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This article presents a hotel broker's perspective of the limited-service hotel market. The discussion attempts to bridge the gap between the theoretical framework by which an appraiser typically approaches an appraisal assignment for a limited-service hotel and the real world motivations and behaviors of buyers and sellers in actual purchase transactions. Rather than offering quantitative models, this article focuses on the buyer-behavior aspect of the valuation process for a limited-service hotel property. [PUBLICATION ABSTRACT]

The goal of this article is primarily to help appraisers understand how buyers and sellers actually value limited-service hotels in the real world, and secondly to provide appraisers with frameworks with which to make gross room revenue multiplier and discount rate selections. The traditional hotel valuation model focuses on the three generally accepted approaches to value: the cost approach, the sales comparison approach, and the income capitalization approach. While these valuation approaches are fundamentally sound when evaluating a limited-service hotel, experience shows that the typical purchaser of a limited-service hotel approaches the transaction with a number of special considerations in mind.

This article is not meant to be a scholarly tome; rather it is the summation of experience and observations from years of involvement in actual sales transactions of limited-service hotel properties.

Categories of hotel Properties

Typically, hotel properties can be grouped into three broad categories: (1) limited-service hotels; (2) select-service hotels; and (3) full-service hotels. A limited-service property can be defined as a hotel operation offering nightly room rentals with few added services beyond a continental breakfast, a meeting room, and perhaps a limited exercise facility. Examples of this category of hotel include Econo Lodge, Super 8, Days Inn, Red Roof Inn, Microtel Inn, and Motel 6.

A select-service property can be defined as a hotel operation designed to answer the market demand for a level of service and amenities beyond the limited-service segment, but less than the full-service hotel segment. Examples of hotel properties within this category include Holiday hin Express, Hampton hin, Courtyard by Marriott, and Embassy Suites. Amenities in this category may include 24-hour food service and snacks, wireless Internet in the lobby, a lobby business computer center with printers, valet service, and a lounge with big-screen TV.

A full-service property can be defined as a property with a higher level of services, including one or more on-site restaurants, extended-hour room service, gift shops, and valet parking. Examples of properties in this category include Hilton, Hyatt Regency, Radisson, and Marriott hotels.

Other subcategories of hotel properties include extended-stay properties, destination resorts, historic properties, and luxury boutique hotels. This article will focus only on the limited-service segment of the hotel market A glossary of hotel industry terms related to the discussion is provided in Table 1.

Typical Buyers' Motivation

The cost approach is almost always inapplicable in the valuation of total assets of a limited-service hotel. A hotel broker will rarely have a listing discussion or buyer consultation involving a cost analysis to predict the likely selling price of a hotel property.

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In addition, while most lenders require the inclusion of a direct sales comparison approach in an appraisal intended for long-term debt financing, rarely are buyers or sellers of limited-service hotels concerned about what other properties have sold for per room or per square foot

In the vast majority of cases, the sole driver of value (here, price) for a limited-service hotel is the income capitalization approach. More specifically, most purchasers will limit their analysis to the prior twenty-four months of trailing revenues and net operating incomes.

The primary explanation for this is that purchasers, above all, view the property to be acquired more as an operating business than as a traditional real estate investment In essence, a limited-service hotel is akin to an asset-intensive business rather than a passive real estate investment Perhaps as many as 75% of limitedservice purchases are made by owner-operators. It is true that there is an active segment of portfolio investors; however, even those purchasers are driven by the quantity and quality of a property's income stream.

Interestingly, in the limited-service hotel world, it is very common for purchasers to build equity and move up to larger properties or grow their businesses by additional acquisitions. Often this is done by placing relatives in newly acquired properties as managers and/or minority partners. Rarely, do owners look for an increase in value through overall market appreciation. Rather, value creation is accomplished by either purchasing opportunistically or by growing the revenues through careful and prudent property management.

Buyers' Decision-Making Tools

There are two primary tools by which purchasers of limited-service hotels typically make acquisition decisions. These include the gross rooms revenue multiplier and an analysis of cash flow.

