available to equity (or net income to equity) Residual equity value Brokerage and legal cost percentage Fraction of the mortgage paid off during the projection period . However. income tax benefits. Mellen." 4. Managing Director of the San Francisco office of HVS International. which in turn depends on the amounts of the mortgage and debt service. Adding the equity component to the initial mortgage balance yields the overall property value.

brokerage and legal costs typically range from 1 to 4 percent of the sale price.i) = P . Because these expenses reduce the proceeds to the seller. The following formula represents debt service: f x M x V = Debt Service Net Income to Equity (Equity Dividend)---The net income to equity (de) is the property's net income before debt service (NI) less debt service. The formula used to determine the fraction of the loan remaining (expressed as a percentage of the original loan balance) at any point in time (P) takes the annual debt service constant of the loan over the entire amortization period (f) less the mortgage interest rate (i) and divides it by the annual debt service constant required to amortize the entire loan during the ten-year projection period.Annual debt service constant required to amortize the entire loan during the projection period Overall terminal capitalization rate that is applied to net income to calculate the total property reversion (sales price at the end of the projection period) Present worth of a $1 factor (discount factor) at the equity yield rate (Ye) Using these symbols. The following formula represents the net income to equity: NI (f x M x V) = de Reversionary Value-The value of the hotel at the end of the tenth year is calculated by dividing the 11th-year net income before debt service (NIll) by the terminal capitalization rate (Rr). Debt service is derived by multiplying the mortgage amount by the annual debt service constant (f). the following formulas can be used to express some of the components of this mortgage and equity valuation process. certain costs are associated with the transaction."Whena hotel is sold. expressed as a percentage of reversionary value (Nlll /Rr). Debt Service-A property's debt service is calculated by first determining the mortgage amount that equals the total value (V) multiplied by the loan-to-value ratio (M). The following formula represents the fraction of the loan paid off (P): (f i) / (fp . In the case of hotel transactions. The following formula represents the property's tenth-year reversionary value: (NIH / Rr) = Reversionary Value Brokerage and Legal Costs--. are calculated by application of the following formula: b x (NIll /Rr) = Brokerage and Legal Costs Ending Mortgage Balance-The mortgage balance at the end of the tenth year must be deducted from the total reversionary value (debt and equity) in order to estimate the equity residual. Normally. Brokerage and legal costs (b). they are usually deducted from the reversionary value in the mortgage and equity valuation process. the broker is paid a commission and the attorney collects legal fees.(fp) less the mortgage interest rate.

Annual Cash Flow to Equity-The annual cash flow to equity consists of the equity dividend for each projection year plus the equity residual at the end of the tenth year. The ending mortgage balance is the fraction of the remaining loan (1 .(f x M x V) X 1/51) + «NI2 .(f x M x V) X 1/52) + '" «NIIO {[(NIll/Rr) ..«1 . The following formula represents the annual cash flow to equity: NIl Nr (f x M x V) = del (f x M x V) = de2 NPO - (f x M x V) = delO Value of the Equity-If the initial mortgage amount is calculated by multiplying the loan-to-value ratio (M) by the property value (V). + (de10 x 1/S10)+(dr x 1/510) = (1 . then the equity value is one minus the loan-to-value ratio multiplied by the property value.M) x V.P). The following formula represents the value of the equity: (1 M) xV Discounting the Cash Flow to Equity to the Present Value-The cash flow to equity in each projection year is discounted to the present value at the equity yield rate (11 sn). The sum of these cash flows is the value of the equity: (1 .(b x (NIll/Rr» (f x M x V» x 1/51°) + (1 . The following formula represents the residual equity value: (NIll/Rr) - (b x (NIll/Rr» - «1 .P) x M x V) = d.M) x V . The following formula represents the ending mortgage balance: (1 P) x M x V == Ending Mortgage Balance Residual Equity Value-The value of the equity upon the sale at the end of the projection period (d-) is the reversionary value less the brokerage and legal costs and the ending mortgage balance.The following formula represents the calculation of equity as the sum of the discounted cash flows: (del x 1/51) + (de2 X 1/52)+ .P) x M x V)] x I/Sl0}= ..M) x V Combining the Equations: Annual Cash Flow to Equity and Discounting the Cash Flow to Equity to the Present Value-The last step is to arrive at one overall equation that shows that the annual cash flow to equity plus the yearly discounting to the present value equals the value of the equity: «NIl . then the remaining loan percentage is expressed as (1 .P) multiplied by the initial loan amount (M x V).If the fraction of the loan paid off (expressed as a percentage of the initial loan balance) is P.

090639 X 0.063448 V Inserting the known variables into the hotel valuation formula produces the following: (3.0% 7.%9.608619 0.266024 0.847458 + V) x 0.70 V = 0.718175 0. it can Solving for Value Using the Simultaneous Valuation Formula-In the case of subject property (the fictional Eldridge Hotel).0% Exhibit 2 illustrates the present worth of $1 factor at the 18 percent equity yield rate. the following intermediary calculations must be made before applying the simultaneous valuation formula. The fraction of the loan paid off during the projection period is:8 P = 0.191052 Because the only unknown in this equation is the property's value be solved readily.437095 0.000 (3. the following known variables have been determined: Annual Net Income Loan-to.0% 10.847452 0.090639 18.370417 0.197548 The annual debt service is calculated as (f (f X X M x V): X M X V) = 0.75% 0.0% 0.225443 0.824.718184 + .0% 3.313911 0.Value Ratio Mortgage Interest Rate Debt Service Constant Equity YIeld Brokerage and Legal Fees Terminal Capitalization Rate Nl M the f Ye b Rr Exhibit 1 & Assumption List 70.000 0.515775 0. M.063448 0. Using these known variables.Exhibit 2 Present Worth of $1 Factor at the Equity Yield Rate Year 1 2 3 4 5 6 7 8 9 10 Present Worth of $1 Factor at 18.063448 X X V) X 0.

