News for the Hospitality Executive
by Anwar Elgonemy
The actions of investors prove that the purchase of a hotel reflects the acquisition of real and tangible personal property only. A hotel investor’s profit and loss statement accounts for income attributable to the business operation through the expense deduction of a management fee and franchise-related fees.
When analyzing deals, one of the first things that hotel investors want to know is whether the property is “encumbered” or “unencumbered” by management and brand. Most hotel investors know that the market typically pays a premium for an unencumbered property over one that’s encumbered. It’s not that one is superior to the other, but it’s because a wider pool of potential buyers normally exists for unencumbered hotels versus encumbered assets, the competition for which tends to drive pricing higher.
On the other hand, a passive investor (i.e., a pension fund, private equity firm, or real estate investment trust) acquiring a well-performing, stabilized hotel encumbered by a long-term management agreement and brand might be riskier in terms of exit strategy, but similar to a passive investment in a Class-A (core) office building occupied by a long-term, blue-chip tenant. Either passive investment yields a risk-adjusted return on the tangible property, not the intangibles.
Further, when doing deals the buyers and sellers of hotels don’t acknowledge the existence of intangible asset value. Most are unfamiliar with the concept altogether and don’t give it much significance. Other than a deduction for management and franchise-related fees, this element isn’t reflected in their investment analysis.
To say the least, the controversial issue of the appropriate treatment of intangibles has engendered much confusion and discussion among hotel appraisers, assessors, attorneys, judges, lenders, and regulators. To a large extent, the issue has been over-complicated for nothing, and way too much time has been spent debating this matter. As such, this article attempts to clarify the misunderstandings about intangible assets by explaining why the net operating income of a hotel is only attributed to the real and tangible personal property. In addition, by explaining why the capitalized net income doesn’t result in the so-called “going-concern value,” the article discusses why it’s unnecessary to try to separate the value of a hotel’s intangible assets from the value of the real and tangible personal property.
The Physical and the Nonphysical
According to The Dictionary of Real Estate Appraisal, intangible assets/property are nonphysical assets including franchises, trademarks, patents, copyrights, and contracts, as distinguished from physical assets such as facilities and equipment. In addition, The Appraisal of Real Estate assumes that for certain types of properties (i.e., hotels and motels) the physical real estate assets are integral parts of an ongoing business, and the market value of such a property (including all the tangible and intangible assets, as if sold in aggregate) is the market value of the going concern, including real property, personal property, and the intangible assets of the business. (The opaqueness of the term “going concern value” is discussed later.)
Without getting too technical, the formal definition of “real estate” describes the physical thing, not the rights in realty. When you buy land and buildings, the real estate is conveyed through the exchange of real property rights. You can touch real estate, but you can only buy its inherent property rights. That is to say ownership is realized by a deed that transfers the rights of the current owner to the new owner.
In turn, the formal definition of “real property” describes the rights in realty. Real property is defined as all interests, benefits, and rights inherent in the ownership of the physical real estate: the bundle of rights with which the ownership of the real estate is endowed. The bundle of rights theory holds that the rights in realty can be broken down into smaller parts. By way of explanation, appraisers do not appraise real estate; they appraise real property, which is an important distinction.
If upon sale of a hotel the identifiable intangible assets are owned by a management or franchise company, then technically speaking the rights inherent in the ownership of the physical real estate don’t include intangible assets. Taking the above logic a step further, if intangible assets of a hotel aren’t part of the bundle of rights with which the ownership of the real estate is endowed, then the so-called market value of the going-concern doesn’t include intangible assets.
Intangible assets, such as brand names, work indirectly through complex chains of cause and effect. They can have an impact on financial performance and can enhance the value of the physical real estate assets with which they are associated. Similarly, the opposite can be true.
