by Patrick Quek, May 1997

In the first of a two-part series, we examine the hotel real estate market from a seller’s and buyer’s point of view.

Despite all the fears of overdevelopment and another downturn for the hotel industry, almost all prognosticators, including PKF Consulting, are projecting hotel profitability to continue to grow. The reasons for this continued growth in profits can be tied to rising room rates, improved operating efficiencies, and controlled inflation.

In an effort to see how this favorable financial outlook impacts the investment community, we have analyzed valuation information from our database. Using data from PKF Consulting’s Trends In The Hotel Industry and Hospitality Investment Survey, we have calculated a "Trends Value" for the typical hotel participating in our surveys. The Trends Value, calculated on a per available room basis, takes into account such factors as the prevailing operating profits, capital reserve requirements, and capitalization rates for each of the years under study. This calculation was made for full-service, limited-service, and resort hotels. It is important to note that this Trends Value does not reflect the actual sales prices for properties bought or sold in any given year.

For the purposes of this article, we have also converted our Trends Values into 1996 constant dollars. This eliminates the effect that inflation has on the dollar amounts. The following chart depicts the indexed historical and projected values of the typical hotels in our surveys.

Driven by the expected growth in profits, it is projected that by 1997, the Trends Value (in 1996 constant dollars) of the "typical" hotel will have improved nearly 75 percent from the depths of the early 1990s recession. As shown in the previous chart, the value improvement of limited-service hotels occurred earlier in the recovery process, but is expected to taper off somewhat in the future, as market conditions temper the profit performance of this segment. On the other hand, full-service hotels took a little longer to recover their value, yet show the greatest potential for value improvement in the future. Resort hotels, driven by the combination of lower capitalization rates and relative lagging improvement in profitability, have shown the least resiliency in value recovery.

Why Sell Now?

 With hotel profits on the rise, why would hotel owners consider selling their property at this time? Market experience and projections say that selling now would cut an owner short of enjoying up to four years (depending upon where the property is located) of rising profits and the corresponding rise in the value of the hotel.

Obviously, the proper time to sell any individual hotel is dependent upon issues unique to that particular asset. Local market conditions, the physical condition of the property, and the financial motivations of the owner are just some of the factors which need to be analyzed before one can properly judge whether or not it is time to sell. However, when you look at the overall state of the current U.S. hotel industry, more than a few compelling reasons can be made for the consideration of selling your hotel now. The following paragraphs summarize some of the reasons why selling your hotel in 1997 might be a prudent move.

Deal From A Position Of Strength

There are several conditions in place now that give the seller leverage over the buyer in the negotiation process. First of all, hotels are a desired asset. Given all the news of improved market and financial performance, hotels are one of the most sought-after forms of real estate for investors. This is most evident on Wall Street, where hospitality related REITs, investment funds, and C-Corporations all need to put their funds to use and are fighting each other to find investment opportunities. Given the cautious movement which has occurred in the market once the Dow hit the 7,000 mark, a case can be made that the investor funds fueling these aggressive Wall Street entities may also slow down, thus resulting in a lessening of hotel acquisition activity.

Leaving Some Crumbs

Professionals realize that successful transactions are the result of balanced negotiations and a "meeting of the minds." While a hotel owner desires to maximize the price paid for his hotel, the buyer comes to the table looking for a price that leaves room for asset appreciation. As mentioned earlier, the hotel industry is expected to experience continued growth in profitability for the next few years. This leaves credible prospects for future return on investment for a potential hotel investor. If hotel owners wait until hotel profitability has peaked out, nothing will be left on the table for potential buyers.

More Builders Than Buyers

Another effect of improving profitability within the hotel industry is that, eventually, it will cost just as much to buy a hotel as it will to build one. Again, comparing the average Trends Value of the typical hotel in our survey and the cost to construct a similar property, we find that the gap is narrowing. On average, the typical hotel in our study was valued at 47.7 percent of its replacement cost in 1991. This ratio is projected to grow to 91.3 percent by year-end 1997.

With the value of the average hotel nearing its replacement costs, the time is approaching when hotel investors will find themselves better off building a new property than investing in an existing one. This narrowing of the gap between purchase price and replacement cost negatively impacts the potential hotel seller in two ways. First, it further shrinks the field of hotel purchasers, many of whom will transform themselves into developers. Secondly, the new hotels that will be built could have a negative impact on the future market performance of the existing hotel, thus further lowering its attractiveness.

Altering Your Investment Strategy

Prudent investors enter a transaction having already developed a proper exit strategy. I believe now is a good time to start reviewing your disposition strategy. What were your goals when you purchased your hotel, and have they been met? Measured in stated-year dollars, Trends Values are double what they were in 1990, and almost 50 percent greater than 1994. I am sure that these rates of return meet the return requirements of most investors.

Exiting hotel ownership does not necessarily mean that you can’t continue to ride the anticipated rise in hotel performance. For example, many sellers will take the proceeds from the sale of their hotel properties and purchase shares of a REIT, a publicly-traded hotel company, or an Investment Fund. Such action makes the "ex" owner’s real estate investment more liquid, while allowing him to benefit from the rise in hotel profitability and values.

How To Exit Gracefully

For hotel sellers, the use of a professional transaction advisor who can properly represent your hotel is a must in today’s marketplace. It is important to make sure your transaction advisor is both credible and qualified to make the case to a prospective buyer that an upside still exists for the hotel asset. Selling a hotel in today’s hotel market environment demands more than pretty pictures and multiple listings. It requires an experienced and knowledgeable transaction advisor who can relate to the investment strategies of potential purchasers, while at the same time representing the best interests of the seller.

Patrick Quek is the president and CEO of PKF Consulting, an international hospitality consulting firm headquartered in San Francisco. 

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