922. Using the assumed financial structure set forth in the previous calculations.000 0.989.000 (4.990.136.122 V = (I - 0.191064} = (1 - Like terms are combined as follows: $29. then $41.393.75 percent and the equity yield is 18 percent.000 The annual debt service is calculated by multiplying the mortgage component by the mortgage constant: Mortgage Component Mortgage Constant Annual Debt Service $29.70)V x 0.000 (3.000 $41.555.000 is the correct value by the income capitalization approach.416 say $41.000 (4.063448 0.393.000/0.990.000 - 0.664.665.063448 (0.370432 + x V) x 0.608631 + x V) x 0. the market value can be allocated between the debt and equity as follows: Proof of Value Mortgage Component Equity Component Total (70%) (30%) $29.197548) x (5.990.225456 + x V) x 0.000 (4.000/O.597.(3.392463 V $29.167.341.063448 0.063448 0.076.122/0.063448 0.266038 + x V) x 0. The equity residual at the end of the tenth year is calculated as follows: .122 0.437109 + x V) x 0.555.000 (5.165 The net income (or cash flow) to equity is calculated by deducting the debt service from the projected income before debt service (see Exhibit 3).100) {(I 0.090639 $ 2.076.063448 0.063448 0.515789 + x V) x 0.70 x V)] x 0.03 x V) x 0.063448 0.69246 $41. If the mortgagee achieves a yield of 7.000 (4.718.000 The value is proven by calculating the yields to the mortgage and equity components during the projection period.526.000 (5.70) V 0.076.69246 V V = = $29.191064 + {[(5.826.313925 + x V) x 0.000 12.100» 0.

667.664.664.826.0%) Less: Mortgage Balance Net Sale Proceeds to Equity $55.664.664. the mortgage .550.000 3.664.922. and the yield to the equity position have been calculated by computer.000 2.824. Reversionary Value ($5.000 2.000 1.664.990.000 4. the proofs derived yield may be slightly less than that actually input.000 29.862.341.664.586. with the results shown in Exhibit 4.000 value is correct based on the assumptions used in this approach.664.Exhibit 3 Forecast of Net Income to Equity Net Income Year 97 98 99 00 01 02 03 04 05 06 Available for Debt Service $3.000 3. As a result.718.297. proving that the $41.000 1.7% 7.526.000 Whereas the mortgage constant and value are calculated on the basis of monthly mortgage payments.000 2.000 4.100) Less: Brokerage and Legal Fees (3.000 The overall property yield (before debt service).000 2.000 4.136.000 Net Income to Equity $1.000 2.000/0.001.000 12.000 2.665.000 1.054.000 2.75% 18.664.000 2. the mortgage yield in this proof assumes single annual payments.000 2.160.000 2.000 2. Valuation Technique 28: 10-Year Discounted Cash Flow Using Mortgage and Equity Rates of Return and the Debt Coverage Ratio Valuation technique 2A uses a loan-to-value ratio to link the amount of the initial mortgage balance with the property's value.393.258. In many instances.969.000 5.597.664.000 2. the yield to the lender.503.0% Position Total Property Mortgage Equity Note: Value $41 .000 1.989.162.000 23.000 4.000 Exhibit 4 Overall Property Yields Projected Yield (Internal Rate of Return Over la-Year Holding Period) 11.677.000 1.000 1.167.000 5.472.305.000 3.000 Debt Service $2. Exhibits 5 through 7 demonstrate that the property receives its anticipated yields.000 2.555.000 $30.

587.474.573804 0.134.000 2.000 $41.000 19.000 2.167.526.665..664.000 2.000 2.000 26.884.Exhibit 5 Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Total Property Yield Present Worth of $1 Factor at 11..000 4.324.000 x 59.553294 0.826.664.000 = = = = *10 year net income of $5.890.000 2.552.024.000 3. The debt coverage ratio (Net income -.526.411170 0.000 4.000 2.459482 0.709.990.000 Exhibit 6 Mortgage Component Yield Present Worth of $1 Factor at 7.453.000 2.000 2.982.800956 0. 0.000 1.000 0.329251 '" "" $ 3.000 1.664.000 x x x x x x x x x 5.000 3.664. the debt coverage ratio requires that the annual net income "cover" the debt service by a .664.000 1.000 * Total Property Value 0.664.641530 0.000 12.969.000 4.840.298.000 2.595781 = = = $ 2.626.000.664.000 2.Annual Debt Service) is used in these cases instead of the loan-to-value ratio.000 2.062.716569 0.586.000 = "" "10th year debt service of $2.7% Discounted Cash Flow Net Income Before Debt Service $ 3.225.477194 Value of the Mortgage Component x x x x x x x x x x 0.862460 0.75% Discounted Cash Flow Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Debt Service $ 2.928687 0.000 2.136.500.250.000 3.369.000 2.513471 0.000 2. plus sales proceeds of $53.000 1.367937 0.922.000 2.894855 0.824.168.000 1.000 2.393.800765 0.690792 0.664.000 1.664.000 4.664.474.341.000 lender is also interested in the relationship between the hotel's net income and annual debt service (interest plus amortization).000 1.000 $ 29.391.513837 . Instead of establishing a maximum loan amount to constrain value.743837 0.641225 0.000 plus ending mortgage balance of $23.000 3.718.

