What’s It Really Worth?
The hotel industry has not fared well during the COVID-19 pandemic. Hotel occupancy and income levels plummeted after March 2020. As of this past October, it was unclear when the recovery could begin as the health crisis was still not under control.
Naturally, this has left numerous hotels struggling. In the coming three years, many hotel owners will likely try to sell their properties or else they will wind up as distressed assets in special servicing. Opportunistic investors will be hunting for properties to buy at deep discounts.
In an uncertain market like this, however, fire-sale prices may not necessarily be widely available. Hotel owners may choose to hold onto their assets and try to ride out the losses during the pandemic rather than walk away from their properties. Yet many hotel owners will be motivated to sell, and some may have to.
There will likely be many opportunities for hotel investors to purchase properties at a fair discount. Deals, however, also are likely to run into reluctant and skeptical lenders. This could result in the denial of many financing opportunities that were once considered safe and profitable.
The problem is that incomes and other benchmarks that determine hotel values have been decimated. Investors and lenders can’t use the accepted norms to assess the value of a hotel, so even some deeply discounted deals may not be financed and go forward. A new approach to evaluating a hotel is needed.
Downturns in the hotel industry occur every seven to nine years, but the problem with COVID-19 is that it is not a normal downturn. The pandemic has severely curtailed tourism and business travel. It has affected every class of hotel property in every market of the country, and it is not clear when the crisis will end and lead to a market recovery.
Traditionally, hotel appraisers use three methodologies to evaluate the asset. The income approach uses net operating income, cash flows and various financial formulas, such as capitalization rates, as its foundation. By contrast, the direct-comparison approach compares the subject property to similar properties that have recently been sold. Lastly, there is the replacement-cost approach, which estimates how much it would cost to replace the asset on a per-room basis.
Each of these methodologies have been part of the standard appraisal 101 toolkit for the hotel industry, but that was yesterday. The pandemic has changed the playbook. Today’s unique market requires the input of people with significant hotel operational experience to make value judgments.
The reason? There is a need to focus on a hotel’s operational results in “normal” times to understand its future value. The focus needs to be on the asset itself and its financial history rather than on current results. By following this path, all of the interested parties can surmise what a hotel can earn in the long run. This is critical information — both for the investor who is looking for a fair discount and for the lender that needs to know what the collateral is worth.
Take, for example, a 100-room hotel located in a reasonably strong secondary market that had a pre-pandemic occupancy rate of 70% along with an average daily rate (ADR) for occupied rooms of $130. Its revenue per available room (RevPAR) was $97.50 and it had an annual net operating income (NOI) of $1.4 million. The property, with the prevailing cap rate of 8.5%, had a street value of $16.5 million. When the property was built, it cost $130,000 per room or $13 million. The original loan amount was $10 million at 6.5% interest and the deal included $3 million in equity. Prior to the COVID-19 outbreak, this was clearly a solidly performing hotel with an acceptable return on equity.
Furthermore, no other local hotel projects were announced at the end of 2019 and the property had good prospects for stable occupancy. One would conclude the property could continue to thrive over the next three to five years. Prior to the pandemic, it could be reasonably assumed that the NOI would climb to $1.7 million and the cap rate would remain stable at 8.5%.
And then the pandemic hit. Within a few months of March 2020, occupancy dropped to 15%. The ADR dropped to $65 and RevPAR fell to just below $10. Within three months of this catastrophic decline in income and occupancy, the property wound up in the hands of a special servicer.
Spotting good deals
There is an obvious problem in assessing the fair market value of the hotel in the above example. Say that a mortgage broker contacts a lender on behalf of a potential borrower looking to buy this hotel. The broker says the investor will be able to acquire the property for $7.5 million but needs a loan of $5 million. Only a few short months before, this would have been an incredibly discounted price.
The lender looks at the post-pandemic NOI of $150,000 and, using the conventional valuation methods, determines the property has a value between $1.8 million and $2.3 million. The deal does not look good on paper and it is likely going to be a problem getting this loan approved.
The point is that the key fundamentals do not reflect the fair value of the property. An individual with hotel experience would know that this asset has a good chance of recovering its full value within a year or two. This property is deeply discounted, even if the present numbers don’t reflect it. It is a good deal that could ultimately yield a huge return for the investor. It also is a safe bet for the lender.
During this time of COVID-19, all of the interested parties should look at the asset, its history, and the realities of its location, flag and future potential. Unfortunately, traditional appraisers tend not to have hotel operational experience, and investors and lenders may pass on worthy deals. For the investors and lenders willing to look beyond convention, however, there are lucrative deals to be made. Look at the asset. Look at the history. Look at the location, flag and general condition of the property. Let these be the essential aspects of why a loan makes sense.