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TheArt& &Scie enceofHo otel Valu uation nina anEco onom mic Dow wntur rn
AnImp provedM Methodol logyforaConstr rained Market t

TheArt&ScienceofHotelValuationinan EconomicDownturn

Following the significant and continuing impact of the global financial and economic crisis on the hotel industry, HVSs valuation assumptions and methodologyhaveevolvedtomoreaccuratelyreflecttheactionsoftypicalbuyers and sellers in the market place who have modified their valuation procedures basedonthecurrentfinancingenvironment. Europeanhotelvalueshavecomeundersignificantpressureinthepasttwoanda halfyearsowingtothecreditandoperatingconstraintsofthecurrentmarket.In this context, we have adapted our valuation assumptions and methodology to ensure that we consider current and mediumterm operating and lending conditions to provide a fair estimate of Market Value rather than a value which overemphasisestheeffectsoffinancialand/oroperationaldistress. In this article we demonstrate how distressed values are at least 1520% lower thanMarketValues.Hence,theimportanceofmakingsurethatthevaluedoesnt penalise the medium and longerterm performance of the asset by assuming currentlydepressedinvestmentparametersandoperatingconditionsthroughout theentireholdingperiod.Havingobservedsomeofthestrategiesputinplaceby currently active buyers, we propose a more flexible, realistic and transparent routetoMarketValuesinuncertaintimes.Theproposedmethodologyconsiders currentcreditmarketconditionsintheshorttermandarefinancingeventinthe mediumterm,basedonimprovedbusinesscashflowsandthesubsequentreturn ofinvestorsandlendersconfidence. Themainpurposeofthismethodologyistorepresentmorecloselybothdebtand equityinvestorssentimentandbehaviourinthecurrentmarketmakingsurethat the true earning potential of the asset is reflected in our conclusion of Market Value, whilst at all times complying with the strict requirements of the Royal InstitutionofCharteredSurveyers(RICS)RedBook.



Current Challenges

The main challenges to hotel valuation during the current crisis have been the lack of transactions, the limited availability of finance, the depressed operating returnsandtheunknownrecoverytimetable.Morethanever,itisimportantthat the valuer has a specialist understanding of the industry and the specific hotel markets to be able to accurately assess the hotels earning potential. Moreover, theprofessionalvaluershouldbeconsciousofthebenefitsandlimitationsofthe different property valuation methods available and systematically adopt two or threevaluationmethodsascrosschecks. A tenyear leveraged discounted cash flow is the most accurate method of valuation,providingthatthereistransparencyforthevaluertoprovethesource of all market assumptions and investment parameters. This valuation method consists of forecasting the hotels future earnings and discounting them to the present value based on the typical investment parameters and return requirementsthatdriveequityanddebtmarketparticipants. Investors and lenders appetite for prime hotels and riskfree deals with fixed leaseincomeand/orguaranteeshascontinuedandevenincreasedthroughoutthe crisis. In contrast, most other type of hotel deals have been very difficult to financeowingtothevolatilityofhotelearningsatthisstageoftheeconomiccycle and lenders more conservative and riskaverse approach. However, as the general economy and hotel earnings recover and there is less default risk, it is likelythatbetterfinancingtermswillbecomeavailable. Therefore, if we were to simply adopt the assumptions and investment parametersofthecurrentmarketandrollthemforwardthroughoutthetenyears projected, we would be purely reporting a distressed value, not allowing for an improvement in the hotels operating cash flows, debt coverage and credit marketsinthemediumterm.Historically,thispotentialupsidehasbeenreflected by merging the investment parameters available today with those from a stable market. However, in essence all that does is to use investment parameters that areeitheroverlyaggressiveforthecurrentmarketortooconservativeforastable market. To represent marketwide investment parameters at all stages, we have adapted our normal tenyear leveraged cash flow method of valuation and builtin a refinancingscenariowhichconsidersboththecurrentandtheimprovedmarket conditions and reflects the likelihood of refinancing in a few years time under morefavourablelendingconditions.Thisscenarioassumesthattheloantovalue ratio will improve, and investors will look to release some of their equity when additional finance and/or better terms are available. We have reviewed this assumption with many experienced hotel lenders and investors, most of whom have confirmed the validity of our approach as it reflects their investment and lendingrationale.



The Science in Practice

The following example will help to illustrate the impact of the refinancing assumptionsontheMarketValueofaspecifichotelproperty.

