Where to Look for the Land-Mines That Can Blow Up Your Hotel Deal !
During my near 20-year career I've reviewed hundreds of hotel valuations, forecast operating statements and feasibility studies. I've learned that even the smallest change, or omission, in underwriting assumptions can materially impact on whether a deal stacks-up. What are they and where to look for these land-mines that could blow up your Hotel Deal!
Below is a list of the traps and pitfalls waiting for you during your due-diligence on a hotel transaction. This is not intended to be a comprehensive list. More of a road-map,
for navigating the terrain of the underwriting process. Drawing on our experience to help guide you through your targeted due-diligence.
1.Defining the Competitive Set
For new hotel development, insight into the target Market needs to be demonstrated, through a representative selection of the Hotel's Competitive Set. For example, if the Development is of an upper-midscale Hotel, and the provided Comp-Set comprises upscale or luxury chain scale hotels, then this should raise a red flag. Underwriters need to factor this into their analysis, and consider undertaking a revised analysis with a more comparable Comp-Set.
The chosen Comp-Set directly influences the forecast revenues for the Hotel. The projected average daily rate (ADR) will be drawn from it. Don't automatically assume that a “new” hotel will achieve ADR levels in-line with, or in-excess, of the suggested comp-set, when it’s representative of a higher or lower chain scale.
2. Competing Hotel Pipeline
One of the biggest risks when examining a transaction is new supply entering the Market. What is the future pipeline of hotels for the locality? When will these future competitors hit the Market? This new supply needs to be considered, and factored in to forecasts. Otherwise occupancy projections, and forecast ADRs could end up being overstated.
3. Length of Ramp-Up
Most hotels ramp-up to stabilisation within the first or second year after an opening or renovation. Be wary of forecasts that show occupancies extending out to four or five years after a material change to the Hotel. This can easily lead to inflated cash-flow projections in later years.
4. Spikes In Revenue
When showing a jump in projected revenues from year to year, underwriters will need to seek specific reasons to support this. I've reviewed countless financial projections showing annual revenue bumps >20%, with the only explanation given that the new owner is going to bring better management. While this may be true in some cases, a good analyst will dig deeper. What are the specific problems identified in the current management’s performance? Has the new management team provided their strategies that support the forecast revenue growth?
5. Declining Expense Projections
Underwriters should review expense projections line-by-line. It may feel tedious to be this detailed. However, a forecast cashflow statement can have many of these small "optimistic" tweaks and assumptions hidden within the detail. When taken as a collective, the cumulative result can have a big impact on the bottom line. You could say its "Death by a thousand cuts" for your Deal!
Comparisons should be made to both historical expenses, and industry benchmarks for the subject's class of hotel. There can be legitimate reasons for forecasting declines in certain expense line items. Yet this can also be a red flag when no justification is present. Particularly where longer term declines in expenses are projected, then a convincing explanation is required.
6. Reduced Labour Supply.
Hotel underwriters need to investigate whether financial statements reflect a fully staffed-up hotel. This is especially true for the current post-pandemic tight labour markets. We can expect it to be challenging to fill & maintain certain hotel positions as we move into a recovery. Many of the experienced hospitality labour force have left the market, and entered other industries, after being furloughed & laid off during the depths of the Pandemic. The staff who remained have been placed under immense stress, as front-line workers. Many have been called on to cover multiple roles within the hotel, and are reaching the point of burn-out.
From an owner's perspective, this may have allowed them to survive the Pandemic’s attack on their business. The reduced labour expense from unfilled positions can mitigate the losses experienced during depressed occupancy and demand. However, if extended too long, this can result in the remaining work force being burnt out, and the guest experience being negatively impacted. This will be reflected in reduced guest satisfaction scores, poor reviews, and declining morale among staff. You won’t see this looking in the Hotel’s cashflow statements alone. It will be important for underwriters to understand the dynamics of the labour market, as we go forward towards the forecast recovery. Include a wider range of data and customer satisfaction sources for the hotel. Finally, consideration should be given to the increased payroll expenses that may arise from attracting back qualified labour into the market, or the training of new entrants to the labour force.
7. One-Off Expenses.
Look out for one-time operating expenses that can appear in historical financials. These can distort what may be taken to be a stabilised position. Underwriters need to analyse the historical financial statements, looking for one-off charges and unusually high expense line items. Always seek an explanation where line items look distorted, out-of-line or as one-off charges.
8. Cash-Flow Hold Period
When underwriting a stabilised hotel, watch out for tinkering and extending of the holding period in the Discounted Cash Flow. The length of the holding period assumption should not affect the projected investment returns. Ask yourself why a 10 year holding period, when it is stabilised within 5 years – what is being gained? In practice, sometimes analysts adjust the holding period without making appropriate adjustments and rebalancing key valuation parameters, such as the terminal cap rate, real income growth rate and the discount rate/ required rate of return (for further discussion of the interplay between these key inputs see Gordon Growth Theory here). This unnecessary engineering of the cashflow can artificially inflate the calculated returns and valuation of the Hotel investment. Watch out for substantial changes in a hotel's value that result from changes in the hold period assumption.
9. What Happens on Reversion
Seemingly small adjustments to the terminal cap-rate and inflation/growth assumptions can have a large impact on the valuation. Hotel investment cap-rate surveys and inflation forecasts can provide wide ranges, with plenty of wiggle room for these key inputs to a DCF analysis. My advice when your underwriting a Hotel DCF model is to consider your valuation assumptions and input variables in aggregate. Stand back, look broadly at the analysis and outcome, and ensure it makes sense as a whole. Has each individual line item or variable adjustment been tweaked all the way to 11, at the upper margin of being reasonable. For example, if EBITDA growth projections are considered aggressive, then the discount rate and cap rate interplay should reflect this risk. As a general guide, the margin between these two inputs should be equivalent to the explicit real growth in net income during the hold period (again, see Gordon Growth Theory) .
10. Capital Deductions
Many hotel acquisitions are planned to coincide with a property improvement plan (PIP), or planned capital expenditure to refurbish or reposition the Hotel. Even when there is no planned repositioning, a hotel brand or franchisor will often have a PIP requirement written into the contract, to maintain the standard of the existing flag. Underestimating the cost of these PIPs, or other necessary renovations, is one of the biggest potential pitfalls for investors considering a hotel acquisition.
11. FF&E Reserve & Management Fees
Hotel owners will account for replacement reserves in varying ways, or omit them completely. An owner-operated hotel may not reflect management fees, or a salary for their management in their operating statements. However hotel cap rate surveys will assume a replacement reserve and professional hotel management within their analysis. Similarly, most hotel financial projections will assume stabilised occupancies and ADRs; with ongoing capital improvements and renovations being needed to achieve this stabilised performance. To draw an accurate comparison when utilising a market-benchmarked discount or cap rate, Hotel underwriters should make appropriate adjustments for replacement reserves and market-aligned management fees.
12. Franchise Terms
The presence of a strong brand/ flag, their loyalty programme and reservation system can contribute to a hotel's success. It is important to understand the contract and terms of a hotel's franchise agreement. Some investors are reluctant to acquire hotels with less than 10 years remaining of a strong-branded franchise agreement. Where a hotel's franchise agreement is contractually breached, expires or fails to be renewed, an owner risks being limited to inferior branding options that will negatively affect revenue and earnings. An underwriter needs to accurately account for the risks associated with the remaining term of the franchise, or risk of breaching contractual obligations, otherwise EBITDA and reversion estimates could become seriously flawed.