Well-established hotel brands are intangible assets that serve as a source of strategic advantage and might create financial value due to their ability to generate cash flows via relatively higher margins. Only extraordinary management and a strong hotel chain affiliation─possibly evidenced by very high revenue per available room (RevPAR), food and beverage sales volume, and net operating income per available room─might suggest value-added because of intangible assets. But at the end of the day, enhanced intangible effectiveness is an acquired competitive advantage that isn’t the property of the hotel owner. Rather, it’s the property of the third-party manager and/or the franchisor. It’s also important to realize that franchise agreements do not automatically convey to new owners, since they need to reapply to the hotel franchise company involved if they want to keep the brand.
Much of the motivation for the determination that intangible assets of a lodging facility exist comes from the fact that intangibles are not subject to property taxes. If some portion of the market value of a hotel can be estimated to be intangible personal property, that portion can be eliminated from the tax assessment rolls.
The identification and quantification of intangible assets of hotels is of concern not only for property tax assessment purposes (ad valorem taxes), but for owners who are adamant that their properties are over-assessed. That is, the assessed value of the tangible property (land, buildings, fixtures, and equipment) is excessive on a per-room basis compared to other hotels in the same municipal taxing jurisdiction.
Lenders are also concerned with the identification and quantification of intangible assets, because of regulations or their company policies. Lenders often do not lend on intangibles. They require an estimate of the tangible (or “hard”) collateral that is subject to their lien, separating out intangibles that might not continue under new ownership. Even if a bank lends against total assets, it tries to know the composition of the various components so that its loan can be risk-rated. This, of course, would have an impact on the loan-to-value (LTV) ratios of levered properties. For example, the Small Business Administration (SBA) stipulates that if the appraisal engagement letter asks the appraiser for a going-concern value, the appraiser must allocate separate values to the individual components of the transaction including land, building, equipment, and business (intangible property).
In a similar vein, Standards Rule 1-4 (g) of the Uniform Standards of Professional Appraisal Practice (USPAP) states that when personal property, trade fixtures, or intangible items are included in the appraisal, the appraiser must analyze the effect on value of such non-real property items. Yet for many hotel lenders, the burden in costs and time in trying to separate real estate and business valuation on the same property (for the same loan) can be excessive.
Causes of Misunderstanding
Over the past 30 years or so, much has been written about intangible assets of hotels. Most of the literature is excellent; however, some of what has been written is esoteric and unsubstantiated by the hotel transactions market. Some of the methodologies presented are purely theoretical constructs which have been primarily developed to reduce hotel property tax burdens. As is well known, a review of the writings on intangible assets of lodging facilities indicates that there is no consistent agreement as to how (or why) such assets should be quantified. It’s still very much a grey area.
In particular, there is a disconnect between the real world of hotel deals (the “market”) and the world of lenders, tax assessments, and appraisal guidelines. The former is more art than science, often driven by ego, gamesmanship, and the hunt for yield; while the latter apply their guidelines that are adhered to by appraisers, which in the case of intangible assets of hotels are procedures that aren’t in sync with what the market is doing.
Clarifying Hotel NOI
Figure 1 demonstrates the breakdown of the assets of the hypothetical “Hotel A” between tangible and intangible property. It’s important to note that since the owner of Hotel A owns the tangible property/assets only, the components that investors typically value are the ones that appear on the left of Figure 1.
In the hotel transactions market, it’s common practice to deduct management fees, franchise-related fees, and a furniture, fixtures, and equipment (FF&E) reserve to attain a net operating income (NOI) that’s capitalized to estimate a market value. However, one of the causes of misunderstanding pertaining to intangible assets is related to the following question: What precisely does a hotel’s NOI quantify?
Figure 2 presents a typical hotel statement of income, also known as a profit & loss statement (P&L). The stabilized Hotel A was built in 1990, is constantly being renovated, is the highest and best use of the site, and offers 260 guestrooms. The mid-scale, full-service property is managed by an independent management company. It also has a brand (“flag”) which is provided by a national hotel chain. In this example the management company is charging a base fee of 3.0% of total revenue for management services and supervision of the property. By employing a professional management agent to handle the day-to-day operation, the owner is maintaining only a passive interest, while income attributed to the “business operation” is being taken by the agent in the form of the base management fee. The management company is being paid a fee to compensate for its return on (and return of) investment in the activities that help generate Hotel A’s NOI. Therefore, the deduction of the management fee in the P&L removes a portion of the business operation component from the stabilized income.