We present the valuation of a hypothetical 250room full service hotel affiliated with an international brand. This hotel enjoys a very good location, in a main Europeanbusinessandleisuredestination,andwasrefurbishedin2007/08. The market has high barriers to entry, and therefore supply has been relatively stableoverthepastdecade;supplyisexpectedtoincreasebyapproximately5% from2010to2012. The hotel has historically generated an annual net operating income of nearly 4,000,000 per year. However, the hotels operating income shrank by nearly 40%in2009. From our forecast of occupancy, average rate, food and beverage revenue, banqueting revenue, other income and operating, undistributed and fixed expenses for the hotel, we have projected the resulting tenyear net operating incomecashflows,whicharepresentedinTable1. The debt service coverage ratio (DSCR) decreased to 1.05 in 2009 due to the reduced level of earnings. We observe that this is below the 1.31.5 minimum DSCRtypicallyrequiredbylendersandisnotexpectedtoexceedthatleveluntil 2012. Table1 TenYearNetOperatingIncomeCashFlowHistoryandProjections (000s)
Net Existing Income DebtService DSCR 4,000 2,100 1.90 3,700 2,100 1.76 2,200 2,100 1.05 2,400 2,800 3,700 3,900 3,960 4,020 4,080 4,140 4,200 4,260 2,100 2,100 2,100 2,100 2,100 2,100 2,100 2,100 2,100 2,100 1.14 1.33 1.76 1.86 1.89 1.91 1.94 1.97 2.00 2.03


Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019


Our projections consider the gradual recovery of the trading performance from 2010 onwards, a similar revenue and cost structure to the historical, a 4.0% reserveforreplacementtofundreinvestmentinthehotelthroughouttheholding periodandinflationarygrowthfromthestabilisedyear(2013)onwards.



TheMarketValueofthehotelisestimatedviathecapitalisationoftheprojected net operating income cash flows through a tenyear leveraged discounted cash flowanalysis. We consider two valuation scenarios. Scenario One considers a theoretical purchase of the hotel assuming investment parameters in line with those available in the market as of today, and no refinancing. Scenario Two assumes current investment parameters but with a refinancing at the end of year three, undermorefavourablelendingterms,aspresentedinTable2. Table2 ValuationParametersScenariosOneandTwo
ValuationParameters StabilisedInflation: Initial Loan/Value: RefinancingLTV Amortisation(years): InterestRate: Terminal CapRate: Transaction/RefinancingCosts: EquityYield: Overall DiscountRate: Scenario1 1.5% 50% none 20 6.0% 8.0% 1.5% 18.5% 13.7% Scenario2 1.5% 50% 70% 20 6.0% 7.0% 1.5% 17.5% 12.2%

Scenario One

We have used our forecast of net operating income for the hotel, deducted the correspondingdebtserviceandaddedthenetsaleproceedsfromdisposingofthe hotel at the end of an assumed ten year holding period to obtain the net cash flowstoequityanddebtcoverageratiobasedoncurrentoperatingandavailable lendingconditions,asshowninTable3. Table3 NetCashFlowstoEquity()
NetIncome Available for DebtService 2,400,000 2,800,000 3,700,000 3,900,000 3,960,000 4,020,000 4,080,000 4,140,000 4,200,000 4,260,000 Total Annual DebtService 1,441,000 1,441,000 1,441,000 1,441,000 1,441,000 1,441,000 1,441,000 1,441,000 1,441,000 1,441,000 + + + + + + + + + + Plus: NetSale Proceeds 0 0 0 0 0 0 0 0 0 42,370,000 = = = = = = = = = = Total CashFlow toEquity 959,000 1,359,000 2,259,000 2,459,000 2,519,000 2,579,000 2,639,000 2,699,000 2,759,000 45,189,000

Year 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

DSCR 1.67 1.94 2.57 2.71 2.75 2.79 2.83 2.87 2.91 2.96

Note:Figureshave beenroundedforpresentationpurposes

Theannualdebtservicepaymenthasbeencalculatedbasedontheloantovalue ratio assumed and the mortgage constant, which reflects the periodic cost of