" which represents the" stabilized" net income used by lenders to size the loan. Using the notation from technique 2A.0% == Discounted Cash Flow $ 1.597." which stands for "debt coverage ratio.Exhibit 7 Equity Component Net Income To Equity $ 1.515775 x 0. the size of the mortgage is calculated by applying the mortgage constant to the annual debt service. especially when lending on new properties.313911 x 2.272.054.847452 x 1.191052 Value of the Mortgage Component = = = "10th year before tax cash flow of $2.503.001.608619 1. the following formulas express the components of this mortgage and equity valuation process.000 plus net sale proceeds of $30.106.862.258.000 • x 0. Since the mortgage constant is the annual debt service for each $1 of mortgage. given market interest rates and the amortization period.000 x 1.677. Many lenders employ both the loan-tovalue ratio and debt coverage ratio and will lend funds based on the constraint that results in the smallest loan.266024 2.000 x 0. In determining the debt coverage ratio. This establishes a maximum annual debt service.297.974.000 specific amount.000 $ 12. and hence a maximum loan amount." and "NIs.000 601.225443 32.000 0. For example. or fourth year of operation). one must decide which net income to use. a debt coverage ratio of 1. the most conservative lenders base the loan on the first year's (or smallest) net income.000 Yield Present Worth of $1 Factor at 18.000 557.000 0.718175 x 0.000 0.000 x 0.000 609.305.000 599. which take time to reach a stable occupancy rate (typically a stable occupancy rate is reached in the second. Since net income typically increases over time. the mortgage can be estimated by dividing the debt service by the mortgage constant: NIS / (OCR x f) = Mortgage Amount .50 in net income for each $1 in annual debt service. Debt Senrice-A property's debt service is calculated by dividing the stabilized net income by the debt coverage ratio: NIs/DCR = Debt Service Mortgage Amount-WIthout the loan-to-value ratio to size the mortgage.162.5 means the lender requires $1.000 690.000 0. The only new symbols are "DCR.000 x 1.160.300. Other lenders use a "stabilized" net income.000 645.437095 1. third.370417 2.000 657.000 833.000 6.000 Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 x 0.

P) multiplied by the initial loan amount: NIs I (DCR x f). the broker is paid a commission and the attorney collects legal fees. The ending mortgage balance is the fraction of the remaining loan (1 . The following formula represents the net income to equity: NI (NIs/DCR) = de Reversionary Value-The value of the hotel at the end of the tenth year is calculated by dividing the 11th-year net income before debt service (NIll) by the terminal capitalization rate (R). The following formula represents the annual cash flow to equity: . Because these expenses reduce the proceeds to the seller.P. they are usually deducted from the reversionary value in the mortgage and equity valuation process. then the remaining loan percentage is expressed as 1. and divides it by the annual constant required to amortize the entire loan during the ten-year projection period (fp) less the mortgage interest rate. brokerage and legal costs typically range from 1 to 4 percent of the sale price. Normally. The following formula represents the residual equity value: (NIll/Ra (b x (NIll/Rr)) - «I - P) x Nls/(DCR x f)) = d. The following formula represents the ending mortgage balance: (1 P) x (NIs I (DCR x f)) = Ending Mortgage Balance Residual Equity Value-The value of the equity upon the sale at the end of the projection period (dr) is the reversionary value less the brokerage and legal costs and the ending mortgage balance. The following formula represents the property's tenth-year reversionary value: (NIll IRr) = Reversionary Value Brokerage and Legal Costs-When a hotel is sold. Annual Cash Flow to Equity-> The annual cash flow to equity consists of the equity dividend for each projection year plus the equity residual at the end of the tenth year.Net Income to Equity (Equity Dividend}-The net income to equity (de) is the property's net income before debt service (NI) less debt service. In the case of hotel transactions. The following formula represents the fraction of the loan paid off (P): (f i)1 (fp - i) = P If the fraction of the loan paid off (expressed as a percentage of the initial loan balance) is P. expressed as a percentage of reversionary value (NIll IRa. The formula used to determine the fraction of the loan remaining (expressed as a percentage of the original loan balance) at any point in time (P) takes the annual debt service constant of the loan over the entire amortization period (f) less the mortgage interest rate (i). certain costs are associated with the transaction. are calculated using the following formula: b X (NIll IRr) = Brokerage and Legal Costs Ending Mortgage Balance-The mortgage balance at the end of the tenth year must be deducted from the total reversionary value (debt and equity) in order to estimate the equity residual. Brokerage and legal costs (b).