According to the most recent edition of the Uniform System of Accounts for the Lodging Industry, the sales and marketing department includes franchise fees, franchise advertising costs, and loyalty program fees, while room reservation expenses paid to the franchise company are charged to the rooms department. Hotel A is operated with a franchise affiliation provided by a national chain, subject to the payment of franchise fees (royalties) of 5.0% of room revenue. In addition, the owner pays an advertising fee comprised of 1.0% of room revenue, plus 6.0% of room income directly generated by the franchisor’s sales offices. Consequently, another business component of the hotel is accounted for by the franchise-related fees. Deducting the brand’s fees in the P&L removes the remaining business component from the NOI. As such, if the base management fee and the franchise-related fees are calculated as expense items, then no additional calculation is necessary to remove their impact from the stabilized NOI.
The expenses of Hotel A also include a deduction for the periodic replacement of FF&E, estimated at 4.0% of total revenue. This accounts for the guestrooms, lobby, restaurant, and lounge furnishings; as well as kitchen, front desk, and office equipment. Therefore, no additional return of tangible personal property is required to be deducted. Also, no additional return on personal property is needed since the applied capitalization rate is equivalent to a weighted return on total assets acquired. (The total amount paid by the owner of Hotel A to the third-party manager and franchisor, as well as the FF&E reserve, is approximately $1.5 million as presented in the right column of Figure 2.)
The NOI of Hotel A is close to $2.2 million. The stabilized capitalization rate of 7.5% would be derived by analyzing similar hotel transactions in the local market, discussions with brokers, and would be supported by applying the band of investment technique. When the NOI is capitalized, the resulting market value is approximately $29.4 million (which will be discussed later).
In a typical hotel P&L, the NOI is net of all management and franchise-related fees (brand costs), so it reflects the income attributable to the real and tangible personal property only. For that reason, in this scenario a hotel appraiser wouldn’t be estimating the so called “going-concern value,” as might be assumed by some practitioners. That’s because the valuation performed nets-out the income attributable to the business operation. Since the capitalized NOI of Hotel A reflects income attributed to the real and tangible personal property only, the calculated value of $29.4 million is, intuitively, the market value attributed to the real and tangible personal property only. Accordingly, the estimate of $29.4 million can be utilized by a hotel appraiser or property tax jurisdiction to derive the appropriate net taxable/assessed value of Hotel A by separating the value of the land, building, and FF&E. (Even if a hotel owner manages his or her property, an appraiser would still need to factor in a deduction for management fees upon sale to derive a market value.)
To separate the three components (land, building, and FF&E), an appraiser or property tax assessor would first need to estimate the land value by analyzing recent comparable land sales, have discussions with local brokers, developers, and owners; as well as refer to hotel development cost surveys. In this example, the value of the land (as if vacant and available) is approximated at $3.1 million. The value of the tangible/taxable personal property is estimated by utilizing the current amount as it would appear on Hotel A’s balance sheet. The amount of the FF&E in-place is $1.7 million per the balance sheet. (An appraiser would also need to do a reality-check on this amount by applying various depreciation methods based on the cost of the FF&E.)
The estimated values of the land and the FF&E are then deducted from the market value of the real and tangible personal property of $29.4 million to separate the value of the building (improvements), resulting in $24.6 million (as shown in Figure 3). The separated value of the building can, therefore, be utilized by a hotel appraiser, tax assessor, or lender without any need to apply esoteric methodologies that would otherwise try to separate the value of intangible assets from the value of the real and tangible personal property. The calculation of the remaining $24.6 million would solve that quagmire in a simple and straightforward manner.
Based on the above analysis, Figure 4 summarizes the tax bill of Hotel A. In this example, the equalization ratio is assumed to be 50.0%, resulting in a net taxable/assessed value of $14.7 million.
