Applying

Value
Drivers
toHotelValuation
by Opgie Ganchev A cautionary tale for investors: Pay attention to the factors that

create value in hotel investing.

T his article is intended to serve

as a valuation guide to hotel
investing. The goal is to enable an
investor to correctly define, build,
and interpret the results of a par-
ticular strategy undertaken in pur-
suit of an acquisition or develop-
ment of hotel real estate. The article
reviews a method of forecasting
cash flow during an explicit fore-
cast period and calculating the
investment reversion by applying
a value-driver formula. It also pro-
vides the tools to analyze the
project’s profitability by assessing its
economic value added and to un-
derstand how return on investment
changes with shifts in strategy.
The article goes through the
following four steps in estimating
the value of a hotel asset:

A graduate of the Cornell University

School of HotelAdministration,
Oggie Canchev is with the New York
real-estateinvestment-bankinggroup
at Credit SuisseFirst Boston
cco~ie.ganchev@ comu.

0 2000, Cornell University

78 CORNlE66
kiOTELANDRESTAURANTADMlNlSTRATlON
QUARTERLY
 (1) Select the appropriate cash-
flow build-up approach; Exhibit 1
(2) Decide on the time horizon Performance statistics of hypothetical hotel acquisition
to fully implement a specific
asset strategy; Actual Actual Actual Forecast
(3) Estimate the value drivers Year 2 Year 1 l-m Year 0
and calculate the investment Market RevPAR $92.00 $100.00 $104.00 $105.00
reversion; and Growth 8.7% 5.0%
(4) Discount the cash flow to Hotel penetration 94% 92% 90% 90%
the present. Room revenue $11,048 $11,753 $11,957 $12,072
Growth 6.4% 2.7%
Selectingthe Cash-flowBuild-up Room-revenue factor 62% 63% 65% 65%
Total revenue $17,819 $18,656 $18,396 $18,573
Approach Growth 4‘7% -0.4%
Two approaches to hotel cash- EBITDA $4,633 $5,037 $5,151 $5,200
flow build-up are the traditional Profit margin 26% 27% 28% 28%
Capital reserve (5%) $891 $933 $920 $929
accounting-driven approach and Cash flow $3,742 $4,104 $4,231 $4,272
the value-driver approach. I review Growth 9.7% 4.1%
both of them here. Dollar figures are in thousands, except for RevPAR. The hypothetical hotel
Accounting-driven approach. has 350 rooms. TTM is trailing twelve months. EBITDA is earnings before
Over the years investors and ap- taxes and debt payments.
praisers alike have applied the ac-
counting framework found in Uni- of known ability, and, ultimately,
form System of Accounts for the Lodging create value for her capital partners.
Industry to build spreadsheets and The historical performance of the
forecast hotel cash flow. USALl is market and the subject hotel is
a profit-and-loss statement that con- summarized in Exhibit 1.
sists of departmental revenues and As observed, the performance of
expenses, undistributed adminis- the competing full-service hotels in
trative costs, and fixed property this particular market has been and
charges. The typical USALI pro continues to be strong. The market
forma provides a great deal of infor- grew at 8.7 percent in the last pe-
mation about property operations, riod and is projected to increase
but masks some of the key value another 5.0 percent in the most
drivers that most investors should current period, whereas the subject
care about. hotel lagged behind. As a result, the
Value-driver approach. The hotel’s RevPAR penetration rate
better approach to forecasting cash declined from 94 percent two years
flow guides an investor through the ago to 90 percent today. Despite the
measures, or the drivers, that build slowdown in growth and the flat-
value: namely, growth, market share, tening of the top line, the hotel’s
level of services and amenities, and profitability has slightly improved.
profit margin. Perhaps management has been keen
To best illustrate that approach, on cutting departmental expenses
let’s use as an example the acquisi- and overhead cost in preparation
tion of a full-service hotel that’s in for the asset sale.
a good location and in a promising Seeing that the subject hotel has
market. This hotel, however, has not performed up to its potential,
been a weak performer due to the the would-be investor intends to
lack of consistent property upkeep invest the necessary amount of capi-
and uneven management. A poten- tal to build the property RevPAR
tial investor is intrigued by the op- back up to the market level and thus
portunity to purchase and upgrade raise profitability. The investor’s
the asset, install a management team repositioning strategy is reflected in

October2000 l 79
 Exhibit 2
Hotel cash-f/o w analysis
Year 1 Year 6 Year 7 Year 6 Year 9 Year 10
-,-Year 2 Year3 / -:------
Year 4 Year 5 :-/-
I- -
Market RevPAR $110.25 $114.66 I $119.25 j $122.82 j $126.51 : $130.30 / $134.21 1 $138.24 i $142.39 j $146.66
Growth 5.0% 4.0% 4.0% 3.0% 3.0% 3.0% j 3.0% 1 3.0% 3.0% , 3.0%
Hotel penetration 90% : 94% 97% 99% 100% i 100% 1 100% 100% 1
Room revenue $12,676 / $13,769 $14,777 $15,534 j $::Ol:l / $16,646 j $17,146 / $17,660 j $18,190 j $:::6
Growth 8.6% 7.3% 5.1% 4.0% I 3.0% , 3.0% j 3.0% 3.0% 3.0%
Room-revenue factor 67% 66% 65% 65% I 65% 65% : 65% -65% i 65%
Total revenue $18,919 $20,862 $22,733 $23,898 $24,864 $25,610 ! $26,378 $27,169 / $27,984 $2:;4
Growth 10.3% 9.0% 5.7% 4.0% 3.0% I 3.0% 3.0% , 3.0% 3.0%
I
EBITDA $5,108 $6,051 $6,820 $7,170 $7,459 $7,683 $7,914 $8,151 j $8,396 : $8,648
Profit margin 27% 29% 30% 30% 30% 30% 30% 30% 30% 30%
Capital reserve $378 $417 $1,137 $1,195 $1,243 $1,280 I $1,319 $1,358 $1,399 $1,441
Percentage 2% 2% 5% 5% 5% 5% 5% : 5% 5% 5%
Cash flow $4,730 $5,633 $5,683 $5,975 $6,216 $6,403 $6,595 I $6,793 $6,996 $7,206
Growth 19.1% 0.9% 5.1% 4.0% 3.0% 3.0% 3.0% 3.0% 3.0%