x 1/51°) = Value of Equity Combining the Equations: Annual Cash Flow to Equity and Discounting the Cash Flow to Equity to the Present Value-The last step is to arrive at one overall equation that shows that the annual cash flow to equity plus the yearly discounting to the present value equals the value of the equity: «NIl .167.000 (4.526.826.665. it can be solved readily.+ (delO X 1/510) + (d.000/1.824.45) x 0.847458 + + + + + + + x 0.000/1.824.000 (3.NIl - (NIs IDCR) del de2 NJ:2 .000 (4.45) (3.969.000 (3.OOO (4.45) (3.000/1.718.718184 x 0.824.000 to estimate annual debt service and hence the mortgage amount.370432 x 0.608631 x 0. we estimate market value using a debt coverage ratio of 1.000 (3.824. The following formula represents the calculation of equity as the sum of the discounted cash flows: (del x 1/51) + (de2 X 1/52) + .824... For the fictional Eldridge Hotel.515789 + x 0. Note that valuation technique 2B does not have the "simultaneous" problem of valuation technique 2A.45) (3.00011.45 on the year 2 stabilized income of $3.437109 x 0.000/1.45) (3.NIs/DCR) x 1/51) + «NI2 .(b x (NIll/Rr)) - «(1 - P) x {NIsI (OCR x f))] x 11510) x f) = + NIs/(OCR V Because the only unknown in this equation is the property's value (V).824.922.NIs I DCR) x 1/ 510) + x 11$2) + {[(NIu/Rr) .313925 x 0. The value can be estimated by: (3. The sum of these cash flows is the value of the equity.45) (3.000/1.824.000 - .NIs/DCR) «NI1O .824.45) (3.266038 {4.45) (3.000 (3.(NIs/DCR) NIl0 - (NIs IDCR) = de10 Value of the Equity-The cash flow to equity in each projection year is discounted to the present value at the equity yield rate (11 sn).824.000/1.000/1.824.

real estate risk.555. The final discount often seems to be divined from some surreal source with no basis in reality.OOO/0. . and it ceases to serve as a market value model because the valuation parameters are no longer derived totally from market information.225456 x 0.341.824. which is how most hotel investors calculate the price they intend to pay. Valuation Technique 3: Discounted Cash Flow Using a Total Property Yield The process of converting the projected income stream into an estimate of value through valuation technique 3.197548) x (5.0001 (3. Exhibit 8 illustrates the discounted cash flow analysis using a 12 percent discount factor .191064 + + {[(5. they add a premium for factors such as liquidity risk.00011.000 - (3.000/(1.loo) «1 .45 x 0.0.000/1." is described as follows: 1.000. sometimes known as the" 10.824.45 x 0..191064} + x 0.00010.136.? the hotel valuation formula can be extended to incorporate the effects of income taxes on value. A discount rate.860.100» x (3.555.000.45) (0.45) (3. The reversionary value is calculated by capitalizing the nth-year net income by the terminal capitalization rate and deducting typical brokerage and legal fees. The ten-year forecast of net income (before debt service and depreciation) and the reversionary value are discounted to the date of value at the rate derived above.Year DCF (discounted cash flow) model. The value of the property is calculated to be $41. and so forth. Used in this fashion.090639»)] x V 0. attempting to obtain accurate rates of return for hotel investments with no debt component is generally unproductive.824. the intermediate calculations are omitted.859.03 (1. Starting with a risk-free rate of return. Valuation Technique 4: After-Tax Investment Model As demonstrated by deRoos and Rushmore. Many appraisers faced with this dilemma use a built-up approach. or more simply not tied to the weighted cost of capital.000 (5.090639» = For the sake of brevity. is established by evaluating the unleveraged return requirements of hotel investors. 3. say $41. the model is formally known as an "investment value model" because it reflects the unique characteristics of a particular investor.824. known as a total property yield. Since most lodging facilities are financed with a certain amount of debt capital. 2. hotel operational risk.(5.

224..293.675 2.330.Exhibit 8 Discounted Cash Flow Analysis Discount Factor Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Net Income At 12% 0.852.184 1.500 * 0.000 3.665.136. indexed by year (i.000 0.048.50663 Discounted Cash Flow $ 3.469 2.341 .32197 Estimated Market Value (Say) Reversion Analysis 11th~Year Net Income Capital ization Rate Total Sales Proceeds Less: Brokerage and Legal Fees at 3.500 In addition to the lender criteria.e. investor criteria.883.45235 4.883.0% $ 55.922. and the projected amounts of the annual reserve for replacement. usually speci fled as the NI in year n + 1 Number of years in the projection period The equity yield.093 19.000 1. on an after-tax basis .987.000 3.000 59.555.000 plus sales proceeds of $53. the after-tax investment technique needs information on depreciation rates.63552 0.543.79719 0. on an after-tax basis Loan-to-value ratio Overall terminal capitalization rate applied to NI11 to calculate the property reversion.526.500 $ 3.000 4.824.468 2.000 $ 5.913 1. tax rates.364.56743 0.068.760 $ 41 .32197 5.000 10.000 4.000 0. NIl for year one net income) Net income used for the reversion calculation.704 $ 41 .89286 0.012 2.550.332.666.969. and property information used in Technique #2.167.71178 0.000 4.608.40388 0.718.0% Net Sales Proceeds *Tenth-year net income $5.431.492 2.750 3.134.000 3.500 $53.826. The parameters in the after-tax investment model are: V NIj NIn n = = Ye M = = = Rc Value of the property Net income available for debt service.

fixtures. indexed by year) Depreciable life of the building (years) Depreciable life of the furniture. the reserve for replacement..e.Exhibit 9 After-Tax Investments Model Basedon the Hotel Valuation Formula b m f t1 = 12 P RFRj L1 L2 IB IBr IF IFr Selling expenses Mortgage interest rate Mortgage amortization term Annual debt service constant Ordinary income tax rate Capital gains tax rate Fraction of the mortgage paid off during the projection period A set of cash flows that will be spent on improving the property over time (i. and equipment (FF&E) (years) Proportion of total value attributable to the building for depreciation purposes Proportion of RFR spent on improvements to the building for depreciation purposes Proportion of total value attributable to FF&E for depreciation purposes Proportion of RFR spent on replacement of FF&E for depreciation purposes The model in Exhibit 9 is shown in algebraic form and contains ten terms: • • • • The mortgage amount The present value of the after-tax operating cash flows during the holding period The present value of the mortgage payments made during the holding period The present value of the mortgage interest tax deduction during the holding period .

