Hotel Online  Special Report


Low Interest Rates and High Demand for
Hotel Assets Fuels Value Gains

February  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: Suzanne Mellen, MAI, CRE - HVS International - San Francisco

The low interest rates which have characterized the hotel financing market over the past year, coupled with very strong demand for quality hotel assets, have lowered capitalization rates and are driving up hotel values. While the factors that are fueling this trend have been in place for the past year, it was only in the third quarter of 2003 that we began to witness value increases as measured by closed transactions. We attribute the significant pick-up in investor activity to the improving national economic outlook and the subsiding of the SARS epidemic.

Investors can now confidently say that the worst is over. Hotel performance has bottomed out and the only direction for hotel earnings is up. The result is a reduction in hotel capitalization rates and discount rates to levels not seen since the Japanese went on a buying spree of hotel assets in the late 1980's. We are once again seeing hotel investments at free and clear discount rates as low as 11%, rates not seen since 1989. Other factors, however, reduce the applicability of the comparison to market conditions at that time. In 1989 inflation was averaging 5%, indicating a 6% real rate of return (11% - 5%). Compare that with the 2% to 3% inflation rate utilized today for most hotel transactions, reflecting an 8% to 9% real rate of return. We are also at the trough of the hotel earnings cycle, whereas in 1989 the long awaited recession had not yet occurred, and hotel earnings were on the precipice of a decline.

The traditional mortgage-equity model explains the reduction in rates of return. Ten year fixed rate interest rates of as low as 6.5%, coupled with investor return requirements in the high teens, result in discount rates in the 11% to 12% range for hotels that are generally stabilized. Compare this with interest rates of 8.5% and investor yield requirements in excess of 19% two years ago, which resulted in discount rates in the 13% to 14% range. The following chart sets forth the change in investment parameters that have driven down capitalization rates to their current level.  This example reflects the discount rates and capitalization rates derived for a high quality hotel asset in a major urban area that has performed well during the recent downturn and is operating at a stabilized level.

The same investment parameters applied to a hotel that has been negatively impacted by the economic downturn result in a higher yield, due to the significant improvement in net operating income forecast for this asset.

Capitalization Rate Derived - 
Stabilized High Quality Hotel
Valuation Inputs
Historical Norm
Current Parameters
Interest Rate:  8.5% 6.5%
Debt Service Coverage Ratio: 1.5 1.6
Equity Yield Rate: 19.0% 17.0%
Valuation Outputs
Value Per Room: $171,000 $193,000
Loan-to-Value Ratio:  65% 65%
Debt Coverage Ratio: 1.6 1.6
Discount Rate: 13.0% 11.0%
Implied Cap Rate: 10.0% 8.0%
Derived Cap Rate (1st Yr. NOI): 10% 9%
Capitalization Rate Derived - 
Underperforming Hotel
Valuation Inputs
Historical Norm
Current Parameters
Interest Rate:  8.5% 6.5%
Debt Service Coverage Ratio: 1.5 1.6
Equity Yield Rate: 19.0% 17.0%
Valuation Outputs
Value Per Room: $122,000 $138,000
Loan-to-Value Ratio:  65% 65%
Debt Coverage Ratio: 1.5 1.5
Discount Rate: 14.8% 12.7%
Implied Cap Rate: 11.8% 9.7%
Derived Cap Rate (1st Yr. NOI): 7% 6%
Utilizing the same investment parameters results in a markedly higher (+1.5 points) free and clear yield rate in the turn around scenario, where net income is forecast to almost double in five years from their current depressed levels. Successful hotel buyers are building significant upside into their earnings forecasts for those hotels which have been negatively impacted by the economic downturn. The result is that many hotels are transacting at "going-in" overall capitalization rates in the 5% to 7% range, based on current earnings. For those hotels which continued to perform well during this most recent downturn the upside being forecast is more moderate, with derived capitalization rates ranging from 8% to 9%.

With discount and capitalization rates at or near their historical low, are hotel investors being adequately compensated for the risks associated with hotel investments?  Only time will tell. The positive operating leverage generated by hotel assets during an upswing in revenues can result in dramatic gains in net income, as was witnessed during the mid to late 1990's.  Conversations with the hotel buyers indicate that part of the rationale for purchasing these assets at such low capitalization rates is that returns remain attractive when compared with those being generated by other real estate assets. Prices are being driven up in all kinds of real estate, and many buyers have withdrawn from the office, industrial, multi-family residential and retail sectors due to the low initial yields that have resulted from a highly competitive seller's market. Buyers bemoan the lack of a significant number of hotels for sale, but given current pricing we can expect that more hotel owners will find 2004 and 2005 an opportune time to put their hotel on the market.


February 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 A Crash Course In Cap Rates / Canadian Lodging Outlook - January 2005 Year-to-Date
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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