Dollar figures are in thousands, except for RevPAR. The hypothetical hotel has 350 rooms.
EBITDA is earnings before taxes and debt payments.

the cash-flow analysis illustrated in
Exhibit 2.
The top of the cash-flow forecast
starts with the market RevPAR and
its likely growth rate. The two mea-
sures provide a quantitative assess-
ment of the market’s room rates,
competitiveness, and growth poten-
tial. The strength of the asset, on the
other hand, is illustrated in the lines
that follow. The hotel’s market posi-
tioning and revenue-producing
capacity are reflected in the hotel-
penetration and room-revenue fac-
tors. The use of a target profit mar-
gin produces the asset’s expected
profitability. This approach to fore-
casting provides an investor with a
straightforward overview of the flow
of cash from the top to the bottom
line.
Value-driverApproach
The value-driver approach to fore-
casting cash flow works as follows.
First, the investor estimates top-line
revenues. The hotel’s chief source
of revenue is rooms (even if it has
a spa, restaurant, or other revenue
sources). Thus, it is crucial to ana-
lyze the drivers that build room
revenue rather than trying to guess
how much money a hotel can ex-
tract from the restaurant, spa, or
telephone department. Here is
where solid market-feasibility
work comes into play. Studying
the growth and the depth of the
market, as well as the individual
market segments, and benchmarking
the existing and future competition
will help an investor to decide how
to enter the market and where to
position the subject hotel.
Market analysis. As I see it, a
hotel-market analysis indicates to
the investor the growth stage of the
market from which to derive the
likely RevPAR growth and the
time that the market would need to
reach stability. In general, markets
can be classified as emerging, mod-
erately expanding, or stable. In an
emerging market, RevPAR growth
rates could be two or three times as
high as the growth rates observed in
stable markets. In contrast, markets
that are topping out are likely to
grow only at the rate of inflation.
Hence, when investing in an emerg-
ing market, the explicit forecast
period should extend until that
market is believed to reach stability
and its RevPAR growth rate starts
to run parallel with that of inflation.
In addition to estimating the
market growth, the market analysis
helps an investor to assess the appro-
priate level of RevPAR that the
market can support and sustain. This
is important since investors in most
cases have little control over the rate
that guests are willing to pay in a
particular market. An investment
strategy that assumes a particular
hotel will achieve rates far above the
market’s RevPAR. inherits a high
risk. Such a strategy is product fo-
cused instead of market driven.
For purposes of building this
investment analysis, the qualitative
characteristics found in every mar-
ket analysis are condensed to two
specific quantitative variables: cur-
rent RevPAR and projected future
growth. In our example, the market
for selected full-service hotels
should support RevPAR of ap-
proximately $105. The second vari-
able, the market growth rate, is ini-
tially projected at 5 percent, and
then gradually levels off and remains
constant at 3 percent. The resulting