not market-derived data. we apply the EVA methodology to the valuation question faced by a C-Corporation." and is used in the context of a REIT considering an acquisition.524. say $41. using the after-tax hotel valuation model. it is simply the after-tax extension of valuation technique 2A. Both the EVA and the accretive/dilutive techniques are classified as "investment value models" because they rely on the unique investment parameters of a given firm. "WACC" is the weighted-average cost of capital. Valuation technique 6 is termed the "accretive/dilutive technique. With this technique. given the other parameters. Accretive/Dilutive technique-are relatively simple but powerful measures of the impact of a purchase on share value. is traditionally used to value entire firms. More formally: EVA = A-T Earnings (WACC x Property Investment) "A-T Earnings" are the after-tax accounting definition of earnings generated by the investment. It is straightforward to input the formula into a spreadsheet and solve for the value.520. Valuation technique 5 uses a popular tool from managerial accounting known as Economic Value Added or EVA.• • • • • • The present value of the depredation tax shelter on the initial allocation to the building during the holding period The present value of the depredation tax shelter on the additions to the building during the holding period The present value of the depredation FF&E The present value of the depredation tax shelter on the initial allocation to tax shelter on additions to FF&E The present value of the tax on the reserve for replacement The present value of the reversion. is $41. we believe the methodology can be extended to single asset valuation as welL "EVA" is defined as the excess return on investment available to shareholders after deducting the risk-adjusted cost of capital. net of capital gains taxes Although the model in Exhibit 9 looks formidable. for the valuations. on an after-tax . Economic Value Added (EVA).) Valuation Technique 5: Economic Value Added (EVA) Public company valuation techniques focus on whether an acquisition adds value to a publicly traded firm. (Note that the model can also be input into a mathematical software package such as Maple™ or Mathematica™ to obtain a closed-form solution. While valuation technique 5.000. Because of the simultaneous nature of the model (value on the left side is a function of value on the right side) the model needs several (approximately 20) iterations to arrive at the correct solution.000. and valuation technique 6. the value of the fictional Eldridge Hotel. io Using the net incomes from Exhibit 1and the assumptions listed in the "Basis of Projections" section near the beginning of the chapter. The two public company valuation techniques we will present in this chapter-valuation technique 5--Economic Value Added.

we believe that the reserve for replacement is an improvement over the traditional depreciation deduction. one can rearrange the terms to arrive at the following equality: Property Investment = A-T Earnings WACC Thus. Hence. To implement the model.basis. this problem is simultaneous and must be solved iteratively to estimate the proper value. which would deduct depreciation. starting from the traditional definition of net income used in a typical lodging pro-forma like Exhibit 1: Less: Net income Income Taxes A-TEarnings Note that this definition differs from a traditional accounting definition of earnings. this technique becomes a specialized fonn of a capitalizedincome technique. Since both the interest expense and depreciation charges are a function of property value. The numerator (A-T Earnings) is the accounting measure of long-run income and the denominator (WACC) recognizes the unique capital structure of a given finn. The valuation is performed by realizing that the most the firm would pay for a property is that amount which makes EVA equal to zero. The premium is a function of the overall market premium for equity investments. in the end. The reserve for replacement is the true economic measure of the costs necessary to maintain the value-creation ability of an asset. whereas depreciation is an approximation. Given this relationship.Tax Rate (%)) x Debt to Value Ratio (%) = Debt Component Equity Component: {Risk Free Rate (%) + (Equity Market Premium (%) x Firm Beta)} x Equity to Value Ratio (%) = Equity Component WACC = Debt Component + Equity Component The equity component is a direct application of modem portfolio theory. driven by the tax code. one must transform the traditional real estate definition of net income into A-T Earnings and determine the weighted-average cost of capital. However. times . A firm's equity cost of capital is derived as a premium over the risk-free rate. Taxable income is then multiplied by a tax rate to arrive at the income tax. the net income definition used in this chapter has a deduction for the reserve for replacement. A-T Earnings are defined as follows. Income taxes are calculated by deducting depredation and interest expense from net income to determine taxable income. including its cost of debt and beta. The weighted-average cost of capital is derived as follows: Debt Component: Debt Rate (%) x (1 .