If the capitalized NOI of a hotel reflects the income attributable to the real and tangible personal property only, deducting income attributed to the management and franchise companies to isolate intangible value would be misleading. This is actually where further confusion has been created pertaining to the grey area of intangible assets.
The crux of the problem is that there is confusion concerning the opaque term “going-concern value.” It isn’t accurate to assume that the capitalized NOI of a hotel results in the market value of the going concern (real property, tangible personal property, and intangible assets of the business). Rather, and as discussed previously, it’s the market value of the real and tangible personal property only.
In plain English, the way that the market values hotel investments by capitalizing the NOI (or by applying a discounted cash flow analysis) does not result in the so-called going-concern value of a lodging facility. The underlying problem is that some appraisers have been assuming that the owner of the hotel actually owns the whole going concern, when in fact he or she doesn’t. To reiterate, it is the tangible assets that are owned by the investor, not the intangibles.
As presented earlier, the independent management company of Hotel A earns the income attributable to the business operation that is acquired and paid for by the owner, while the franchise company owns the full rights to the brand name, reservation system, trademarks, etc. The expenses associated with these intangibles are netted-out of the NOI; therefore, the income attributed to the business operation is not there for appraisers to value from the get-go.
As such, it would be beneficial if the term “going-concern value” is abandoned when appraising hotels, for three reasons. First, there is little agreement as to the term’s meaning; second it’s a somewhat sloppy construct. Third, the imprecise term could just as easily be interpreted as “investment value of the going concern” or “insurable value of the going concern.” In order to accurately identify what is being valued, the term market value of the real and tangible personal property should be adopted when appraising hotels. This would help eliminate the confusion.
I wrote this article after being asked by an affiliated investor to look into whether his hotel was fairly assessed for property tax purposes. Throughout the process, it became evident that isolating intangible assets of a hotel is like trying to pass an elephant through the eye of a needle. That’s because there are property tax regulations and certain valuation guidelines that don’t accurately reflect the realities of the hotel investments market. Furthermore, the catch-all phrase “going-concern value” is very confusing, especially when applied to hotel valuations.
To recap, the misunderstandings about intangible assets center round the following. First, the NOI of a hotel, especially when analyzed by active participants in the market, represents income attributable to the real and tangible personal property only; therefore, when capitalizing the NOI, the resulting amount is the market value of the land, improvements, and equipment that’s owned by an investor, not the going-concern value. Second, if the intangible assets of a hotel are fully owned by a management or a franchise company, then the bundle of rights with which the ownership of the real estate is endowed does not include intangible assets of the hotel to start with. Third, if intangible assets of a hotel are not part of the bundle of rights with which the ownership of the real estate is endowed, then the going-concern value doesn’t include intangible assets.
Moreover, appraisals are requested by clients for virtually any reason, such as financings, litigations, and condemnations, etc. Appraisers should be valuing hotels the same way under any circumstances, including property tax appeals. In other words, the assets and the rights being appraised do not change just because the use of an appraisal varies. Appraisers should also value hotels the same way that investors analyze deals.
Lodging facilities are such a unique form of real estate that they require their specific valuation guidelines and technical terminology. Hotels are so distinctive because their “leases” are only 24-hours in duration and are “renewed” 365-times-a-year. Hotels are also labor- and capital-intensive, are typically branded via a lodging chain affiliation, are susceptible to extreme volatility in value, and have exceedingly high employee turnover. Above all, it’s extraordinarily difficult to distinguish between excess cash flow due to a superior management and brand, and excess cash flow due to superior real estate (such as a location advantage or an exceptional facility). Whether to attribute the excess cash flow to real property or to intangible personal property is a wild-goose chase.
Given the uniqueness of hotels, it’s basically impossible to isolate a specific value for their intangible assets, even if there is excess cash flow attributed to superior management and/or brand. When valuing hotels for real property assessment purposes or for lenders (where only the market value of the land and improvements is at issue), it’s unnecessary for an appraiser to subdivide the overall property value into its individual components. It suffices to isolate the value of the land, building, and FF&E, because that’s what tax assessors and lenders really want to know.