80 CORNELL HOTELAND RESTAURANTADMINISTRATIONQUARTERLY

decline in RevPAR growth can be
attributed to an overall decline in
the occupancy rates and moderating
rate growth as new hotels enter the
market.
Competitive analysis. The
purpose of the competitive analysis
is to establish a benchmark set of
hotels against which the subject
hotel can be analyzed. The most
important piece of this analysis is
estimating the market share the
hotel is most likely to command
with respect to its competitive
set. This analysis usually examines
the extent of occupancy and rate
penetration to show the relative
strength and operating strategy
of each competitor. However,
the ultimate factor that drives a
hotel’s room revenue is the yield-
penetration rate, or the RevPAR-
penetration rate. The relationship
between occupancy and rate pen-
etration is already captured in the
RevPAR yield. I also recommend
that an investor run a RevPAR-
sensitivity analysis, as discussed in
the box on the next two pages.
Calculating Cash Flow
Finding the hotel’s cash flow in-
volves a calculation of room rev-
enue, total revenue, and earnings
before taxes and debt service
(EBITDA). This section shows
those calculations.
Room revenue. After diligently
studying the market and the com-
petitive hotels, one can estimate the
appropriate market RevPAR and its
growth, as well as the subject pen-
etration rate, and thus calculate the
hotel room revenue. The calculation
is as follows:
Market RevPAR x
Hotel Penetration Rate % x
No. of Rooms x No. of Days
For example:
Year-l room revenue =
$110.25 x 90% x 350 rooms x
365 days = $12,676,000
Exhibit 3
Room-revenue factors and profitability ratios for
various hotel tiers, 7997
Luxury
RevPAR $98.28
Room-revenue factor 61.6%
GOP 37.7%
EBITDA 30.6%
Source: Smith Travel Research,
This approach to estimating
room revenue requires the investor
to think of the two factors that are
the primary drivers of room rev-
enue-namely, growth and market
share.Investors usually have no
control over market growth, which
proceeds at whatever rate the mar-
ket can sustain. The subject hotel
can grow at a faster rate than the
market-provided it can steal mar-
ket share.Even if the hotel can do
so,however, eventually its business
will grow no faster than the rest of
the market.
Note that in our example the
RevPAR-penetration rate expands
from 90 percent in the first year to
100 percent by the fifth year and
thereafter. In fact, the rise in market
share allows the hotel revenue to
grow at a rate that is almost twice
the market rate until the hotel
reaches stabilization and starts to
grow with the market. This is
based on the expectation that a
new, effective management team
will use the improved facility to
gain more market share.
Total revenue. While room
revenue is generally the most im-
portant source of revenue, asthe
hotel offers more amenities and
services to its guests,the size of
other revenue sources asa propor-
tion to total hotel revenue increases.
As illustrated in Exhibit 3, room
revenue for the average limited-
service hotel accounted for 95 per-
cent of total revenue in 1997,
Price category Limited service
Upscale j Mid-price Total U.S.
-/-
$74.70 / $66.85 $45.55
65.2% i 71.9% 95.0%
35.9% / 30.5% 53.4%
28.2% 1 29.9% 45.2%
1998 HOST Report.
whereas for a full-service property
that percentage ranged from 62
percent to 72 percent depending
on the hotel’s price category.
Instead of trying to guessor
break out the revenues for each
individual department during the
preliminary analysis,it is simpler
to build a single assumption that is
consistent with the rating, services,
and amenities the hotel will offer
and thus derive the hotel’s total
revenue. That assumption is a room-
revenue factor, or a percentage of
the total revenue attributable to
the rooms division.
Total Hotel Revenue = Room
Revenue + Room-revenue Factor %
For example, year-l total revenue =
$12,676,000 + 67% = $18,919,000
In our example, the room-
revenue factor is targeted at 65 per-
cent, which is not attained until the
third year of the forecast. In the
beginning, asthe hotel focuses on
generating demand and building
room revenue, the other sources of
revenue may lag behind.
EBITDA margin. The profit
margin, or earnings before income
taxes and debt service, should not
be put into the model in a vacuum.
It should reflect the industry norms,
the specific local market characteris-
tics, and the management’s track
record in operating similar hotels.
As shown in Exhibit 3, EBITDA
margins for full-service hotels in the
United States for 1997 were around
30 percent, and for limited-service
October2000 l 81
hotels, 45 percent. Gross-operating- growth, RevPAR, market share, can preserve the discipline required
profit (GOP) performance regis- room-revenue factor, and profit in the underwriting of the pro forma
tered similar results. Limited-service margin-the investor can gain a and at the same time achieve the
hotels were at the top of the profit- meaningful grasp on an appropriate flexibility needed in the invest-
ability chart with a GOP margin strategy for the asset. ment analysis and capital rationing
of 53 percent, whereas full-service process.
hotels operated at between 36 and Integrating the Value-driver Approach
39 percent. Note that the value-driver frame- Choosing a Time Horizon
Although the example applies the work of analyzing cash flow does A common practice among hospi-
EBITDA margin, I recommend that not supersede the accounting ap- tality consultants and investors is to
investors estimate the GOP margin proach to forecasting revenues and use a lo-year forecast horizon,
first and, after adjusting for the cor- expenses. It rather seeks to avoid the which is perhaps an artifact of a
rect amount of fixed charges and complexity and rigidity found in time when the hotel businesswas
management fees, calculate the the accounting-valuation frame- more stable than it is today. An in-
EBITDA line (see Exhibit 4). work. Using the value-driver ap- vestor needs to determine whether
In summary, the value-driver proach, an investor should use the a lo-year window is the right time
approach to cash-flow build-up accounting pro forma to calculate the period one should use and, if not,
should replace accounting pro formas value drivers and use them as inputs what forecast period should apply.
in the investment analysis. By think- in the investment-analysis section of The purpose of determining a
ing through the value drivers- her model. This way the investor specific forecast period is to capture

Room revenue factor =

The Further Step of Risk Analysis RiskNormal(65%,1%), which specifies a normal
Risk analysis should be considered as an integral part of any val- distribution3 with a mean of 65 percent and a
uation analysis. By no coincidence, the value-driver hotel-valuation standard deviation of 1 percent; and
framework presented in the accompanying article lends itself well to
EBITDA margin =
performing this task. The key part is that any of the value drivers
RiskUniform(27%,32%), which specifies a uniform
could and should be analyzed as a distribution of probabilities.
distribution4 with a minimum value of 27 percent
Achieving the targeted hotel market penetration rate or profitability
margin is not really that certain. What is more likely to happen is and a maximum value of 32 percent.
that the actual results would fall within a range of possibilities that By entering the distribution formulas above in the valuation spread-
would be centered around the forecasted value drivers. sheet, the investor has defined the uncertainty of the investment. Before
One of the tools any investor could use is @Risk software, jumping into the simulation analysis, however, it is important to account
which returns distributions of possible outcomes and the probabili- for any correlation among the input variables, or the selected value
ties of getting those results.’ The software can help an investor not drivers. For example, when the hotel RevPAR penetration is relatively
only by showing what could happen in a given situation, but also high, the rooms revenue as a percent of total sales is most likely to be
presenting how likely it is that it will happen. The example pre- high as well, thus forming a positive correlation between the RevPAR
sented at the beginning of the accompanying article illustrates the penetration and room-revenue factor. This positive correlation is even
use of risk analysis and the utility of Q Risk. In a stabilized year, the stronger between the RevPAR penetration and the EBITDA margin.
value drivers were assumed at loo-percent RevPAR penetration, Since the highest profit margins are achieved in the rooms department,
65percent room-revenue factor, and 30-percent EDITDA margin. the higher the rooms sales relative to the total revenue mix, the higher
A more likely scenario is that the property RevPAR penetration the room-revenue factor, thus the higher the EBITDA margin.
could go as high as 102 percent or as low as 97 percent of the After quantifying the dependency among the value drivers, the
market, the room-revenue factor could be plus or minus a couple investor can proceed with the simulation analysis, which involves
of points, and the EBITDA margin could range anywhere from running hundreds or even thousands of iterations of the valuation model
27 percent to 32 percent. By using @Risk software, the investor until sufficient results are returned. The accompanying table provides
could incorporate this uncertainty by creating the following a summary of the simulation results, as well as graphs illustrating the
distributions, which employ functions found in the application. expected profitability of the contemplated hotel investment.
Both the NPV and the IRR profitability distributions show that the
RevPAR penetration = investment is expected to be profitable. Even though the project could
RiskTriang(97%,100%,102%), which specifies a produce a negative NPV (see the summary statistics), the chances of that
triangular distribution* with a minimum value of happening is less than 10 percent. Hence the proposed investment should
97 percent, a most-likely value of 100 percent, increase shareholder value 90 percent of the time. Likewise, the equity
and a maximum value of 102 percent; IRR will most likely be around 27 percent, further safeguarded by the
80-percent probability of earning approximately 22 percent or higher.