.490 0.589.820% 6.000 291.. This technique was specifically created for investment valuation for a .000 1. 0.: Next.828.589. To perform the EVA valuation on the fictional Eldridge Hotel. the depreciation calculation is: Building Portion $41.5% x 1.000 1.675% 8. below) A-TEarnings 3. using the assumptions listed previously: Stablized Net Income Income Tax (see calc.164. WACC $3.830/year 1.589.165. with 20 percent of total value as the FF&E basis.170. modified for the unique circumstances of public companies.25)} x 60% WACC Value 1. 39 years FF&E Portion $41.080/year = = Value x Debt Cost (%) x Debt to Value Ratio $41.590.35%) x 40% Equity Component = 5..08495 = $41. BUilding depreciation is based on a 39-year life.250/year $1.495% = A-TEamings -. we start with the calculation of A-T Earnings. with 60 percent of total value as the building basis.000 3.000 Valuation Technique 6: Accretive/Dilutive Technique The accretive/ dilutive technique is similar in concept to the EVA technique in that it is a capitalized income model.000 831. the WACC is calculated: Debt Component 7.533. respectively. With value established at $41.0% x (1 .000 TImes: Tax Rate Income Tax Depreciation consists of two pieces.000.824. FF&E depreciation is based on a 7-year life.000 x 60% .824.533. The debt to value and equity to value ratios are determined from the firm's capital structure.5% + (4. say $41.000 Less: Income Tax Calculation: Less: Less: Stablized Net Income Depreciation Interest Expense 3.828.000 -.589.the unique beta of the subject firm.0% x 40% $1. as the percentage of total firm value attributable to debt and equity.000 35% 291.188. 7 years Total Depreciation Interest expense is calculated as: Interest Expense = = 639.000 x 20% -.589. building and FF&E.000 x 7.

Thus: FFO Available from Purchase Conversion Factor = Net Income x Net Income to FFO = $3. This figure assumes 6 percent "leakage" and 4 percent administrative costs in converting net income to FFO. The WACC calculation for the accretive! dilutive technique differs from the EVA technique in two important ways. FFO differs from net income in two major ways." The second is the cost of administering the REIT. such as securitization costs and SEC requirements. no tax adjustment is necessary. shareholders will receive as FFO some fraction of the net income generated from incremental investments.824 x 90% = $3.091 percent.442 The WACC is based on the acquiring fum's stock price.091% x 60% 2. a REIT whose stock is trading at ten times FFO has an equity cost of capital of 10 percent. the most common measure of cash flow is termed "Funds From Operations. Second. To value the fictional Eldridge Hotel using the accretive I dilutive technique.8% x Equity to Value Equity Component ee Equity Cost of Capital (%) Ratio(%) 9.0% x 40% = 2. we proceed by calculating the FFO available from purchase." or FFO. because REITs are not taxed at the corporate level. First. The WACC calculation proceeds as: Debt Component Debt Rate (%) x Debt to Value Ratio (%) 7.8% := 5. Generally. the issue of income taxes does not enter the valuation calculus. Using the stabilized year's net income as a starting point. For example.. these costs should not exceed 15 to 20 percent of net income. FFO is estimated to be 90 percent of net income. The analyst needs to estimate the amount of leakage and administrative costs. In the REIT arena.REIT. the after-tax cost of debt is the same as the before-tax cost. a REIT's equity cost of capital can be determined directly as the inverse of the FFO multiple.4545% = 8. giving an equity cost of capital of 9. The debt to value and equity to value ratios are calculated in the same manner as the EVA model. In general. The technique is expressed formally as: Value FFO Available from Purchase WACC FFO Available from Purchase is modeled as a percentage of net income. Since REITs do not pay income taxes at a corporate level.255% . Thus. which trades at 11 times FFO. The first is the lease structure which is inserted between the property and the REIT. giving rise to what is known as "leakage.455% WACC := + 5.

193. and the mix of facilities offered.Exhibit 10 Comparable Sales Transactions Sale No. due to the inferior market position of the Eldridge.610.000 340 rooms $135.000.310 $138. brand affiliation. a REIT would pay up to $41.000 $41.000 Average Market pertonner.000.000 Thus. This gives final adjusted sale prices per room.442. 1 2 Adjusted Sale Price Per Room $137. Other adjustments are made for the condition of the physical plant.350.2 needs to be adjusted downward 3 percent. due to the Eldridge's superior market position. The most fundamental adjustment is to derive a sale price per room.000 $41. age.100.no 73% $120 $3.000 Indicated Value of The Eldrige $41.000 + WACC + 0.000.000 for the Eldridge Hotel.000 3 . 25 years old Sale Price (1998) Property Size Sale Price per Room 1998 Occupancy 1998 Average Rate TIM"' net income Comments: $34.600. Valuation Technique 7: Sales Comparison Approach Three property transactions in 1998 were found in the HVS International Major Sales Transactions database of hotels that were considered comparable to the fictional Eldridge Hotel.700. In the case of the Eldridge Hotel. Sale No.1 Sale No. below-market financing. Sale No. The sales comparison approach takes information from these sales and adjusts the data to arrive at an estimate of value for the Eldridge.000 350 rooms $142.000. but is very well operated.860 80% $127 $4.08255 = $41.300.700 $137.000 260 rooms $130.290 77% $126 $4. as follows: Sale No. as shown in Exhibit 10. relative market strength.1 needs to be adjusted upward 5 percent. average physical plant. and indicated property values for the Eldridge. * Trailing 12 months Value = FFO Available from Purchase = $3. due to the Eldridge's superior physical condition and age. say $41.000 Market Leader with potential to reduce expenses Sale No.2 $50. 3 $46. Sale No. Exhibit 10 summarizes these transactions.3 needs to be adjusted upward 2 percent. given the assumptions provided.700.696.000 RevPAR lag market.