As we reach the end of this article, I would like to leave the reader with the following points which should help clarify misunderstandings about intangible assets of hotels:
For further research, the reader might want to review the following:
ReferencesAllen, Laurence G. Letter to the Editor. “Response in reference to the determination of hotel value components for ad valorem tax assessment,” The Appraisal Journal (January 1994): 162–164.
Anson, Weston. The Intangible Assets Handbook (Chicago: American Bar Association, 2007).
Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010), 102.
Appraisal Institute, The Appraisal of Real Estate, 13th ed. (Chicago: Appraisal Institute, 2008), 29.
Belfrage, Eric E. “Business Value Allocation in Lodging Valuation,” The Appraisal Journal (July 2001): 277–282.
Berg, Peggy. “Evaluating the Value of a Brand,” Lodging Hospitality (May 1994): 13.
deRoos, Jan A. “Business Enterprise Value in Hotels─The Reality vs. the Shell Game,” Cornell Real Estate Journal (Spring 2006): 29–34.
Dowell, Bernice. T. “Hotel Investment Analysis: In Search of Business Value,” Assessment Journal (Fall 1997): 46–53.
Egan, Patrick J. “Mixed Business and Real Estate Components in Hotel Valuation,” The Appraisal Journal (July 1996): 246–251.
Garippa, John E. “New Appraisal Theories Will Reduce Hotel Assessments,” Real Estate Forum (November 2002): 86.
Gloodt, Peter H. “Hotel Valuation: Splitting the Hospitality Business from the Real Estate Assets,” The Journal of Multistate Taxation and Incentives (July/August 1998): 139–145.
Hennessey, Sean F. “Myths about Hotel Business and Personalty Values,” The Appraisal Journal (October 1993): 608–611.
Kinnard, Jr., William N., Elaine M. Worzala, and Daniel L. Swango. “Intangible Assets in an Operating First-Class Downtown Hotel,” The Appraisal Journal (January 2001): 68–83.
Lennhoff, David C. “Business Enterprise Value Debate: Still a Long Way to Reconciliation,” The Appraisal Journal (October 1999): 422–428.
Lennhoff, David C. “Intangibles are the Real Thing,” Probate & Property (September/October 2004): 34–36.
Lennhoff, David C. and Heather J. Reichardt. “Hotel Valuation Myths and Misconceptions Revisited,” Property Tax Valuation Insights (Winter 2011): 85–93.
Lennhoff, David C., ed. A Business Enterprise Anthology, “Hotel Investment Analysis II: What’s the Real Deal?” by Bernice T. Dowell (Chicago: Appraisal Institute, 2012): 167–173.
Lesser, Daniel H. and Karen E. Rubin. “Understanding the Unique Aspects of Hotel Property Tax Valuation,” The Appraisal Journal (January 1993): 9–27.
Lesser, Daniel H. Letter to the Editor. “Hotel property tax valuation issues,” The Appraisal Journal (October 1994): 639.
Lesser, Daniel H. “Total Assets of the Business and Lodging Facilities: What Should Be the Final Chapter,” Journal of Property Tax Assessment & Administration (Fourth Quarter 2004): 37–45.
Love, A. Scruggs, Bruce H. Walker, and Douglas W. Sutton. “New Option in Hotel Appraisals: Quantifying the Revenue Enhancement Value of Hotel Brands,” The Appraisal Journal (Summer 2012): 223–234.
Matonis, Stephen J. and Daniel R. DeRango. “The Determination of Hotel Value Components for Ad Valorem Tax Assessment,” The Appraisal Journal (July 1993): 342–347.
Mellen, Suzanne. “Assessment Valuation Issues: Hotels,” Presentation at the Northern California Chapter of the Appraisal Institute's 2010 Annual Fall Conference.
Nelson, Roland D., Jay L. Messer, and Laurence G. Allen. “Hotel Enterprise Valuation,” The Appraisal Journal (April 1988): 163–171.
Nilsson, Marie, Peter Harris, and Russell Kett. “Valuing Hotels as Business Entities,” Journal of Leisure Property (April 2002): 17–28.
