Hotel Online  Special Report

Hotel Investments; 
The Magic, Curse Of Leverage

CANADIAN LODGING OUTLOOK
July 2004 Year-to-Date


The Canadian Lodging Outlook is a joint monthly publication 
of Smith Travel Research and HVS International, 
Vancouver and Toronto, Canada
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By: Stephen Rushmore, MAI, CHA - HVS International - New York

Investors acquire hotels to earn a return on their invested capital. This return includes periodic cash flow profits accruing after payment of debt service plus any property value appreciation or mortgage amortization realized when the hotel is sold. A return typically is expressed as a percentage of the capital invested and reflects the various risks associated with that particular investment.  Hotels are considered risky investments as they require specialized management expertise, are vulnerable to economic downturns and overbuilding and suffer from rapid functional obsolescence. Hotels are relatively illiquid in that it can take three to six months to sell such an asset -even in a good market.

Most hotel acquisitions generally are financed with both debt and equity capital. Debt comes from lenders such as banks, insurance companies, pension funds and other similar capital sources. Equity is typically raised by the hotel's owner and can come from friends, family, investors or equity funds. 

The primary difference between debt and equity is that debt generally has first preference to the Net Income of the hotel because payment of debt service must be made before profits can be distributed to the investors. Because debt lenders have this preference on the hotel's cash flow, their return requirements typically are lower than those of the equity investors. This differentiation between the returns desired by the debt and equity money sources gives rise to a phenomena known as financial leverage. Financial leverage is a method of increasing the returns to the equity investors by borrowing debt capital with lower return requirements and thus reducing the amount of equity needed to purchase the hotel. The more debt used to replace equity, the higher the leverage and the higher the "potential return" to the equity investor.

For example, let's say a hotel generates a Net Income of US$1 million per year and can be acquired for US$10 million. If the buyer uses all equity to purchase the hotel, the return would be 10%.

Now let's assume the buyer finances the hotel with 50% debt, which requires a debt service payment of 8% of the US$5 million borrowed or US$400,000 per year.  This leaves US$600,000 to the equity investor as a return on the US$5 million equity invested or 12%. Column #1 in the following table shows how the equity return increases as the leverage escalates from 50% to 90%. With 90% of the hotel's purchase price financed by debt, the equity investor would achieve a 28% return on the US$1 million invested. Not bad.

The downside of financial leverage is that should the US$1 million assumed Net Income in Column #1 decline, it is possible to create a negative leverage situation.  Column #2 shows the consequences of what happens if the Net Income declines to US$600,000. With 50% leverage there is US$200,000 available to the equity investor producing a 4% return on the US$5 million invested. That equity return drops to 1% with 70% leverage and then crosses over to negative territory at 80% and 90% leverage, which means that the debt service exceeds the Net Income, and the equity investors must find additional sources of capital to pay the lender's debt service. With 90% leverage, the debt service is US$720,000, which is US$120,000 short of the US$600,000 of assumed Net Income. Not a pretty picture.

Lenders attempt to reduce their risk exposure by evaluating the expected debt coverage ratio, which is the Net Income divided by the Debt Service. The debt coverage ratio for the 50% leveraged hotel with a US$1 million Net Income is 2.50.  This ratio declines to 1.39 when the hotel is financed with 90% leverage. Most lenders want to see a debt coverage ratio of at least 1.25 debt coverage ratio at the US$600,000 Net Income.

Leveraging a hotel acquisition can produce magical financial returns in up markets where expected Net Incomes are rising.  However, leverage can work quickly against you when the economic picture darkens and Net Incomes decline. Most hotel investors opt for a more conservative approach to leverage and typically look to make an equity investment of between 25% to 35% of the purchase price. Even at this level of leverage, the equity return is enhanced by more than 50% when compared to an unleveraged return.


