3 Methods for Hotel Valuation

1. Income Capitalization Approach

The income capitalization approach is based on the principle that the value of a property is indicated by its net return, or what is known as the "present worth of future benefits." The future benefits of income-producing properties, such as hotels, are the net income, estimated by a forecast of income and expense, along with the anticipated proceeds from a future sale. These benefits can be converted into an indication of market value through a capitalization process and discounted cash flow analysis.

We consider a ten-year leveraged discounted cash flow to be the most accurate method of valuation, provided there is a transparency for the appraiser to prove the source of all market assumptions and investment parameters. Once the appraiser has forecasted all future income and expenses for the property, the hotel’s future earnings can be estimated. The appraiser then assumes an optimum capitalization rate, which reflects the risk of owning a hotel over that period. We further assume the sale of the asset at the end of the ten-year period. We then discount the forecasted earnings and the sale proceeds to the present value based on the investment parameters and return requirements of equity and debt participants.

This approach is generally considered to be the preferred method of valuation for income-producing properties, because it most closely reflects the investment thinking of knowledgeable buyers.

2. Sales Comparison Approach

The sales comparison approach is based on the assumption that an informed buyer will pay no more for a property than the cost of acquiring an existing property with similar utility. To obtain a supportable value, the sales proceeds from the similar property should be adjusted to reflect the differences between the two assets. While hotel investors are interested in the information contained in the sales comparison approach, they usually do not employ this approach in reaching their final purchase decisions. Factors such as the lack of recent sales data and the numerous insupportable adjustments that are necessary often make the results of this technique questionable.

The sales comparison approach is most useful in providing a range of values indicated by prior sales and in establishing an indicator of pricing momentum; however, reliance on this method beyond the establishment of broad parameters is rarely justified by the quality of the sales data.

3. Cost Approach

The cost approach is based on the assumption that an informed buyer will pay no more for a property than the cost of building a brand new property with similar utility. The value is obtained by calculating the current cost of replacement and subtracting any depreciation factors, such as physical deterioration, and functional and economic obsolescence. The depreciated amount should than be added to the value of land, as though it were vacant and available to reach an estimated total value. The cost approach may provide a reliable estimate of value in the case of new properties, but as buildings and other improvements grow older and begin to deteriorate, the resultant loss in value becomes increasingly difficult to quantify accurately. This method is however useful in determining the cost to enter the marketplace or when valuing newer properties.

We find that most knowledgeable hotel buyers base their purchase decisions on economic factors such as projected net income and return on investment. Because the cost approach does not reflect these income-related considerations and requires a number of highly subjective depreciation estimates, this approach is given minimal weight in the hotel valuation process. 

Source: HVS