As to the a gross rooms revenue multiplier, the vast majority of sales of limited-service hotel properties tend to fall in the range of 2.0 to 4.0 times the most recent trailing twelve months gross rooms revenue. If the appraiser's final value conclusion falls outside this range, careful reconsideration should be undertaken to justify the special conditions under which such a conclusion would be considered reasonable in the context of a realistic marketplace.

Generally, a multiplier near the bottom end would likely represent either a distressed sale situation, an older property in disrepair, or a poor location. On the other hand, a price point at the upper end of the range would likely represent a well-flagged property in good condition in one of the more favorable markets in a defined geographic area.

The second consideration, analysis of cash flow, serves as a reality check in analyzing the purchase. Appraisers should remember that most limitedservice hotel purchasers are cash-flow investors, not asset-based investors. Therefore, while some real estate investors will tolerate a minimal level of positive cash flow in anticipation of a large capital gain when they sell the property, few purchasers of limited-service hotels will be satisfied with a level of cash flow insufficient to meet their on-going financial needs.

Most purchasers view a limited-service hotel as a business opportunity. Owners of limited-service hotels have significantly greater hands-on management of their properties than managers of other real estate investment properties. In fact, it is more than a cliché that owners and their families often live on-site. While they may not take a salary in the typical sense, many prospective purchasers are concerned with a sufficient cash flow from the property to support their families. Consequently, whatever the price is, purchasers will typically attempt to ascertain whether the current operation will generate sufficient income to meet debt service and create some level of positive net income during the period of ownership.

Factors Influencing the Gross Rooms Revenue Multiplier

There are objective and subjective factors that ultimately influence a purchaser's willingness (or unwillingness) to pay a particular multiplier for a property. These factors include the property's franchise affiliation; design; post-acquisition expenses; location; financial history and trends; local competition; and perceived distress.

Franchise Affiliation

While not impossible, it has become exceedingly difficult to obtain traditional long-term financing without a nationally known franchise affiliation or flag. There are certainly instances where independent limited-service hotels are capable of being financed, but they typically fall in the category of very small properties (generally under 50 rooms) or have some type of intangible name associated with them, such as the hotel Bel-Air near Beverly Hills, California, or the Rosewood Mansion on Turtle Creek in Dallas, Texas.

In addition to whether or not a property is flagged, it is important for an appraiser to distinguish between franchises since they are not viewed equally in the marketplace. For example, it would be misleading to compare, without adjustment, a Holiday Inn Express with an Econo Lodge. In the limited-service market segment, the Holiday Inn Express brand is one of the most highly coveted flags. Consequently, there is far more demand, and typically a premium is paid for a Holiday Inn Express compared to a flag that tends to be less stringent in its franchise quality and design requirements.

Clearly, in the perfect world it would be advisable to compare like-branded properties in the sales comparison approach. However, when such a data set is not available it is critical that appraisers consider a line-item adjustment for different qualities of franchise affiliation.

Design Considerations

Design characteristics greatly influence multipliers paid. Figure 1 shows the exterior of a typical flagged, limited-service hotel. However, appraisers of limited-service hotels may encounter the following differences in property design.

Corrridors. One of the most obvious differences in property design is interior versus exterior corridors. Few hotels today are constructed with exterior corridors. In fact, there are only a limited number of franchises available for properties with this design. There are some exceptions, however, where exteriorcorridor properties are desirable. Examples can be found in the Southwest where motorists often prefer to drive up to one-story properties with exterior entrances. There are also a few examples of franchise companies allowing a combination of both interior-and exterior-corridor rooms in a specific property. Despite these exceptions, the major flags for the most part are phasing out exterior-corridor properties and replacing them with interior-corridor properties.

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Some franchise companies are downgrading properties with outmoded designs to a lower-tier with lower price points. This is illustrated by the well-known brand La Quinta, which was converting older, exterior-corridor La Quinta properties to a sister Baymont Inn flag before it sold ownership of the Baymont brand to Cendant Consequently, it would be inappropriate for an appraiser to compare a newer La Quinta to an older La Quinta that had been converted to a Baymont Inn.