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CANADIAN LODGING OUTLOOK
HVS INTERNATIONAL - CANADA
July 2004 Year-to-Date
July  2004
Year to Date
Number
of Rooms
Occupancy
Rate 2004
Occupancy
Rate 2003
Average Room 
Rate 2004
Average Room 
Rate 2003
RevPAR 
2004
RevPAR 
2003
Room Supply 
% Change
Room Demand 
% Change
Nova Scotia Area 1,432 55.4% 56.9% $77.90 $80.07 $43.16 $45.56 0.7% -2.0%
Halifax, NS 1,674 66.9% 69.2% $124.51 $120.44 $83.30 $83.34 0.0% -3.3%
Montreal, QC 14,185 61.8% 60.8% $119.07 $119.31 $73.59 $72.54 0.4% 2.0%
Quebec City, QC 3,044 60.7% 60.2% $131.24 $127.62 $79.66 $76.83 0.9% 1.8%
Quebec Area 3,193 54.7% 53.8% $91.51 $89.78 $50.06 $48.30 0.2% 1.8%
Toronto Downtown 12,355 66.5% 52.2% $152.97 $141.26 $101.73 $73.74 -1.5% 25.5%
Toronto North/East 6,450 57.4% 47.6% $108.95 $107.16 $62.54 $51.01 0.0% 20.5%
Toronto Airport/West 6,662 67.9% 59.4% $108.17 $106.95 $73.45 $63.53 -4.6% 9.1%
Ottawa, ON 7,800 60.8% 62.3% $125.04 $125.56 $76.02 $78.22 1.2% -1.1%
Ontario East 4,059 52.6% 51.2% $92.22 $90.92 $48.51 $46.55 0.1% 2.9%
Ontario Southwest 8,468 54.0% 54.2% $88.44 $86.47 $47.76 $46.87 2.7% 2.4%
Ontario North 5,098 52.0% 52.9% $81.36 $82.27 $42.31 $43.52 0.0% -1.5%
Niagara Falls, ON 7,663 51.9% 48.8% $123.77 $108.58 $64.24 $52.99 4.2% 10.9%
Ontario Central 7,882 55.6% 55.1% $100.77 $98.84 $56.03 $54.46 1.8% 2.8%
Winnipeg, MB 3,712 61.4% 59.0% $91.26 $91.62 $56.03 $54.06 0.0% 4.1%
Regina/Saskatoon, SK 3,453 57.2% 58.0% $90.26 $86.78 $51.63 $50.33 -0.1% -1.4%
Calgary, AB 5,617 65.0% 60.9% $121.93 $116.76 $79.25 $71.11 -1.3% 5.4%
Edmonton, AB 5,052 62.5% 61.2% $100.29 $97.38 $62.68 $59.60 2.1% 4.3%
Alberta Area 7,773 59.4% 58.1% $95.11 $91.12 $56.50 $52.94 2.0% 4.2%
MountainRegions, AB 2,266 66.5% 61.5% $235.67 $223.59 $156.72 $137.51 0.5% 8.6%
Vancouver, BC 11,757 66.3% 59.6% $130.43 $126.68 $86.48 $75.50 0.2% 11.5%
British Columbia Area 8,849 48.3% 48.2% $101.50 $101.32 $49.02 $48.84 0.8% 1.1%
Victoria, BC 2,992 56.5% 55.5% $100.57 $96.68 $56.82 $53.66 1.7% 3.6%
Provinces
Alberta 20,708 62.5% 60.0% $118.81 $113.29 $74.26 $67.97 1.3% 5.5%
British Columbia 24,619 61.3% 57.2% $126.37 $124.80 $77.46 $71.39 0.9% 8.1%
Manitoba 4,097 60.8% 58.9% $89.89 $90.37 $54.65 $53.23 0.0% 3.2%
New Brunswick 2,817 58.3% 59.4% $97.19 $94.60 $56.66 $56.19 1.2% -0.7%
Newfoundland 1,279 63.2% 62.7% $112.62 $108.15 $71.18 $67.81 0.0% 0.9%
Nova Scotia 3,106 61.9% 63.7% $105.97 $104.38 $65.60 $66.49 0.5% -2.4%
Northwest Territories INS INS INS INS INS INS INS INS INS
Ontario 65,332 59.2% 54.7% $116.78 $111.30 $69.13 $60.88 0.6% 8.9%
Prince Edward Island 792 48.2% 48.1% $98.48 $94.90 $47.47 $45.65 0.0% 0.2%
Quebec 21,527 61.1% 59.8% $129.32 $128.41 $79.01 $76.79 0.4% 2.6%
Saskatchewan 4,575 54.4% 54.8% $84.40 $81.58 $45.91 $44.71 0.3% -0.5%
Yukon Territory 585 49.6% 45.2% $88.68 $84.37 $43.99 $38.14 0.0% 9.8%
Canada 149,437 55.5% 53.9% $101.43 $98.17 $56.29 $52.91 0.7% 3.6%
© Smith Travel Research, 2004. Reproduction or quotation in whole or in part without permission is forbidden. *INS - Insufficient Data

