Hotel and Motel Investment 101
In the aftermath of 9/11, the tourism and travel industry took a major financial hit, affecting companies from Hertz to Marriot. However, this rapid decline positioned certain sectors, including lodging, for a spectacular comeback. And while the double digit growth experienced during the recovery may not be sustainable forever, the long-term outlook for hotel/motel investment opportunities remains strong.
Business travel continues to boom as the juggernaut that is the U.S. economy chugs along, and as the baby boomer generation continues to enter into retirement, leisure travelers will provide full service resorts and tourist cities such as New York and San Francisco a steady pipeline of business.
Additionally, with interest rates remaining low in recent years, the relatively higher return rates in hotel real estate have attracted an increasing amount of new debt and equity capital into this market. The result has been solid growth in property value as the supply of buyers and investment capital remains strong.
Find a Niche
Investing in hotel/motel properties requires that you know your niche, or at a minimum have a vision for creating that niche. Who will your clientele be? What drives the market in the area you’re looking to invest?
Finding this niche and matching it with the appropriate property is critical. A three to four star hotel with a restaurant, bar and gift shop, located along I-80 in Iowa might attract enough business to keep the doors open, but the same property located in Las Vegas will likely struggle against the larger more upscale resorts catering to the affluent gambler. Knowing your target market and matching your services to the cliental is a crtical key to success in the lodging industry.
Valuation and Risk vs. Return
Perhaps as important than finding your niche is determining valuation and verifying that you are investing your hard-earned dollars in a property that can generate an appropriate return for the risk. Obviously a property in a high priced resort destination carries more risk than the roadside hotel on a busy interstate that caters to passing motorists. There are a variety of methodologies for calculating the value of a commercial property. Appraisers will often use a combination of replacement cost and comparable sales analysis to determine a value. While this may be useful to some degree, perhaps for determining a list price for sellers, buyers are encouraged to analyze their properties from an income perspective -- specifically by calculating the net operating income (or NOI) by subtracting expenses and the cost of vacancy (excluding interest, amortization and depreciation), and dividing it by the market capitalization rate.
Market Cap Rate = NOI / Valuation of Similar Properties with NOI = Total Revenue – Operating Costs + Vacancy Rate Cost
To determine how much you should pay for a property:
Valuation = NOI/Market Cap Rate
Cap rates vary from market to market and by type of property. Generally speaking an investor prefers a higher cap rate, meaning that they’ve paid less for a property with a given income than they would for a property with similar income but a lower cap rate. Cap rates are also a function of risk. Like most investments, the higher the risk, the higher the return, and cap rates are no exception. Top quality, full-service hotels in good markets have cap rates in the 7 to 8 percent range while middle tier properties hover around 10 percent. Older, limited-service hotels have cap rates over 10 percent.
Categories of Hotel Properties
Many commercial investors use a grading system to assist them with their research. For example, with office space, properties are divided into Classes, A, B, and C. When investing in hotels, there are similar tier systems used to identify the different levels of investment in terms of return and risk. There are generally considered to be around four categories or tiers of property. Essentially, newer, quality hotels located in popular resort areas or major metropolitan areas will fall into the first tier. These are usually 4 to 5 star hotels in terms of service or amenities, but a newer 3 star with great location and no immediate need for renovation might fall into this category as well.
Second tier properties are mid-market hotels in a good location. They are relatively new (less than 10 to15 years) and will require little to moderate renovation in the near future. These are the ultimate “middle-class” operations, offering just enough amenities at a reasonable price to capture a majority of the market.
Tier 3 and Tier 4 properties are older buildings, usually with exterior room entrances and limited or no amenities. These are some of the most challenging investments, but their returns can be terrific. In fact, in recent years, the strongest growth has been in the limited-service hotel market with an average of 11 percent annual revenue growth and close to 18 percent in operating profits.
Keep Your Eye on the Ball
Investing in a hotel or motel is certainly not a one-size-fits-all venture. From roadside motels along rural interstates to beachfront resorts, the variables are innumerable.
However, the one common thread that exists across all levels of such an investment, regardless of amenities, is that revenue and profits are driven primarily by guest room revenue -- the one exception are casinos, who often give away rooms so that their guests will spend money gambling. Focus on providing the guest with a pleasant night’s stay for an appropriate price, and you’ll find your job a whole lot easier. While restaurants, bars and banquet halls can add gravy to your margin, a lodging facility will ultimately fail if the guests are not satisfied with their room. Industry experts do acknowledge however, that alternative revenue sources offer more consistent and predictable income. Many hotel owners have developed these additional cash flow amenities to smooth the often volatile room rental market.
Like any other investment, the hotel business has its share of risk. Identifying these risks and zeroing in on which risks you will be most exposed to is the best way to mitigate them. Here are just a few, especially as it relates to the ability to generate revenue and perhaps more unpredictable, the costs associated with a lodging operation.
- Recession – An economic recession can cause both leisure and business travel to drop. If you’re in a market that attracts international business, you should keep an eye on those economies as well.
- Labor costs - Unemployment is at historic lows, and potential legislative initiatives surrounding immigrant labor have the potential to hit the service industry particularly hard.
- Energy Costs – Especially in colder climates, don’t underestimate the volatility of this cost. Any major disruption in the world’s oil supply may cause both your operating costs to rise and perhaps your “traveler” business to drop.
- Insurance Costs – Since 9/11, liability insurance has risen in many sectors including the lodging industry, especially if the property is in a high profile area like New York or Orlando.
Financing a hotel or motel is like financing any other commercial property. Lenders will take the usual things into consideration such as operating costs and income, as well as the overall condition of the property. Underwriters will also consider expected future growth and the overall risk of the investment (think back to market cap rates). Expect a lender to loan a maximum of 70 percent of the sales price, so you’ll need the other 30 percent either from a down payment or through owner-financing.
With almost any commercial real estate venture, an investor needs to identify how involved they’d like to be in the management of the property, and in the case with hotels, the daily operations of the business. There are a myriad of different management structures you can establish, and the larger the operation, the more complex these decisions will become. Room cleaning and laundry, building and grounds maintenance, restaurant operations, etc. are all on the table when it comes to who and how those operations will be managed.
When investing in smaller hotels/motels, a “hands-on” investor might choose to live on-site and participate in the day to day operations – or they may take a more passive approach, and hire someone to live in the manager’s suite rent-free with a modest salary and let them handle the daily management responsibilities – small motel owners often look for semi-retired couples for this role.
There are also opportunities to convert small to mid-size private operations to more well-known franchises such as Motel 6 or Best Western – thereby reaping the rewards of its corporate support, training and national advertising campaigns.
With larger operations, one popular route is to enlist the assistance of a hotel management and consulting company such as Aramark and Marcus Corporation. These firms bring solid experience and expertise in everything from vending machine services to operating full-service catering and convention facilities. Additionally, they can often manage these additional services independently of other hotel operations providing you the opportunity to manage the areas you feel comfortable with and eliminating the hassle of the remaining operational areas.