financing as a percentage of the total loan amount. We note that the projected earningsallowforahealthycoverageofdebtservice. Thenetsalesproceedsresultfromcapitalisingthe11thyearnetoperatingincome into perpetuity at the terminal capitalisation rate and deducting the typical transaction costsbornebythesellerandtheremainingmortgagebalanceatthe endoftheholdingperiod. We have then discounted the annual cash flows to equity at the assumed equity yieldwhichreflectsthereturnrequirementsofequityparticipantsinthecurrent market. This results in the value of the equity component (16,765,000), as showninTable4. Table4 DiscountedCashFlowAnalysisScenarioOneBaseValue()
Year 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 NetIncome ToEquity 959,000 1,359,000 2,259,000 2,459,000 2,519,000 2,579,000 2,639,000 2,699,000 2,759,000 45,189,000 Equity Discount 18.5% 18.5% 18.5% 18.5% 18.5% 18.5% 18.5% 18.5% 18.5% 18.5% x x x x x x x x x x Discount Factor 0.84388 0.71214 0.60096 0.50714 0.42796 0.36115 0.30477 0.25719 0.21704 0.18315 = = = = = = = = = = Discounted CashFlow 809,000 968,000 1,358,000 1,247,000 1,078,000 931,000 804,000 694,000 599,000 8,277,000 16,765,000 16,765,000 0 33,530,000 33,500,000 134,000 13.66%

Value ofEquityComponent: Plus:Value of the Mortgage: Less:Capital Deduction: Total PropertyValue: RoundedTo: Value perRoom: PropertyYield:

Note:Figureshave beenroundedforpresentationpurposes

Thevalueofthemortgageisbasedonthevalueoftheequitycomponentandthe equitytovalue(ETV)andloantovalueratios(LTV).
TotalValue=ETV+LTV 100%=ETV+50% ETV=100%50%=50% Thus,LTV=16,765,000

We have assumed no additional capital deduction in our analysis, beyond the alreadyforecastreserveforreplacement. As illustrated in Table 4, our tenyear leveraged discounted cash flow analysis indicates a Market Value for the hotel of approximately 33,500,000 (134,000 perroom).



Scenario Two

However,weconsiderthatpresentlendingconditionsarenotrepresentativeofa normalinvestmentenvironment.Therefore,theriskisthatbyonlyconsidering theseconditions,asshowninTable4,thehoteliseffectivelybeingundervalued. So if we were to take into consideration the very likely event that an investor wouldexpecttorefinancethisinvestmentwhenoperatingandlendingconditions improve, and we adopt the Scenario Two valuation parameters, the picture changessubstantially. ToderivethetotalcashflowtoequityunderScenarioTwowehaveusedthesame forecast of income and expense, deducted the corresponding debt service and addedthenetproceedsofrefinancingthehotelattheendofyearthree. Uponrefinancing,thehotelhasbeenvaluedusingatenyeardiscountedcashflow analysisbasedonpostrefinancingcashflowsfrom2014onwardsandimproved investmentparametersinordertoderivethequantityoftheloanandtherevised annual debt service. The inputs and outputs of this analysis are summarised in Table5. Table5 ValueBasedonPostRefinancingYearCashFlowsandNew MortgageSize()
ValuationInput YearofValue: 2013 Inflation: 1.5% Loan/Value: 70% mortisation(years): 20 Term: 10 InterestRate: 6.0% Terminal CapRate: 7.0% TransactionCosts: 1.5% EquityYield: 17.5% *Beforecapital deduction,ifany ValuationOutput Value:* 47,900,000 Value PerRoom: 191,600 Overall DiscountRate: 10.8% CapRateHistorical NOI: 8.1% CapRate1stYearNOI: 8.3% Mortgage@70.0%LTV: 33,549,000 MortgagePerRoom: 134,196 Annual DebtService: 2,884,000 DSCRRefi.Year: 1.37

Thenetproceedsofrefinancinghavebeencalculatedbasedonthesizeofthenew mortgage less the outstanding mortgage balance of the initial mortgage and an assumed1.5%costofrefinancingasafeetothelender,asshowninTable6. Table6 CalculationofNetRefinancingProceedstoEquity()
RefinancingYearValue: NewLoan/Value Ratio: NewMortgage: Less: OutstandingBalance ofInitial Mortgage: RefinancingCosts@1.50%: NetRefinancingProceeds 47,900,000 70% 33,549,000 14,801,000 503,000 18,200,000

Table 7 shows the calculation of net cash flows to equity according to the assumptionsofScenarioTwo.Weassumeasaleofthepropertyattheendofthe holdingperiod.