’ ecwww.palisade.com>> 3The traditional “bell shaped” curve applicable to distributions of

2The direction of the “skew” of the triangular distribution is set by the outcomes in many data sets.
size of the most-likely value relative to the minimum and the maximum, 4 Every value across the range of the uniform distribution has an
The probability of the minimum and maximum values occuring is zero. equal likelihood of occurring.

82 CURNEll HOTELANDRESTAURANTADMINISTRATIONQUARTERLY
 Exhibit 4
EBITDA adjusted for fixed costs and fees

Year 1
---------- Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 6 Year 9 Year 10
Total revenue $18,919 $20,662 $22,733 $23,898 $24,864 $25,610 $28,378 $27,189 $27,984 $28,824
Growth 10.3% 9.0% 5.1% 4.0% 3.0% 3.0% 3.0% 3.0% 3.0%
GOP $8,811 $7,928 $8,888 $9,320 $9,897 $9,988 $10,287 $10,598 $10,914 $11,241
Margin 38% 38% 39% 39% 39% 39% 39% 39% 39% 39%
Real-estate taxes $850 $878 $902 $929 $957 $985 $1,015 $1,045 $1,077 $1,109
Property insurance $150 $155 $159 $184 $169 $174 $179 $184 $190 $198
Other charges $135 $221 $303 $341 $386 $377 $388 $400 $412 $424
Cost of management $588 $828 $882 $717 $748 $768 $791 $815 $840 $885
Percentage 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%
EBITDA $5,108 $6,051 $6,820 $7,170 $7,459 $7,883 $7,914 $8,151 $8,396 $8,848
Profit margin 27% 29% 30% 30% 30% 30% 30% 30% 30% 30%
Capital reserve $378 $417 1 $1,137 $1,195 $1,243 $1,280 $1,319 $1,358 $1,399 $1,441
Percentage 2% 5% 5%
Cash flow $4,730 $Z3 $:&3 655z75 $8,218 SzI3 $5%5 i $8,793 $f%6 $75:8
Growth 19.1% OkI% 5.‘1% I 4.0% 3.6% 3.6% I 3.0% 3.6% 3.8%

Dollar figures are in thousands, except for RevPAR. The hypothetical hotel has 350 rooms.
EBITDA is earnings before taxes and debt payments.

The power of combining the value-driver

Summary of @RISK simulation results valuation framework and @Risk software
Room- comes into play also in capital rationing. Most
RevPAR revenue hotel investors limit themselves to calculating
NPV 813% Total IRR Equity IRR penetration factor EBITDA only the expected returns, the NPV, and the
IRR, but they generally don’t quantify the risk
Mode $4,891 15.5% 28.9% 100.2% 64.8% 29.1%
associated with achieving specific returns.
Mean 2,090 14.1% 23.4% 99.7% 85.0% 29.5%
The most widely accepted measure of risk in
Std. Dev. 1,981 1.0 2.6 1.0 1.0 1.4
finance is the standard deviation, which is
Max. 5,842 16.0% 28.0% 101.8% 88.7% 32.0%
easily calculated by @Risk. In the example,
Min. (1,895) 11.9% 17.9% 97.1% 61.8% 27.0%
the risk of increasing shareholders’ value by
$2.09 million is quantified at $1.98 million per
Distribution for NPV @13% standard deviation. The same risk-and-return
.a90 1.0 profile is also calculated for the project IRR.
J r" Provided that an investor is presented with
2.072 0.8
i+m multiple projects, the expected returns along
‘E ’ g-J
j$ ,054 5 a p 0.6 with their corresponding risk profiles can be
2 plotted on a graph and matched to specific
.z?z
n ,038 = c 'j?2 0.4 investments. Rather than using a standard
%2-
,016 n - i: 0.2 deviation, an investor could choose another
9% measure of risk and plot the expected return
0 a232 0 against it. Other good measures of risk are
the probability of a project NPV to be less
N 7 ti m- i lo- d g g o 8 8 8 8 than zero and the probability that the hotel’s
9 $wJ
R K cash flow would be insufficient to cover debt
P r o f i t a b i 7 i‘;t y- service in a given year.-O.G.
Equity IRR
The graphs show the probability distribution
of a hypothetical project’s profitability after
multiple iterations of @RISK software. While
the project could lose money, as indicated by
the lefthand part of the graph at upper left,
.2z; that probability distribution shows a greater
2 ,080 z c 3 0.4
n -Et,“? likelihood of a solid profit. The upper right
,040 n - x 0.2 graph shows only about a 1 O-percent prob-
9%
0-22 ability of a reduction in value. The probabili-
0 0
,160 ,163 ,207 ,230 ,253 .277 ,300 ties for internal rate of return (IRR) are
,160 ,163 ,207 ,230 ,253 ,277 ,300
similar, as depicted in the lower graphs.
P r o f i t a b i I i t y

