Hotel Online  Special Report

A Crash Course In Cap Rates

January  2005 Year-to-Date

The Canadian Lodging Outlook is a joint monthly publication 
of Smith Travel Research and HVS International, 
Vancouver and Toronto, Canada
By: Ian Ricci and Carrie Russell, AACI - HVS International - Canada

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 
Or vice versa, when analyzing a sales transaction net income divided by the sale price equals the cap rate:
Net Income / Sale Price = Cap Rate 
There are two key points of confusion when using cap rates, the first being the definition of net income, and the second being what accounting period the net income is based on.

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.

Net Income $1,200,000 $1,500,000 $1,800,000
Cap Rate  8.0%  10.0%  12.0%
This example is reflective of current market trends. We are seeing investors willing to purchase properties based on lower historical cap rates, and anticipating upside potential in net income which results in higher projected and stabilized cap rates. It is the general sentiment of the hotel investment market that 2003 was the low point in the cycle and hotel transactions reflect this expectation as investors forecast a rebound in hotel performance and increases in net income.  This trend is expected to continue into 2005, as most major markets in the country continue to post occupancy and average room rate increases, without any major upward pressure on expenses.

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.


January 2005

© Smith Travel Research, 2004. Reproduction or quotation in whole or in part
without permission is forbidden. *INS - Insufficient Data
Selina Lai
HVS International – Canada
2120 Queen St. East, Suite 202
Toronto, ON M42 1E2
(416) 686-2260, ext 21
(416) 686-2264 FAX

Also See 2004 Canadian Hotel Transaction Survey / Canadian Lodging Outlook - November 2004 Year-to-Date
HVS International Hotel Development Cost Survey 2004 / Canadian Lodging Outlook - September 2004 Year-to-Date
Defining a Hotelier; The Hotel Professional Has Gone Through a Major Transition Over the Past 20 Years / Mark Keith / Canadian Lodging Outlook - August 2004 Year-to-Date
Hotel Investments; The Magic, Curse Of Leverage / Canadian Lodging Outlook - July 2004 Year-to-Date / September 2004
June Results Are In And.......We’re Back! / Canadian Lodging Outlook - June 2004 Year-to-Date / Aug 2004
Hotel Life Expectancy / Canadian Lodging Outlook - March 2004 Year-to-Date / May 2004
European Hotel Transactions 2003 - Country Analysis / Canadian Lodging Outlook - February 2004 Year-to-Date / April 2004
2003 an Unbelievably Strong Year for US Hotel Sales / Canadian Lodging Outlook - December 2003 Year-to-Date / February 2004
2003 Canadian Hotel Transaction Survey / Canadian Lodging Outlook / January 2004
2002 Canadian Hotel Transaction Survey / Canadian Lodging Outlook / Feb 2003
How To Get The Best Sales Price; Positioning Your Hotel for Sell / Stephen Rushmore / Canadian Lodging Outlook - July 2003 YTD / September 2003
Lodging Market Impact of Hosting Olympic Winter Games; Will Salt Lake City Experience Apply to Vancouver and Whistler? / Canadian Lodging Outlook - June 2003 YTD / August 2003
Year-to-date Occupancy through April is 50.4% for all of Canada / Canadian Lodging Outlook - April 2003 YTD / June 2003
SARS and Its Impact on Tourism in Toronto / Canadian Lodging Outlook - March 2003 YTD / May 2003
Hotel Values in Europe - Current Trends / Canadian Lodging Outlook - December 2002 Year-to-Date / Feb 2003
2002 Canadian Hotel Transaction Survey / Canadian Lodging Outlook / Feb 2003
Performance Clauses Essential In Hotel Management Contract / Stephen Rushmore / Canadian Lodging Outlook / Dec 2002
Separating the Hotel Looker From the Hotel Buyer / Stephen Rushmore / Canadian Lodging Outlook / Sept 2002
Making The Ideal Hotel Investment / Stephen Rushmore / Canadian Lodging Outlook / Aug 2002
Reporting In at Six Months..../ Canadian Lodging Outlook / July 2002
The Global Approach To Hotel Valuations / Canadian Lodging Outlook / June 2002
Hotel Insurance Premiums on the Rise? / Canadian Lodging Outlook / May 2002 
Hotel Development Cost Can Determine Feasibility / Canadian Lodging Outlook / May 2002 
Hotel Internet Distribution Channels / January 2002 Month-to-Date Results / Canadian Lodging Outlook / April 2002 
2001 Was a Great Year If You Were in Edmonton! / December 2001 Year-to-Date Results / Canadian Lodging Outlook / Feb 2002 
2001 Canadian Hotel Sales / Canadian Lodging Outlook / Jan 2002 
The Effect on Capitalization Rates and Discount Factors After September 11 / Canadian Lodging Outlook / Dec 2001 
So How Bad Was September for Canadian Hotels.. Pretty Bad! / Nov 2001
So How Bad Was September for Canadian Hotels.. Pretty Bad! / The Canadian Lodging Outlook / September 2001 
Have Hotel Values in Canada Declined Since September 11th? You Bet They Have / The Canadian Lodging Outlook / August 2001 
The Popularity of Boutique Hotels / The Canadian Lodging Outlook / July 2001 
Rising Energy Costs Cause Concern in the Lodging Industry / The Canadian Lodging Outlook / June 2001 
Niagara Falls: With Supply Comes Demand / The Canadian Lodging Outlook / May 2001
Does Supply Generate Demand? / The Canadian Lodging Outlook / May 2001 
Optimism With a Hint of Caution, As Analysts Predict a Softer Year for the Canadian Hotel Industry / Mar 2001 
Limited-Service Growth in Canada - Where’s it Going? / The Canadian Lodging Outlook / January 2001 
HVS Canada in Review - Year End 2000 / The Canadian Lodging Outlook / March 2001 
Canadian Lodging Outlook / May 2000 Year to Date Statistics / HVS International - Canada / July 2000 
The Rule of Thumb Method...Does It Still Hold Weight? / Elaine Sahlins - HVS / Oct 2000
What’s Hot and What’s Not in Western Canadian Hotel Markets / Mar 2000

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