Average Room Size. Average room size is another design element that should be noted. Older properties are sometimes designed with larger rooms that can be desirable in generating higher RevPARs and possible room additions through reconfiguration or creation of suites. A property with undersized rooms will typically exhibit a lower level of interest by buyers. Room size also tends to become a factor in that some chains will not accept an average room size below a certain level.

Quality of Construction. Another design consideration is the quality of property construction. For example, concrete construction is often considered more trouble free than wood-frame construction. Moreover, some properties, by design, offer different levels of construction quality. For example, it would be important to recognize the relatively lower construction cost of the original Microtel brand compared to some other limited-service properties.

Manager's Living Quarters. A fourth design element is whether or not the property incorporates an adequate owner's or manager's living suite. As previously mentioned, limited-service hotels are commonly family businesses where the owner and family often live on-site. The lack of such accommodations can diminish demand and negatively influence the price paid for a property.

Restaurants. Existence of an on-site restaurant is also an important factor.

Most new limited-service properties are designed without a restaurant component. It may seem counterintuitive, but the existence of a restaurant represents a negative condition in most buyers' minds.

Traditionally, restaurants in limited-service properties are more akin to a property amenity rather than a profit center. In fact, most such restaurants operate on a break-even level at best and often represent both a management and financial burden for the hotel owner. As most owners will not operate the restaurant themselves, this presents the additional risk of finding an acceptable tenant for the space. Typically, these restaurants are not considered prime locations for restaurant tenants. Consequently, when the restaurant components become vacant, which is not uncommon, it can create a negative appearance to the entire property.

Age. The age of a property is another design consideration. Note that many lenders may be reluctant to finance properties over a certain age, often twenty years or so.

Post-Acquisition Expenses

Post-acquisition expenses are typically represented in two categories: (1) soft goods and equipment replacement, and (2) the franchise's required product improvement program (PIP).

In regard to the first category, buyers are very attune to the necessity of replacing outdated individual room beds, dressers, televisions, and mattresses. Buyers also carefully evaluate property equipment items such as boilers, washer and dryers, and room key systems.

The second category, PIP expenses, is inextricably linked to the first. All franchise properties undergo regular property inspections by franchise representatives. These inspections can last from several hours to more than twenty-four hours. At the end of an inspection, the property will be given a score. The scoring systems vary from franchise to franchise, but all scores represent the assessed condition and maintenance of the property.

A high inspection score can sometimes positively influence the resulting multiplier, since a high score represents a somewhat objective third-party assessment of the property endorsing good management and/or physical condition. On the other hand, a low score is often indicative of deferred maintenance as identified by the franchisor. This becomes important to a purchaser, since a franchisor will likely force a new owner to address these issues in a relatively short time frame, if they intend to retain the existing franchise. Consequently, given a lower recent score, most prudent purchasers would reduce the price they are willing to pay, which in turn would result in a lower multiplier.

The inspection score also can be somewhat predictive regarding the potential mandatory PIP expenses that a prospective purchaser will face.1 When a franchised property is sold, the franchiser will often require a laundry list of improvements, which can include new soft goods, renovated exterior facade, improved signage, renovation of parking lot, etc. These demands can total several hundred thousand dollars; however, this determination generally only occurs after the property is under contract and becomes part of the buyers' due diligence process. Consequently, it would advisable for an appraiser to inquire about recent inspection scores, any anticipated PIP, and any ongoing discussions regarding conditions, franchise transfer, or new application for affiliation.

Location

Location is critical for a limited-service hotel. There is a hierarchy of locations. Typically, the most coveted location is near a highway or an interstate in a desirable metropolitan city. The desirability of the city is a factor because many buyers are not local. Currently, there are an abundance of buyers relocating from the West Coast Many of these buyers have heard of the larger, more well-known cities and tend to gravitate to those areas.

Probably the next-best location for a limited-service hotel is a highway or interstate location between major cities. For example, a location on Interstate 35 anywhere between San Antonio and Dallas is likely to create demand. Next in the hierarchy is a secondary, small-town location. Again, because limited-service hotels are basically family businesses, the quality of life in a location-including cultural opportunities, quality of education, and convenience to shopping-is important to prospective purchasers.