October2000 l 83

Exhibit 5
Comparison of hotel values with different forecast periods
5 10 15 20 25
Horizon (years)
correctly the expected changes in
the marketplace and hotel opera-
tions that directly affect cash flow
and return on invested capital. The
forecast horizon should, therefore,
span as many years as it takes for the
market and the property to reach
stability. The value of the property
should not be manipulated simply
by extending or shortening the
length of the forecast period. The
only change should be in the distri-
bution of the property value be-
tween the explicit forecast period
and the period that follows, or the
continuing (reversion) value, as
illustrated in Exhibit 5.
Assuming a five-year forecast,
continuing value accounts for as
much as 72 percent of the total, and
the value in the holding period
accounts for only 28 percent of the
total, whereas in a 25-year forecast
the continuing value drops to 11
percent and the explicit value is 89
percent of the whole. In both cases,
the total value of the property does
not change. The value is still $48.4
million; only its distribution derived
from the explicit forecast and con-
tinuing value changes.
Selecting a different horizon
period can erroneously produce a
deviation in values if the underlying
assumptions used in the calculation
84 CURNEllHOTELAND RESTAURANTADMINISTRATIONQUARTERLY
of the continuing value are not con-
sistent with the rest of the forecast.
For instance, it was a common mis-
take among the investors in the
1980s to forecast that revenues
would grow at a higher rate than
expenses. This approach to cash-
flow build-up led to the creation
of hotel pvoforwm that showed an
ever-increasing profit margin. Cor-
respondingly, if the explicit forecast
horizon were to be extended, then
the extension would have led to an
increase in value, solely due to the
increasing profit margin. Stated in
another way, the longer the explicit
forecast period, the higher the
value! Most investors probably real-
ized the illusory nature of that as-
sumption after the market slumped
in the early 1990s.
Holding-period effects. Each
investor has a different plan for
holding the asset.As 1just ex-
plained, the value of the property
should not change asa result of
extending or shortening the length
of either the explicit forecast hori-
zon or the holding period. As the
holding period changes, however,
the internal rate of return (IRR)
will certainly change. This change is
triggered not by a variation in the
value of the hotel, but by a change
in the rate of return over the time
the investment is held. Furthermore,
the change in IRR will reflect the
change in the risk of the investment,
as explained by the increase or de-
crease in the variability of the pro-
jected cash flow.
I find it unwise for investors to
adjust the value of the assetto
maintain a particular IRR assump-
tion. That approach would break the
integrity of the valuation analysis,
because the required rate of return
on invested capital would not accu-
rately reflect the risk profile of the
projected cash flow. Thus, it would
be unrealistic for an investor to seek
a premium rate of return after the
hotel is stabilized, even if a high cash
flow (and a high risk) during the
initial work-out period justifies
requiring a premium rate of return.
As cash-flow variability decreases,
the value of the asset will likewise
decrease. But in this instance, the
lower value would be solely attrib-
utable to the investor’s demand of
a high rate of return for the asset,
whose risk profile changed after
stabilization and as such would war-
rant lower risk-adjusted rate of re-
turn. Hence the drop in the IRR.
Calculating the Investment Reversion
By definition the continuing value,
or the investment reversion, is ana-
lyzed as an annuity investment that
pays a perpetual cash flow that is
either constant through time or
grows at a constant rate. As men-
tioned above, the explicit forecast
period should span as many years as
necessary for the property to reach a
stable rate of operations by the end
of that period. This is imperative
since the integrity of the investment
reversion relies on the following key
assumptions:
l hotel profit margin stays constant;
and
l hotel cash flow grows at a con-
stant rate, sustained by a continu-
ous investment drawn off the
replacement reserve.
Most hotel investors are familiar
with the growing free-cash-flow
perpetuity formula. It is:
Value = NOI,+, + R
where
NOI,+, = normalized level of cash
flow after reserve for replacement
in the first year after the explicit
forecast period, and
R = capitalization rate.
An alternative technique is the
value-driver formula, which breaks
down and expressesthe growing
free-cash-flow perpetuity formula
in terms of the value drivers: profit
margin, ongoing capital require-
ment, cost of capital, and growth.
That formula is asfollows:
Value =
EBITDA,+, x (1 -RR+PM) + (WACC-g)
where
EBITDA,+, = normalized level
of cash flow before reserve for
replacement in the first year
after the explicit forecast period; Thevalue drivers are
RR = reserve-for-replacement
percentage; growth, RevPAR,market
PM = expected stabilized EBITDA
profit-margin percentage; share, room-revenuefactor,
WACC = weighted average cost
of capital; and
g = expected growth in cash flow
and profit margin.
in perpetuity.
The value-driver formula is the
algebraic representation of the
growing cash-flow perpetuity for-
mula where the hotel EBITDA,is
forecasted to grow at the same rate g
and is only valid ifg is lessthan
WACC. The expression WACC-g
corresponds to the hotel cap rate R,
whereas the numerator decomposes
the hotel NO1 in the form of the
key value drivers of profit margin
and necessary continuous capital
investment. The expression RR+ PM
represents the investment rate or the
proportion of cash flow allocated for
property upkeep and FF&E replace-
ment. The overall expression should
read: Cash flow (EBITDA) times
one minus the investment rate
equals free cash flow, or NOI.
All of the components used in
the formula above are present in
the hotel proform, except for the
weighted average cost of capital.
WACC is a function of the target
debt-to-equity capital structure and
the corresponding required rates of
return. Real estate is one of the few
industries where one can reasonably
predict cash flow and, thus, leverage
can be relatively high. Typical loan-
to-value or loan-to-cost ratios range
from 60 percent to 75 percent.
Leverage above that range bears
high risk and should command high
equity returns. The result is that
WACC cannot simply be lowered
by adding leverage and keeping
October2000 l 85
 Exhibit 6
DCFapproach to hotel-investment analysis
Year 1
~--------- Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 6 Year 9 Year 10
EBITDA $5,108 $6,050 $6,820 $7,169 $7,459 $7,683 $7,913 $8,151 $8,395 $8,647
Profit margin 27% 29% 30% 30% 30% 30% 30% 30% 30% 30%
Capital reserve 2% 2% 5% 5% 5% 5% 5% 5% 5% 5%
CAPEX
Cash flow $5,683 $5,975 $6,216 $6,403 $6,595 $6,793 $6,996 $7,206
Growth 434.6% 100.6% 5.1% 4.0% 3.0% 3.0% 3.0% 3.0% 3.0%