O’Neill, John W. and Eric E. Belfrage. “A Strategy for Estimating Identified Intangible Asset Value: Hotel Affiliation Contribution,” The Appraisal Journal (Winter 2005): 78–86.
Rattermann, Mark R. ed. The Student Handbook to The Appraisal of Real Estate, 13th ed. (Chicago: Appraisal Institute, 2009), 16.
Reichardt, Heather J. and David C. Lennhoff. “Hotel Asset Allocation: Separating the Tangible Personalty,” Assessment Journal (Winter 2003): 25–31.
Reynolds, Anthony. “Attributing Hotel Income to Real Estate and to Personalty,” The Appraisal Journal (October 1986): 615–617.
Rubin, Karen E. “Hotel Real Estate Tax Valuation: Current Issues,” The Real Estate Finance Journal (Fall 1998): 32–40.
Rushmore, Stephen and Karen E. Rubin. “The Valuation of Hotels and Motels for Assessment Purposes,” The Appraisal Journal (April 1984): 270–288.
Rushmore, Stephen and Thomas Arasi. “Adjusting Comparable Sales for Hotel Assessment Appeals,” The Appraisal Journal (July 1986): 356–366.
Rushmore, Stephen. Notes & Comments. “Hotel business value and working capital: A clarification,” The Appraisal Journal (January 1987): 144–147.
Rushmore, Stephen. “Why the ‘Rushmore Approach’ is a Better Method for Valuing the Real Property Component of a Hotel,” Journal of Property Tax Assessment & Administration (Fourth Quarter 2004): 15–27.
Sahlins, Elaine. HVS Hotel Development Cost Survey 2011/12, (San Francisco: HVS, January 2012).
US Small Business Administration Office of Financial Assistance, Lender and Development Company Loan Programs─SOP 50 10 5(D) (Washington, DC: SBA, 2011), 188.
Wolverton, Marvin L., David C. Lennhoff, James D. Vernor, and Richard Marchitelli, “Allocation of Business Assets into Tangible and Intangible Components: A New Lexicon,” The Appraisal Journal (January 2002): 50.
Court CasesChesapeake Hotel LP v. Saddle Brook Township, Tax Court of New Jersey, 001690–99 (2005).
Downeast Inns, Inc. and Fine Valley Assoc. v. Town of Conway, New Hampshire Board of Tax and Land Appeals, 16382–95PT (1999).
EHP Glendale LLC v. County of Los Angeles, Los Angeles Superior Court, BC385925 (2009).
Hardage Hotels LLC v. Lisa Pope, Assessor, Platte County, State Tax Commission of Missouri, 06–79089 (2007).
Mount Washington Hotel Preservation LP v. Town of Carroll, New Hampshire Board of Tax Land Appeals, 18306–99PT (2004).
RBI Acquisition Company, Inc. v. Supervisor of Assessments of Howard County, Maryland Tax Court, 03–RP–HO–0055 (2006).
About the Author
Anwar Elgonemy is director of investments for Equinox Hospitality Group, a San Francisco-based private equity firm. He draws on over 20 years of experience in lodging sector acquisitions, developments, financings, and valuations. Previously, Elgonemy was a senior vice-president with the hotel group of Jones Lang LaSalle (NYSE: JLL). Prior to JLL, he was employed by PKF Consulting (valuations), Marriott International (feasibility), Laventhol & Horwath (advisory), and Hilton and Holiday Inn (accounting/operations).
Widely published, he is the author of the best-selling book Skin in the Game: The Past, Present, and Future of Real Estate Investments in America. He has also been published in the Cornell Hospitality Quarterly and the Real Estate Finance Journal.
His professional real estate designations include Certified Commercial Investment Member (CCIM), Counselor of Real Estate (CRE), Fellow of the Royal Institution of Chartered Surveyors (FRICS), and Member of the Appraisal Institute (MAI). He is an alumnus of the University of Houston Conrad Hilton College and the Harvard University Graduate School of Design.