Cost vs Price vs Value of a Hotel Room
May 29, 2018 12:42pm
Frequently confused, often used interchangeably and seldom understood – The cost, price and value of a hotel are not the same thing! It is rather surprising that industry stakeholders routinely seem to obfuscate these distinct terms and their implications on the worth of an asset. This article aims to set the record straight and explain the specific differences when performing a hotel’s monetary assessment. In a bid to avoid ‘death by jargon’, I’m also going to tell you a story…
The total cost of a hotel is simply the accumulation of all expenditures incurred during the tenure of its development. This could include (but may not be limited to) the original procurement cost of both – the land as well as the Floor Space Index (FSI) permitted for construction, the actual expenses incurred while building the hotel (such as cement, steel, plant, machinery, mechanical, electrical, plumbing, tile, marble, granite, carpets, furniture, fixtures, equipment, amenities, etc.), soft costs such as hiring of consultants & advisors, expenses related to licenses & permits and finally the cost of interest accrued on any loans that may have been deployed during construction. (Phew!)
To be clear, the cost of a specific hotel asset does not change with time. It is absolute and finite, it is static and bears reference to the real expenses incurred at the time of actual construction. Moreover, the cost of a hotel must not be confused with various other fancy terms such as replacement cost, reconstruction cost, refurbishment cost or restoration cost, all of these having specific meanings that are not the same as hotel development cost, although they may have a role to play when valuing a hotel. (Hope I’m not confusing matters already?) Finally, the cost of a hotel, when viewed independently, is not an accurate representation of its true worth.
Once Upon a Time: Let’s say that Mr. Awesome procured two acres of commercially zoned land at a cost of $25 Million in Imagineville. The FSI available was 1.5, thereby allowing a permissible construction of about 130,000 sq ft. Over a span of three years, it costs Mr. Awesome $100,000 per room to develop a 100-room upscale hotel for $10 Million. The total cost of the hotel was therefore $125 Million. Let’s park this thought for now.
This, now refers to the actual transactional amount exchanged between a buyer and seller. Conceptually, just like the price of a pack of chips, or a Rolls Royce for that matter – the price of a hotel is the absolute currency spent when the asset is traded. It could conceivably be similar, higher or lower than its cost. Innumerable factors could influence the price of an asset:
As is (hopefully) evident, a hotel’s price is thus directly impacted by various external forces and it may change as the conditions alter. While the price of a hotel is therefore a strong indicator of its attractiveness (or lack thereof) in a marketplace, it too is not an accurate representation of its true worth.
Once Upon a Time: Let’s assume that Mr. Awesome had a dream run and made good money during the hotel’s first five-years of operations. He decided to then sell this asset. His stars aligned in just the right position and he found an interested buyer (Lets call her Ms. Splendid, shall we?), who was keen to own a hotel in Imagineville. While Mr. Awesome wanted to sell the hotel for $200 Million, after much debate and discourse, Ms. Splendid eventually acquired it for a price of $175 Million. How did they arrive at this magical number specifically? Read on…
There are a variety of approaches that can be employed, when ‘valuing’ a hotel:
The income, cost or price of a hotel are all therefore useful levers when attempting to value an asset. Do note, however, that a hotel’s value could be higher than its traded price because, say, a seller may have had to transact under duress. Conversely, the value could be lower than the price it sold at because the buyer was willing to pay a premium (for reasons best known to him) at the time of acquisition.
A host of factors could, therefore, influence a hotel’s value. While the income generating ability of a hotel, its replacement cost or the price of comparable transactions are all relevant and important yardsticks, they are not independently a true reflection of the asset’s worth. A combination of these valuation approaches would ideally be the most logical way to determine the true worth of a hotel.
Once Upon a Time: Ms. Splendid had decided to retain a Hospitality consulting firm (wisely so, I may add) to value the upscale-hotel before making the decision to acquiring it. Based on detailed market research and a logical revenue & expense forecast exercise, the firm had concluded that the present value of the hotel, based on its ability to generate long-term income was $150 Million. The firm had also opined that should Ms. Splendid aspire to build a similar hotel in a comparable location in Imagineville, the replacement cost of that asset would be $220 Million. Thirdly, the firm’s research revealed that two hotels with a similar inventory, product, branding, location and repute had recently traded in Imagineville for $160 Million and $170 Million respectively. So, while the fair value of the hotel was admittedly between $150 Million to $220 Million, she eventually purchased the hotel by offering a price that was a premium to both – the income and sales-comparison based values and a discount to the replacement-cost based value. Her urgent need to buy an asset nullified the option to build one on her own as that would require time and would likely cost more than the offer price of $200 Million. It also justified a premium on the income-based & sales-comparison based values, as alternatives were not easily available for purchase. However, these two values also provided her the right tools to negotiate with Mr. Awesome, who was in the market to sell, and had admittedly made a handsome IRR on his initial investment from five year of steady operating cash flows. Hence the transaction of a hotel that…
Was built at a cost of $125 Million
Got valued at a range of $150 to $220 Million
And sold at a price of $175 Million
The fact that Ms. Splendid & Mr. Awesome eventually got married and lived happily ever after is probably immaterial…
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