-Horizon - CV - Total Weight cost Growth 3.0%

Five-year forecast $13,664 $34,750 $48,414 Equity 25.0% 25.0% Profit margin 30.0%
Ten-year forecast $26,549 $21,865 348,414 Debt 75.0% 9.0% Capital reserve 5.0%
Cost of capital 13.0%
NPV Q 13% $48,414 - $45,500 = $2,914 WACC (cost of capital) 13.0% Cap rate 12.0%

Cost = $45,500,000, or $130,000 per key. Dollar figures are in thousands. The hypothetical hotel has 350 rooms.
EBITDA is earnings before taxes and debt payments. CV is continuing value. WACC is the weighted average cost of capital.

the equity required rate of return
constant.
In our acquisition example the
borrowed capital amounts to as
much as75 percent of the purchase
price and bears an interest rate of 9
percent. If the loan is to be paid off
based on an amortization schedule,
then the loan mortgage constant
should be included in the WACC
calculation. In our case,the loan is
structured asan interest-only bal-
loon, and the principal amount is to
be returned at the end of the term.
Equity holders, on the other hand,
are in the deal looking for a 25-
percent return on their invested
capital. Hence the weighted average
between the debt and equity cost of
capital is calculated at 13 percent
[(.75 x .09) + (.25 x .25)].
EBITDACapRate
One of the benefits of the value-
driver formula is that it allows
one to express the EBITDA-
capitalization rate using the key
value drivers, asfollows:
REB,TDA= (WACC-g)+( I-RRaPM)
The above equation demonstrates
that one can add value by focusing
on improving just one of the value
drivers (i.e., cost of capital, growth,
profit margin, or required invest-
ment). Obviously, a reduced cost of
capital will allow an investor to bid
up a price. The two other factors
that drive the price multiple up are
growth and profit margin. Higher
future growth translatesinto a lower
cap rate and ultimately into a higher
price. The samereasoning holds for
the profit margin. The higher the
profit margin, the greater the pro-
ceeds for the investors, and the
higher the price. However, it is im-
portant to note that these two value
drivers do not come free of charge.
Keeping an assetcompetitive in the
market, growing cash flow, and sus-
taining a healthy profit margin re-
quire continuous investment in
property upkeep and FF&E replace-
ment. The higher the investment
required to achieve a given growth
rate and sustain a given profit mar-
gin, everything else held constant,
the higher the cap rate will be,
which will push the purchase price
lower.
About cap rates. By applying
the simple perpetuity formula
(NOI+R) when valuing acquisitions,
many analysts fall into a circular
reasoning that the cap rate, R, ap-
plied in the investment reversion
will equal the cap rate paid for the
asset.For example, the assumption
is that if one buys an assetat an
%percent cap rate, one should be

86 CURNEll HOTEL AND RESTAURANTADMINISTRATIONQUARTERLY

 Exhibit 7
Investment analysis including fax consequences
Year 1 Year 2 -Year 3 -Year 4 -Year 5 -Year 6 -Year 7 Year 6 -Year 9 Year
- 10
EBITDA $5,108 $6,050 $6,820 $7,169 $7,459 $7,683 $7,913 $8,151 $8,395 $8,647
Less taxes 0
- ($235) - -($381) -($392)
($300) ($338) ($349) ($359) ($370)
- ($77) - - - -
Tax-adjusted EBITDA $5,108 $5,973 $6,585 $6,870 $7,121 $7,334 $7,554 $7,781 $8,014 $8,255
Profit margin 27% 29% 29% 29% 29% 29% 29% 29% 29% 29%

Capital-reserve 2% 2% 5% 5% 5% 5% 5% 5% 5% 5%

Cash flow $4,730 $5,556 $5,449 $5,675 $5,877 $6,054 $6,235 $6,422 $6,615 $6,814
Growth 17.5% (1.9%) 4.2% 3.6% 3.0% 3.0% 3.0% 3.0% 3.0%