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Contact:
Selina Lai
HVS International – Canada
2120 Queen St. East, Suite 202
Toronto, ON M42 1E2
(416) 686-2260, ext 21
(416) 686-2264 FAX
slai@hvsinternational.com
www.hvsinternational.com

Also See June Results Are In And.......We’re Back! / Canadian Lodging Outlook - June 2004 Year-to-Date / Aug 2004
Hotel Life Expectancy / Canadian Lodging Outlook - March 2004 Year-to-Date / May 2004
European Hotel Transactions 2003 - Country Analysis / Canadian Lodging Outlook - February 2004 Year-to-Date / April 2004
2003 an Unbelievably Strong Year for US Hotel Sales / Canadian Lodging Outlook - December 2003 Year-to-Date / February 2004
2003 Canadian Hotel Transaction Survey / Canadian Lodging Outlook / January 2004
2002 Canadian Hotel Transaction Survey / Canadian Lodging Outlook / Feb 2003
How To Get The Best Sales Price; Positioning Your Hotel for Sell / Stephen Rushmore / Canadian Lodging Outlook - July 2003 YTD / September 2003
Lodging Market Impact of Hosting Olympic Winter Games; Will Salt Lake City Experience Apply to Vancouver and Whistler? / Canadian Lodging Outlook - June 2003 YTD / August 2003
Year-to-date Occupancy through April is 50.4% for all of Canada / Canadian Lodging Outlook - April 2003 YTD / June 2003
SARS and Its Impact on Tourism in Toronto / Canadian Lodging Outlook - March 2003 YTD / May 2003
Hotel Values in Europe - Current Trends / Canadian Lodging Outlook - December 2002 Year-to-Date / Feb 2003
2002 Canadian Hotel Transaction Survey / Canadian Lodging Outlook / Feb 2003
Performance Clauses Essential In Hotel Management Contract / Stephen Rushmore / Canadian Lodging Outlook / Dec 2002
Separating the Hotel Looker From the Hotel Buyer / Stephen Rushmore / Canadian Lodging Outlook / Sept 2002
Making The Ideal Hotel Investment / Stephen Rushmore / Canadian Lodging Outlook / Aug 2002
Reporting In at Six Months..../ Canadian Lodging Outlook / July 2002
The Global Approach To Hotel Valuations / Canadian Lodging Outlook / June 2002
Hotel Insurance Premiums on the Rise? / Canadian Lodging Outlook / May 2002 
Hotel Development Cost Can Determine Feasibility / Canadian Lodging Outlook / May 2002 
Hotel Internet Distribution Channels / January 2002 Month-to-Date Results / Canadian Lodging Outlook / April 2002 
2001 Was a Great Year If You Were in Edmonton! / December 2001 Year-to-Date Results / Canadian Lodging Outlook / Feb 2002 
2001 Canadian Hotel Sales / Canadian Lodging Outlook / Jan 2002 
The Effect on Capitalization Rates and Discount Factors After September 11 / Canadian Lodging Outlook / Dec 2001 
So How Bad Was September for Canadian Hotels.. Pretty Bad! / Nov 2001
So How Bad Was September for Canadian Hotels.. Pretty Bad! / The Canadian Lodging Outlook / September 2001 
Have Hotel Values in Canada Declined Since September 11th? You Bet They Have / The Canadian Lodging Outlook / August 2001 
The Popularity of Boutique Hotels / The Canadian Lodging Outlook / July 2001 
Rising Energy Costs Cause Concern in the Lodging Industry / The Canadian Lodging Outlook / June 2001 
Niagara Falls: With Supply Comes Demand / The Canadian Lodging Outlook / May 2001 
Does Supply Generate Demand? / The Canadian Lodging Outlook / May 2001 
Optimism With a Hint of Caution, As Analysts Predict a Softer Year for the Canadian Hotel Industry / Mar 2001 
Limited-Service Growth in Canada - Where’s it Going? / The Canadian Lodging Outlook / January 2001 
HVS Canada in Review - Year End 2000 / The Canadian Lodging Outlook / March 2001 
Canadian Lodging Outlook / May 2000 Year to Date Statistics / HVS International - Canada / July 2000 
The Rule of Thumb Method...Does It Still Hold Weight? / Elaine Sahlins - HVS / Oct 2000
What’s Hot and What’s Not in Western Canadian Hotel Markets / Mar 2000


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