NetIncome Available for DebtService 2,400,000 2,800,000 3,700,000 3,900,000 3,960,000 4,020,000 4,080,000 4,140,000 4,200,000 4,260,000 TotalAnnual DebtService 1,441,000 1,441,000 1,441,000 1,441,000 2,884,000 2,884,000 2,884,000 2,884,000 2,884,000 2,884,000 + + + + + + + + + + Plus: Refi./Sale Proceeds 0 0 0 18,200,000 0 0 0 0 0 33,569,000 = = = = = = = = = = TotalCashFlow toEquity 959,000 1,359,000 2,259,000 20,659,000 1,076,000 1,136,000 1,196,000 1,256,000 1,316,000 34,945,000 DSCR Ratio 1.67 1.94 2.57 2.71 1.37 1.39 1.41 1.44 1.46 1.48

Year 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Note:Figureshave beenroundedforpresentationpurposes

Followingtherefinancingevent,thebuyertakesadvantageofadditionalfinance based on improved level of earnings and general financing conditions and this results in larger annual debt service payments. We note that the DSCR upon refinancingisstillwithinthe1.31.5minimumrangetypicallyrequiredbylenders inthestabilisedyear. Theresultingcashflowstoequityarethendiscountedattheequityyield(initially 18.5%andthen17.5%afterrefinancing,giventhereductioninequityneededto fund the project, less operating risk and the higher returns on the existing investmentfromtherefinancingproceeds).Thisresultsinthevalueoftheequity component(22,531,000). This valuation methodology considers the upside potential of refinancing the current loan when the property is stabilised and more favourable lending conditions are available on the return to the equity participant and the current lendingconditionsonthereturntothedebtparticipant.Thus,toobtainthehotels MarketValue,weaddthevalueoftheoriginalmortgagetothevalueoftheequity componentundertherefinancingassumption. We have assumed no capital deduction in our analysis, beyond the already forecastreserveforreplacement.




Year 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 NetIncome ToEquity 959,000 1,359,000 2,259,000 20,659,000 1,076,000 1,136,000 1,196,000 1,256,000 1,316,000 34,945,000 Equity Discount 18.5% 18.5% 18.5% 18.5% 17.5% 17.5% 17.5% 17.5% 17.5% 17.5% x x x x x x x x x x Discount Factor 0.84388 0.71214 0.60096 0.50714 0.44649 0.37999 0.32340 0.27523 0.23424 0.19935 = = = = = = = = = = Discounted CashFlow 809,000 968,000 1,358,000 10,477,000 480,000 432,000 387,000 346,000 308,000 6,966,000 22,531,000 16,765,000 0 39,296,000 39,300,000 157,000 12.2%

Value of EquityComponent: Plus:Value of Initial Mortgage: Less:Capital Deduction: Total PropertyValue: RoundedTo: Value perRoom: PropertyYield:

Note:Figureshave beenroundedforpresentationpurposes

ThisresultsinaMarketValueofthehotelof39,300,000(157,000perroom) whichinourviewmoreappropriatelyreflectstherequirementsofanexperienced andknowledgeablehotelinvestoractinginthecurrenteconomicenvironment. Agraphicillustrationoftheprocesswouldbeasfollows.

Table 9 Illustration of the Current and Changing Circumstances and Refinancing Scenario

35,000,000 33,000,000 31,000,000 Net Debt Drawdown 17,000,000 15,000,000 5,000,000 3,000,000 1,500,000 Initial Mortgage Mortgage Upon Refinancing Net Refinancing Proceeds

Net Sale Proceeds

NetIncome DebtService











Wehighlightthefollowing. The hotels operating performance is currently depressed, achieving lower thanhistoricalearnings;

HVS SLondon

The eArt&Scienceo ofHotelValuatio oninAnEconom micDownturn9

However, improveme ents to the e hotels tr rading and profitabilit ty can be y expected over the co oming year rs as the ec conomic en nvironment reasonably recovers; The illustration show ws that the loan alw ways remain ns affordab ble to the business,w withabovet thresholdDS SCRthrough houttheholdingperiod d; Thevalueo ofthehotelundercurre entoperatin ngandlendingcondition nsisbased on a depr ressed level of earning gs and does s not factor r in the pos ssibility of obtaining higher leverage on the e investmen nt and relea asing equity y when the rkets and the t hotels trading t hav ve recovere ed. Thus, th his method credit mar undervalue esthehotel; Thevalueo ofthehoteluponrefina ancingisbas sedonanor rmalisednet toperating income an ndlendingconditions(i includingde ebtcoverageratio)and dtherefore represents safairerref flectionofth hehotelsfut tureearning gpotential.

