Hotel Cap Rates are changing. What are hotel cap rates? What do the changes mean for your hotel buy or sell, hotel financing or refinancing, or next visit from the FDIC? What is the relationship between cap rates and equity return expectations? Suzanne Mellen, Managing Director of HVS' San Francisco office is one of the experts I look to in this area ([email protected]), and she gave us some great information that I want to share with you today.

What are Cap Rates?

Coincidentally, several blog readers have recently told me a little sheepishly that they sort of know what cap rates are, but could use a little refresher. So here is a one minute review that puts it all in street English (my apologies to the appraisers and financial analysts) and explains why cap rates are so important.

And if you want to skip the basic explanation, and get straight to the hot information Suzanne Mellen gave us, just skip to the next section below.

First, appraisers and many investors use "cap rates" as one of the benchmarks for determining a hotel property's value -- actually any property's value -- for purchase and sale, evaluating collateral for loan underwriting, or other investment purposes.

A "cap rate" is just the rate (expressed as a percentage) of return that a certain set of cash flows represents on the value of an asset. The basic formula for expressing the relationship between Cap Rate, Asset Value and Cash Flow is:

(Cap Rate ) x (Asset Value) = Cash Flow

For example

(A 10% cap rate) applied to (an asset value of $1,000,000) = (Cash Flow of $100,000)

At a 10% cap rate a million dollar asset would be expected to produce $100,000 of cash flow

But if you remember your basic algebra, you can rearrange the formula to solve for any one of the variables. So here it is in another format:

(Asset Value) = (Cash Flow) / (Cap Rate)

This means that a $100,000 cash flow implies the following values at the indicated cap rates

Cap Rate ....... Value Implied
5% .................... 2,000,000
6% .................... 1,666,666
7% .................... 1,420,000
8% .................... 1,250,000
9% .................... 1,111,111
10% .................. 1,000,000

Thus the implications of the market demanding a higher cap rate on are profound. If cap rates go up, as it appears they have, as a seller of an asset, you will receive a lower price. As a borrower or lender, the value of the collateral goes down. The cash flow may be the same, but the value is reduced when higher cap rates are required.

And the final reminder: Cap rates and values move in opposite directions. In other words, as cap rates go up, the value of the asset on the same cash flow go down. As cap rates go down, the value of the asset goes up on the same cash flow.

All of the slides included below are courtesy of Suzanne Mellen, MAI, CRE, Managing Director of HVS, and were presented by Suzanne in the Industry Leader's State of the Industry power panel on May 7, 2008. These are also her comments on the slides.

A picture is often worth a 1,000 words, and this slide is one of them. It shows cap rates for various asset classes of real estate from 1994 through present. You can see how there has been a significant decline in cap rates and in discount rates since 1994.

But the factors affecting hotel values, wholly aside from investor demand or supply, are very complex as shown in this series of slides from Suzanne, seeking to show the inter relationship of factors like the credit Crunch, lower LTVs, higher returns demanded by equity, and effects of a recession and recovery.

The following slide reflects the performance of a sample hotel as it would have been anticipated before the capital crunch - assuming no recession, and a moderate amount of upside generated by above-inflationary gains in average rate. Note that this case study is of a sample hotel, and should not be taken as a projection or commentary on any single hotel or hotel values at large.

Given the general consensus that hotel values have only declined around 5% to 15% from their peak, the equity yield would have to decline to 15% to compensate for the lower LTVs and anticipated temporary decline in NOI. Investors with whom we spoke indicated that their equity return requirements have remained the same or have increased in the current investment environment, due to the perception of greater risk. Lower LTVs should lower equity return requirements, given the lower risk of reduced leverage, but it appears that it may take awhile for investor views (both buyer and seller) to catch up with the reality of the new investment paradigm.
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Jim Butler
Chairman, Global Hospitality Group
Jeffer, Mangels, Butler & Marmaro LLP
1900 Avenue of the Stars, 7th Floor
Los Angeles, CA 90067-4308
(310) 201-3526 direct
[email protected]
www.HotelLawBlog.com