Dividing the Eldridge's 1998 net income by the 9. setting value per room at 3. we expect that future earnings will decline. NO 1 2 1998 Net Income $3.000. which may not mirror the future path of earnings.000. sales 1 and 3 are more representative of market transactions than is sale 2. In the case of the Eldridge.000 -.097 = $41.5 to 4.000 Market Drived Capitalization Rate 9. It is important to develop these rates consistently. as new supply comes into the market. We will use $41.000 as the point estimate of value via the sales comparison approach.P More formally: Value = Average Daily Rate x Number of Rooms x 1. In most cases.20 percent to a high of 9. because the appraiser must use his or her judgment in their application. Valuation Technique 8: Market-Derived Capitalization Rate The information in Exhibit 11 can be used to derive market-based capitalization rates. Which average daily rate should I use: a "trailing" or historical ADR.57% 3 The market-derived capitalization rates range from a low of 9. on an inflation-adjusted basis.300. known as the ADR rule-ofthumb.5 times annual room revenues. which states that a property is worth 1.200. which is generally understood to have traded at a premium to its true value.000 One of the immediate questions one asks when implementing the rule is.. These rates are based on historic net income.85 percent.000.165. The capitalization rate is simply the trailing 12-month net income divided by the sale price.7 percent capitalization rate obtains the following estimate of value: $3.000. depending on occupancy.000 Valuation Technique 9: Room-Rate Multiplier The lodging industry has a well-known "thumb" rule. with an average of 9.000 Sale Price $34.54 percent.600.000 $46.85% 9. we recommend using the net income in the 12 months prior to sale as the basis for the calculations.160. The table below details the rates for the three comparable sales shown in Exhibit 10: Sale.0. say $41. We therefore will adjust the average market-derived capitalization rate up to 9.The indicated values provide a range of values that would be expected in a competitive selling environment.000 $50.000 $4. which gives more weight to sales 1 and 3 than to sale 2. It is therefore important to adjust these rates if it is expected that future conditions will make these rates higher or lower. ADR in the first projection year.350.993. or the stabilized-year ADR? Since the rule's origins are .000 times its average daily rate on a per room basis. In the case of the Eldridge Hotel.000 $4. the adjustments are part of the appraiser's art. The rule is essentially a RevPAR multiplier.7 percent to reflect this future erosion of earnings.20% 9.

Single. "accurate. but apply a stabilized ADR when applying the rule to properties under development.Exhibit 11 Classification and Comments on Income Approaches to Value Classification Before or Cap or After Tax Yield B B C y Model Band 01 Investment Hotel valuation FormulaBefore-Tax Discounted Cash Row with total property yield Market Derived Capitalization Rate Hotel Valuation FormulaAfter-Tax Economic Value Added Ba. equity yield WACC& Rrm Beta Comments Simple. easy to understand. hard to support total properly yield. hard to Support EDR. no debt LTVorDCR debt terms.740. value may not be reflective of longterm wealth impact. comparable adjustments difficuH. B Y B C A Y A C Accretive/ DUutive A C WAGe & FFO multiple Terms: DCR-Debt Coverage Ratio EDR-Equity Dividend Rate LTV-loan to Value Ratio FFO-Funds from Operations WACe-Weighted Average Cost of Capital clouded in lodging folklore. deblterms. Applying the room-rate formula results in the following value: $139. easy to understand.isof Return Assumptions WACC. well supported. limited to CoCorpenvironment Aceounting-based measure of net income (A-T Earnings) not appealing to real estate traditionalists. Extensive research by Corgel and deRoos revealed that practitioners generally use the current year's expected ADR when applying the rule to existing hotels. hard to explain.13 x 300 x 1. U This inconsistency is a source of confusion and inaccuracy.000. The stabilized average daily rate (Year 2-see Exhibit 1) for the 300-room Eldridge-Hotel is $139.' tough to support equity yield.739.000 . say $41. nodebl Overall Gap Rate. Explic~ handling of reversion.000 = $41.Debt terms. equity yield Overall Yield. See Before-Tax comments + very hard to implement Can look at relative size of tax effects. Umited to REIT environment" Cap Rate is based on oorrent FFO multiple. EOR LTV or OCR. We take the position in this chapter that the rule should be consistently applied to a stabilized ADR. one must use a generally accepted standard when applying the rule. Complicated. Easy to model.13. easy to understand (IRA).

2A) Hotel Investment Formula-DCR14 constraint (tech.000 $41.000 $41.000. . More formally: Value = Coke™ price x Number of Rooms x 100.000 $41. 10) Market-Value Models Sales Comparison Approach (tech.860.40 in the room mini -bars.000 $42. "What is a property worth?" has given rise to an increasingly broad set of methods to estimate value.520.200. the various approaches produced values that are in a very narrow range. 2B) Discounted Cash Flow with total property yield (tech.330.000 $41.000.000 to $42.000 Income Approaches: Band of Investment (tech.000 $41.000 $41. the value of the Eldridge by this "precise" valuation method is: $1. as some properties seriously" misprice" soda in relation to property value.000. The rules of thumb give a rough indication of value. 1) Hotel Valuation Pormula=Ll'Vl'' constraint (tech. 8) $41. The question.165. from $41.000 = $42.700. Thus. 4) Economic Value Added (tech. Summary ------------------The results of the 11 approaches to valuing the fictional Eldridge Hotel that we discussed in the chapter are summarized below: Rules of Thumb Room-Rate Multiplier (tech.600.160. but should not be relied on as definitive.000 times the price of a Coke'" in the on-floor vending machine or in-room mini-bar.000 $41.000 $41. 3) Models Investment-Value Income Approaches: Hotel Valuation Formula-After-Tax (tech.990. 9) Coke™-Can Multiplier (tech. 6) $41.Valuation Technique 10: Coke ™ -Can Multiplier Another valuation rule-of-thumb used in the lodging industry is that each room of a hotel is worth 100. 5) Accretive/Dilutive Technique (tech.000.000 The Eldridge Hotel sells cans of soda for $1.000 We urge market participants to use this technique judiciously. as opposed to the hypothetical case of the Eldridge Hotel. 7) Market-Derived Capitalization Rate (tech. It is instructive to explore whether we would have achieved a similarly narrow range of values if we had been valuing a real hotel in the real world.740. They are simple.40 x 300 x 100.590.000 As you can see.