Impact on Ma arket Values s

he following is an illu ustration of f the impac ct of using different eq quity/debt Th as ssumptionsontheMark ketValueofthehotel. Tab ble10 ImpactonMarketValu ueofDiffere entEquity/D DebtAssump ptions

As shown in Table T 10, th he impact and a importa ance of the e adoption of o sensible rameters is crucial. Although A restricted deb bt availabili ity is not part p of the par offi ficialdefiniti ionofdistre essedvalue ,perhapsitshouldbe. Ma ain Advantages In conclusion, , we note that this approach a to o hotel valu uation, considering a ref financing wh hen the hot tel has reached a stabil lised perfor rmance and the credit ma arketsareba ackinbusin ness,hasthefollowinga advantages. Itprovides smoreflexib bilityadaptingtomore econvention naloruncer rtaintimes, considerin ngcurrentan ndmedium termoperatingandlen ndingcondit tions; Itreflectsm moreaccura atelytheinv vestorssen ntimentand investment tstrategies notably, itconsiders stheverylik kelyscenari iothatthei investorwillrefinance totakeadva antageofbet tteravailabl lelendingte erms; afteraperiodoftimet It reports Market Val lue as oppo osed to a value v which is more re eflective of distress, producing p a more real a listic estima ate of the hotels true e potential earningsandcomplies swiththeRICSRedBoo ok.



AbouttheAuthors AnaCamposBlancoisanAssociatewithHVSsLondonoffice,specialising in hotel valuation and consultancy. She joined HVS in 2007 after completingadiplomainTourismManagementattheCEUUniversity,Spain and an MBA at IMHI (ESSEC Business School, Paris, France). Since joining HVS, she has provided investment advice and worked on hotel feasibility studiesandvaluationsacrossEuropeandNorthernAfrica.Sheiscurrently pursuing a MSc in Property Investment from the CEM (College of Estate Management,Reading)andisexpectingtograduatein2012.

Sophie Perret is an Associate Director with HVSs London office. She joined HVS in 2003 and has ten years operational experience in the hospitalityindustryinSouthAmericaandEurope.OriginallyfromBuenos Aires, Sophie speaks English, Spanish and French. She holds a Bachelors degree in Hotel Management from Ateneo de Estudios Terciarios, and an MBA from IMHI (Essec Business School, France, and Cornell University, USA). Since joining HVS, she has advised on a wide range of hotel investment projects and related assignments. Sophie is responsible for developingHVSsworkinFrance,Italy,andAfrica. Forfurtherinformation,pleasecontactAnaCamposBlancoorSophie Perret. AnaCamposBlancoAssociate DirectLine:+442078787762 SophiePerretAssociateDirector DirectLine:+442078787722 710ChandosStreet CavendishSquare LondonW1G9DQ Tel:+442078787700 Fax:+442078787799



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HVSistheworldsleadingconsultingandservicesorganisationfocusedonthehotel,restaurant,shared ownership, gaming and leisure industries. Established in 1980, the company offers a comprehensive scopeofservicesandspecialisedindustryexpertisetohelpyouenhancetheeconomicreturnsandvalue ofyourhospitalityassets. Because hotels represent both real property and operating businesses, the founding partners of HVS decided to develop the first comprehensive valuation methodology for appraising these specialised assets. Their initial textbook on this topic entitled The Valuation of Hotels and Motels, published by the AppraisalInstitute,createdtheindustrystandardforvaluinghotelsandisnowusedbyvirtuallyevery appraiseraroundtheworld.HVScontinuestobeattheforefrontofhotelvaluationmethodology,having publishedsixtextbooksandhundredsofarticlesonthissubject,whichareusedinappraisalcoursesand seminarsandatleadinghotelschoolssuchasLausanne,IMHIandCornell.HVSassociatesareconstantly called upon to teach this methodology to hotel owners, lenders and operators and to participate at industry conferences. HVS principals literally wrote the book on hotel valuation, which significantly enhancesthecredibilityandreliabilityofourconclusions. Over the past three decades, HVS has expanded both its range of services and its geographical boundaries. The companys global reach, through a network of 30 offices staffed by 400 seasoned industry professionals, gives you access to an unparalleled range of complementary services for the hospitalityindustry: Consulting&Valuation InvestmentBanking AssetManagement&Advisory SharedOwnershipServices GolfServices ExecutiveSearch RiskManagement PropertyTaxServices Convention,Sports&EntertainmentFacilities InteriorDesign Sales&MarketingServices HotelManagement(USonly) EcoServices Food&BeverageServices GamingServices HotelParkingConsulting

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