Cost = $45,500,000, or $130,000 per key. Dollar figures are in thousands. The hypothetical hotel has 350 rooms.
EBITDA is earnings before taxes and debt payments. WACC is the weighted average cost of capital.

able to sell that assetfor the same
&percent cap rate at the end of the
holding period. In most cases,how-
ever, the reason someone is willing
to pay a low cap rate for an acquisi-
tion is that he or she believes that
earnings potential can be improved
greatly. So the effective cap rate paid
on the improved level of earnings
will be much higher than 8 percent.
Once the improvements are in place
and earnings are up, buyers would
not be willing to bid the same cap
rate unless they can make additional
improvements.
The expected growth, profit mar-
gin, additional investment, and cost
of capital are the primary determi-
nants of the assetEBITDA cap rate,
and all are in the value-driver for-
mula. Unless one is comfortable
using an arbitrary cap rate, one is
much better off by applying the
value-driver formula to analyze
which factor drives the price of the
assetthe most and whether that is
consistent with the investor’s span
of control, overall strategy, and
competency.
Discountingthe CashFlow
Exhibit 6 summarizes the DCF-
valuation analysis of the hotel cash
flow derived from the pro-forma
build-up example discussedearlier
in this article.’ Remember that the
investor plans to reposition the asset
up to the quality level present at the
other competitive hotels. To do so,
the investor plans to spend $7 mil-
lion in capital expenditures during
the first two years. After discount-
ing the additional capital outlay
and the projected cash flow at a
13-percent cost of capital, the DCF
value of the hotel investment is
calculated at approximately $48.4
million. Clearly, at an acquisition
price of $45.5 million, the invest-
ment today is expected to add
shareholder value of $2.9 million
over the life of the project. Note
also that by applying the value-
driver formula, the EBITDA cap
rate is calculated at 12 percent,
given the 3-percent projected
growth rate, 30-percent profit
margin, 5-percent replacement
reserve, and 13-percent weighted
average cost of capital. Since no
changes are expected in the under-
lying economic assumption after
the fifth year, extending the forecast
to 10 years will yield the same re-
sult as the five-year forecast.
L For a discussion of the DCF methodology,
see: Stephen Rushmore, “Seven
valuation Techniques,” Cornell
rant Adminisfration Quarterly,
(August 1992), pp. 49-56.
The above investment analysis
assumesthat after the hotel is reposi-
tioned and profitability improved, the
investor would hold the assetin per-
petuity, or at least for a relatively long
period of time. Such a strategy and
valuation gamework would be ap-
propriate and consistent if the inves-
tor is a hotel company looking to
expand and build equity in its brand.
In this case,the investor would view
the property asbeing a key assetlo-
cated in an important market with
no expectation of selling it in the
immediate future.
An opportunity fund, on the other
hand, would approach valuing the
same assetdifferently. Constrained
by the equity partners’ short-term
investment objective, such an investor
would plan at the time of purchase
to cash out of the assetafter captur-
ing the increased value that would
result from improved profitability.
That assumption would change the
valuation framework to reflect the
anticipated investment require-
ments-probably an investment
horizon of from three to five years.
For undertaking the risk of buying
an underperforming assetand turn-
ing it around by deploying additional
Current Hotel- capital, the opportunistic investors
Hotel and Restau-
Vol. 33, No. 4
will seek a relatively high rate of
return. Consequently, the free cash

October2000 l 87
 Economic-value-added Technique
The economic-value-added (EVA) technique shows the profits that WACC = weighted average cost of capital; and
a project earns in excess of its cost of capital. The EVA helps the
g = expected growth in cash flow in perpetuity.
investor evaluate the asset performance in any single year, while
the DCF shows the investment returns over the entire life of the The EVA continuing-value formula comprises two distinct value-
project. Measuring the value created by the asset in a single period creating components. The first expression returns the present value
of time, the EVA is defined as follows: of the economic profit, or the spread between the EBITDA yield and
WACC, in the first year after the explicit forecast in perpetuity. The
EVA = Invested Capital x (ROIC - WACC) second expression looks at any incremental economic profit created
That is, EVA equals the spread between the EBITDA property by sustaining a higher profit margin producing additional growth at
yield (ROIC) and the cost of capital (WACC), times the amount of returns exceeding the cost of capital.
the invested capital. If the yield is higher than the cost of capital, The expression RR+PM represents the investment rate.
economic value is being created. The opposite is also true. When Furthermore, the investment rate times the growth rate expresses
the yield is less than the cost of capital, value is being destroyed. the return on newly invested capital. Hence, additional value is
The EVA approach looks at the incremental value added over created if the return on newly invested capital is higher than the cost
the property’s invested capital at the beginning, during, and after of capital. The inverse holds true as well. If the return on newly
the forecast period. The total value of the asset is as follows: invested capital is less than the cost of capital, then holding on to an
Value = underperforming asset would destroy shareholder value in the long
run. Finally, if the return on newly invested capital equals the cost of
invested capital PV of forecasted PV of forecasted capital then incremental economic value is neither being created nor
at beginning + economic profit during + economic profit after
destroyed.
of forecast explicit forecast period explicit forecast period
For instance, if the profit margin were to drop from the projected
Provided the same financial projections, the EVA technique 30 percent to about 22 percent, as shown in our example, assuming
produces the same value as the DCF approach. The accompanying that the additional investment remains at 5 percent of revenue and
table (on the next page) illustrates this. cash flow keeps growing at a 3-percent clip, then the return on
Like the application of the value-driver formula in the DCF cal- newly invested capital would equal WACC. As a result, the second
culation of the reversion value, the EVA continuing-value formula component of the EVA continuing-value formula would equal zero. In
relies on the same value drivers expressed as follows: such a case, any additional investment in FF&E would simply match
EVA CV = EVA,+, + WACC + EBITDA,+, x RR-PM x the investors’ cost of capital. Cash flow would still grow, but at a rate
((g x PMsRR) - WACC) + (WACC x (WACC-g)) of return no higher than the investors’ implied cost of capital--thus
producing no incremental economic profit that would be over and
where
above the economic profit produced by the initial capital investment.
EVA,, = normalized economic profit in the first year The EVA approach to investment analysis provides the link
after the explicit forecast period; between the DCF-IRR academic mentality and real-life cash-yield
narrow-mindedness. In the example provided, the unleveraged
EBITDA,+, = normalized level of cash flow before IRR is calculated at 13.6 percent, whereas the fourth-year EBITDA
reserve for replacement in the first year after the yield is 13.7 percent (yield is based on total investment including
explicit forecast period; the additional capital expenditures). More often than not, the two
investment returns are close to each other. As one can see, the yield
RR = reserve-for-replacement percentage;
climbs considerably in the first three years and then levels off as the
PM = expected stabilized EBITDA profit-margin property reaches a stabilized level of operations and cash flow starts
percentage; to grow with the rate of inflation. As a rule of thumb, one could guess
-

