Capitalization rates, commonly referred to as "cap rates" are a much bantered about term in real estate investment. A cap rate generally indicates the return an investor expects to achieve on his or her investment, and the direct capitalization approach is a simplistic method of determining the value of a hotel. To determine the value of a hotel using the direct capitalization method the hotel's net income divided by a cap rate equates to the hotel's value:

Net Income / Cap Rate = Hotel Value 

Net Income / Sale Price = Cap Rate 

In terms of the definition of net income, should reserve for replacement, management fees, franchise fees, debt service, and depreciation be deducted? All of which could negatively or positively affect the overall net income value based on their inclusion or exclusion therefore affecting the calculated cap rate. In today's hotel market the industry standard is to calculate net income prior to debt service or depreciation, but inclusive of a reserve for replacement, management fees and franchise fees, with management fees and a reserve for replacement each typically equal to 3% to 5% of total revenue.

The accounting period can also significantly impact the cap rate and is an important factor to understand when analyzing sales transactions. To illustrate the potential variances in cap rates we have shown an example of a hotel with a sales price of $15,000,000. The cap rate on this sale could potentially be reported as 8%, 10% or 12%, and all would be correct, depending on the accounting period used for the calculation.
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The reverse would be true in a market with expectations of new supply that would put downward pressure on occupancy and average room rate, or if investors have an indication of upward pressure on expenses that will erode the net income.  In this case it is likely that historical cap rates would be higher than projected or stabilized cap rates.

It is always important to note however, that cap rates are not just market driven an are also impacted by numerous property specific factors including the property type and geographic location as well as the cost of capital and an investors perception of risk.

To conclude, cap rates are a critical element to understanding how the hotel investment market is functioning, it is important to clearly define the variables being used to calculate the cap rate to ensure all parties are on the same page.