On the bottom of the qualitative locational scale are rural and isolated locations. Even new properties can suffer large amounts of locational obsolescence unless there is a compelling reason for such properties existence. A property in remote West Texas is less likely to generate demand. It would be exceedingly rare for such a property to sell at a multiplier near the range of those in more desirable locations.

Financial History and Trends

A verifiable history of revenues is critical for most buyers. A property with only a partial-year history of operation will be more difficult to underwrite by a lender and will be viewed as riskier by a potential purchaser.

In the same way, most purchasers are influenced by the prior twelve months of trailing revenues and expenses. However, almost of equal importance is the evidenced trend in revenues. Higher multipliers paid almost always are a result of upward trending revenues. Finally, prospective purchasers need to satisfy themselves that there are underlying factors in the local market that will further this increasing trend.

Level of Local Competition

In the limited-service segment, local markets can become saturated with recognizable brands. Most franchisors have some geographic limitations on locating the same brand within a certain proximity to another unit within the brand. Consequently, if a property is losing its flag or is unbranded, the inability to secure one of the major flags could seriously impede the effective demand for the property and the multiple at which it will ultimately sell.

Perceived Distress

Limited-service hotel buyers are not unique in their appetite for opportunistic purchases. Suffice it to say that when there are distress situations-such as lender-owned properties, properties in bankruptcy, or litigation-multipliers on the upper end are rarely seen.

A framework for Overall Discount Rates

Appraisers typically find themselves selecting and using overall discount rates, either in the process of completing a discounted cash flow valuation or in developing an overall capitalization rate by unloading the discount rate by deducting an expected annual property value appreciation.

Hotel appraisers are well versed in various ways to develop discount or capitalization rates via band of investment, extraction from comparable sales, thirdparty surveys, debt coverage ratio models, or investor surveys. The intent of this portion of the article is not to provide yet another technique, but rather provide a logical framework by which to judge the reasonableness or the results of these techniques.

Table 2 shows a matrix that attempts to provide some connection between the appropriate risk premium (above and beyond the risk-free rate) associated with limited-service hotel properties that have different property and locational characteristics. The inspiration for this model is "Schilt's Risk Premium for Discounting Projected Income Streams," which was a model developed for estimating discount rates for closely held businesses.2

The model presented in Table 2 is useful when developing an overall capitalization rate (OAR) that will be applied to an annual estimated net operating income (NOI) stream. The model demonstrates the likely difference between the perceived risk characteristic created by physical and locational attributes between differing categories of limited-service properties. It should be noted that the implied rates shown are only a guide and are based on personal experience in a local Texas market. These results may be back-tested with historical transactions in the reader's local market to ascertain the level of applicability there.

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Conclusion

Appraisers tend to default to the typical three-approach framework for valuation of limited-service hotels. However, limited-service hotels may be perceived much more like on-going businesses than traditional real estate investments. This article has attempted to set out some of the factors that the hotel appraiser should consider if the resulting value is to approximate the thinking of active buyers and sellers in the limited-service hotel marketplace.

[Author Affiliation]

Byron B. Hinton, MAI, operates JDH Asset Valuation Group, a regional appraisal practice with offices in Austin and Fredericksburg, Texas. Along with his valuation practice, he manages the Central Texas office of Scoggin Blue, LLC, a multioffice boutique brokerage firm focusing on marketing hospitality properties throughout the Southwest United States. In addition to being a member of the Appraisal Institute, he is also an Accredited Senior Appraiser with the American Society of Appraisers and a member of the Royal Institution of Chartered Surveyors. Hinton has taught appraisal courses for the American Society of Appraisers and the World Bank in Mexico, Kenya, Slovenia, Uzbekistan, and Russia. He also has served as technical reviewer for two real estate textbooks: Income Property Appraisal by Fisher and Martin, and Essentials of Real Estate Investment, 5th edition, by Sirota. Hinton received a BBA, with honors, in international trade and finance, and an MBA1 with a specialization in real estate and finance, from the University of Texas at Austin. Contact: T 512-963-3000;

E-mail bhlnton@ktc.com