flow during the forecast window adjusted rate of return. Such an
and the net proceeds from the sale investor would assign a higher value
of the asset need to be discounted than what the asset would be worth
at the investors’ weighted average if held by the opportunity investor
cost of capital. However, when esti- in perpetuity. The opportunity in-
mating the reversion value at the vestor should be aware, though, that
end of the holding period, one at the time of sale the fund would
should apply a lower cost of capital need to sell the asset at the pro-
in the value-driver formula to ar- jected lower yield to another inves-
rive at the appropriate EBITDA tor who would be willing to accept
capitalization rate. Such an adjust- it.
ment is necessary since the risk Income taxes. The reader will
class of the asset would have im- have noticed that the model aspre-
proved and an investor seeking sented so far has not accounted for
a stabilized asset and yield predict- income and capital-gains taxes.
ability would require a lower risk- Partly the omission is for the sake
of simplicity. The other reason for
not considering taxes is that tax
liability varies from one investor to
another. Pension funds and REITs,
for example, are exempt from pay-
ing income taxes, whereas C-corps
can typically pay taxes ashigh as
40 percent of the net profits. One
thing, though, is certain: no one
will pay any taxes if the project is
not profitable.
For those investors who are re-
quired to include taxes in their
valuation analysis, the value-driver
model can be easily adjusted to
account for income taxes while still

88 EORNM HOTELAND RESTAURANTADMINISTRATIONQUARTERLY

with a great level of confidence that the project’s IRR would fall the hotel is able to grow cash flow and sustain its profit margin
anywhere between the third and fifth year EBITDA yield, depending mainly because of the investments made during the previous
on the perpetual-growth and profit-margin assumptions. period. The capital spent on upgrading and replacing tired FF&E
Veterans in the industry prefer to use yields to measure invest- is not lost. In fact, the return on this incremental capital invest-
ment returns simply because they are easier to calculate and ment is easily measured by calculating the incremental cash flow
understand. The IRR requires more sophisticated calculation, which realized in the following period. Such returns are one of the
oftentimes can be overstated by inflating the sale price or jacking highest in the industry since the initial investment is already
up the growth rate. Most troublesome, however, is the calculation of made and subsequent smaller investments can leverage off the
cash-on-cash return, or NOI over the total invested capital. In this fixed asset base and produce higher rates of return. Cash-on-
calculation the yield is understated since cash flow is reduced by the cash yields calculated based on EBITDA over total investment
replacement-reserve expenditures without recognizing the benefit of are the appropriate yields investors should use when estimating
this additional investment. That benefit is not realized and readily their return on capital or measuring economic performance
observable until the next period in the forecast, during which against their cost of capital.-O.G.

preserving its integrity. To do this,
an investor should make a separate
tax calculation that is consistent
with the investor’s profile and deal-
transaction structure. After calcu-
lating the correct taxes for each
year, the hotel EBITDA should
be reduced by the tax provision
amount as presented in Exhibit 7-
thus becoming earnings after taxes
(but before debt service). The dis-
count rate, or WACC, should be
adjusted to an after-tax basis as
well.
Rather than be driven heavily by
tax consequences, investors should
be concerned with estimating the
right value drivers, building com-
petencies around them, making the
right investment choices, raising the
necessary amount of capital, and
meeting the objectives and claims
of each of the stakeholders involved
in the transaction. Investment in
real estate does, of course, provide
tax shelters such as depreciation
and interest, but the lesson of the
1980s is that those factors should
not be chief motivating factors for
a hotel purchase.
An investor can analyze the prof-
itability and assess the risk of any
hotel investment in many different
_ _
ways. However, by using the value-
driver build-up and valuation
framework, an investor can be as-
sured of properly forecasting, dis-
counting, and analyzing hotel cash
flow. Forecasting cash flow based
on the value drivers helps an inves-
tor discern more easily the flow
of cash though the property. Dis-
counting the cash flow by using
the value-driver formula ensures
that investors solve for their ex-
pected return without over-
extending their span of control
and capability. CQ

October2000 l 89