It is important to support all of the income approaches using the best available data.15 using the classic troika of the cost approach. The following are "cap-rate" techniques: band of investment. Managers in this environment seek to invest when it can be demonstrated that the investment adds to the value of the firm. it uses an income approach to value the property.single-dimension models that do not incorporate the collective actions of market participants. Firm. with high-quality input data. economic. and accretive/dilutive. The difficulties in applying the technique to income-property markets include the paucity of sales. while the yield-based models are not. Investors. based on actual sales transactions. The most effective use of this tool is establishing a reasonable range of value. The income approaches evolve from two different manners of thinking. but it is difficult to quantify the impact of these problems on the property's value. The strengths and weaknesses of each of the income approaches are listed in Exhibit 11. the investor's unique cost of capital. Due to the difficulties in applying these adjustments. on the other hand. and thus the parameters used in these models are easy to support. To estimate value. is a sound tool for gauging value based on actual market transactions. it is easy to identify the fact that a given location has problems. investors typically rely on a modified income approach tailored to their circumstances. The market-derived capitalization rate is a hybrid approach. The cost approach provides a physically oriented estimate of value. The sales comparison approach. Publicly traded real estate firms have a unique form of investment-value question. For instance. and functional obsolescence.or investor-specific data are available for the investment value models. On the other hand. this is known as an accretive investment. Each set of these techniques has its strengths.16 which includes the effects of income taxes. yield-based models produce more accurate valuations than cap-rate" models. It is difficult in many cases to determine the returns required by equity participants. however. Market-value models must be supported by the analyst's reasonable expectations of investor behavior and a thorough understanding of market conditions. give a quick "ballpark" estimate. market-derived capitalization. These adjustments require judgment in three areas: the amount of physical. and making accurate adjustments. with the capitalization rate derived from comparable sales. properly applied to homogenous properties in thickly traded markets such as Single-family homes. and the income approach. They do. the sales comparison approach. obtaining sales that are truly comparable to the subject. EVA. and other investor-specific conditions. The caprate" models are easy to implement and easy to understand. These are Single-period models that implicitly account for growth in income. Then there are the "yield" or "discount-rate" techniques: the hotel valuation formula (both before and after tax) and the lO-year DCF are multi-period models using explicitly calculated cash flows over a holding period to arrive at value. Appraisers are charged with estimating market value. The difficulty in applying this technique is making the proper adjustments for obsolescence and depreciation. wish to estimate investment value. this technique has not been included in this chapter. U U .

Use of a variety of methods is encouraged. II Endnotes ~---------------1. Value based on a debt coverage ratio will be discussed separately.. A. pp. Based on monthly amortization. such as the value to specific C~Corporations or partnerships.. 5. to a particular 16.: The Appraisal Institute. Valuation: A New Technique. 11. 62-69. Hotels and Motels: A Guide to Market Analysis.~~I 2. see Corgel. a potential seller would not only wish to know market value. these produce both a most-likely value via appraisal as well as establish estimates of bids by potential buyers." 12. Hotels and Motels. but also buyer-specific valuations. 102.23. "Lodging Property Valuation Models: The Effects of Taxes and Alternative Lender Criteria. and S. Wmter 1993. Readers who would like more information about how the after-tax investment works with a spreadsheet should contact Professor deRoos at: Cornell University. No.824 million is the Year 2 net income. MAl "Simultaneous April. sth Ed. with an occupancy percent is estimated to represent a stabilized operation. (American Institute of Real Estate Appraisers. 12. 1967). 182 Statler Hall." 14. NY 14853-6902. John B." Mellen. 10th Ed. "The ADR Rule-of-Thumb.75% -t. Hotels and Motels. p. The Year 2 projection. Investment Analysis. a classic three-approaches" appraisal plus the EVA and after-tax SVF are the appropriate models. Rule-of-Thumb model School 9. For instance. In this case. 15. Rushmore. Stephen." International Journal of Hospitnlity Management." The Comell Hotel and Restaurant AdministratUm Quarterly. investor based on his or her investment From The Appraisal of Real Estate." Market value is defined as "the price at which a willing seller would sell and a willing buyer would buy. Ruslunore. The calculation is made using a monthly interest rate (7. ill. . 1992).. 3. and Jan A. 13. 353-365. neither being under abnormal pressure. 10. (The Appraisal Institute. and Valuations (Chicago.12 in this case) and the number of months in the respective terms (300-month amortization term. Corgel and deRoos. "LTV" stands for "loan-to-value. 1983. 4. For an extended discussion. deRoos. "OCR" stands for "debt-coverage-ratio. of Hotel Administration. 4. pp. requirements. Market participants should select the most appropriate models for their own use. of 72 The $3.. p." p. 236. 7 8 Appraisal lournal. "Investment value is the value . Suzanne R. December 1995. Vol. 6. 1992). 120~month projection period). J. Rushmore. "The ADR as a Predictor of Lodging Property Values. deRoos. Ithaca." From Appraisal Terminology and Htmdbook. Rushmore.

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