|August 2005 - Persistent low, long-term interest rates and the no-end-in-sight
recovery of the lodging sector create a dilemma for hotel Discounted Cash
Flow (DCF) number crunchers regarding the selection of a terminal cap rate
(the rate used to estimate resale value at the end of the holding period).
With capitalization rates sinking deeper into the single digits, sellers of respectable-looking hotels have begun to appear en masse under the theory that prices will not move much higher than today's levels. Liquid buyers come to terms with these seemingly opportunistic sellers because of the nearly impossible task of finding alternative placements for capital with such attractive current yields, forward-looking cash flow fundamentals, and inflation protection as hotel assets. An 'IRR burn' may be felt by today's buyers, however, if values decline by enough to compromise income returns when it comes time to check out of the hotel portfolio. So where do the DCF number crunchers come in?
These stressed-out soles working diligently on the behalf of buyers and sellers must decide on a terminal cap rate to model current deals. A fee-seeking fund manager will waste no time informing the analyst that the standard industry practice involves adding 50 bps. to the current cap rate. Thus, the terminal cap rate number today might be 8% + .5% = 8.5%.
A rebellious analyst with alternative job prospects in hand could respond by arguing that hotel markets are prone to cyclical movement and characterized by mean-reverting performance. Following this line of reasoning, the terminal cap rate for hotels should be elevated to approximately 10%. According to RERC survey data (see Exhibit 1) the average going-in hotel cap from 1992-I through 2005-I equals 10.8% - so 10% is still an aggressive estimate for the long-run rate.
The dilemma facing DCF makers - use a terminal cap close to the current rate or close to the long-run average rate! The difference between an 8.5% rate and a 10% rate translates into $176,471 in value per $100k of NOI ($100k/.085 - $100k/.10). And for a disposition fee rate of three percent, the opportunity fee loss equals $5,294 per $100k of NOI (.03 x $176,471). Assume a property has a $100k NOI that grows at 4% per year and will be sold in year five. Capitalizing the year six NOI by 10% and 8.5%, respectively, produces quite different expected IRRs. The fund manager would much prefer to do market deals with a 10.92% IRR based on an 8.5% terminal cap rate rather than an 8.15% IRR based on a 10.5% terminal rate.
What's a Number Cruncher to do?
The fundamental question becomes one of misrepresentation of the true IRR based on a faulty assumption about the terminal cap rate. Just as a terminal cap rate assumption of 8.5% may be too low in an 8% current pricing environment, a terminal cap rate assumption of 12% may be too high in an 11.5% current pricing environment. Certainly, this problem is not symmetrical because of the incentives on the part of fund sponsors is to use as low a terminal rate as somehow justifiable.
To solve this problem we need to convince ourselves of three general
assumptions. First, transaction costs usually prohibit earning short-term
profits from trading hotel assets so holding periods will be long term
- at least five years. Second and most importantly, hotel incomes and values
are mean reverting. This empirical fact is becoming more-and-more evident
as we move through time with reliable data (see, for example, Exhibit 1).
Third, few if any sponsors will guarantee that they can correctly time
the markets. We have no choice but to trust history and the equilibrium
principles that keep driving the performance in real asset markets back
to a steady state - it's 10 percent!
PKF Consulting Corporation
|Also See:||Hotels Increase Marketing Budgets by 6.1 Percent in 2004; Hotels Continue to Shift Marketing Dollars from Advertising to Person-to-Person Selling / PKF Study / June 2005|
|Hotel Insurance Expense: Minor Cost, Major Concern; PKF Study Finds Premiums Doubled Since 1999 / June 2005|
|Rampant Optimism in U.S. Hotel Investment Arena / PKF / June 2005|
|Hotel Real Estate is Alive in 2005 / Scott Smith, MAI / June 2005|
|U.S. Hotels Staff Up - Rising Benefit Costs at Highest in 15 Years / Mark Woodworth / May 2005|
|Hotel Guests Not Picking Up the Phone / Robert Mandelbaum / April 2005|
|Are Hotel Employee Benefits Really Soaring? / Gregory J. Miller and Robert Mandelbaum / March 2005|
|Plying the Per Diems: How Market Forecasts Should Impact Hotel Rate Strategy / Gregory J Miller / PKF / February 2005|
|Double-Digit Profit Growth for U.S. Hotels in 2004 and 2005; Strong Revenue Growth Overcomes Some Expense Concerns / PKF / February 2005|
|Hotel Construction Signs Along the Road to Recovery; Measuring Hotel Developer Intent / R. Mark Woodworth and Robert Mandelbaum / January 2005|
|Understanding the Recovery Occurring in the Meeting’s Market; Surveying the Meeting Planners / Robert Mandelbaum / December 2004|
|First Half 2004 Hotel Profits Solidify 2005 Outlook; Industry Still Lags Far Behind its Past Peak Performance in 1998 / HRG & PKF Consulting / December 2004|
|Room Rates Across the Top 50 Hotel Markets in the U.S. Will Increase by 3.7% in 2004; Five Highest and Five Lowest Average Daily Room Rate Hotel Markets in 2005 / December 2004|
|Perspectives on the Road to Recovery - U.S. Lodging Industry 2005 / HRG & PKF Consulting / November 2004|
|Other Revenue Is Good Revenue / Robert Mandelbaum / November 2004|
|Uncanny! Hotel Occupancies “Key Indicator” of Presidential Election Outcome / October 2004|
|Is the Hotel Industry Smart Enough to Avoid Overbuilding; Ten Reasons Why Real Estate Markets Become Overbuilt / Jack B. Corgel / July 2004|
|PKF Consulting/HRG Survey Forecasts Banner Year for Hotel Transactions; Investors Favoring the Full-service Segment / May 2004|
|First Uptick for Hotel Industry in Three Years; Full-Service Hotels Lead the Way In U.S. Hotel Profits for 2004 / Hospitality Research Group / March 2004|
|Demand in the Full-service Hotel Sector is Expected to Increase by 6.3% in 2004; Best and Worst Hotel Markets in Terms of RevPAR Growth / PKF Consulting / January 2004|