 Return on Investment for hotel assets
It is clear that companies and individuals would only invest in projects as long as the rate of return on investment is attractive. The definition of ‘attractive’ can vary, with some investors desiring higher rates of return based on the risk profile of a particular project, for example, in higher risk areas it is not uncommon for investors to seek higher rates of compensation for their capital.
How to measure return on investment has always been a topical subject with a wide range of measures available. However, it would appear that the norm for most companies and institutional investors tend to be around two main measures:
- Internal rate of return (IRR)
- Return on investment (ROI)/return on capital employed (ROCE)
IRR - Is the discount factor (used to measure risk) that gives the project’s cash flow (normally over a 20 year period with a terminal value attributed through application of an exit multiple) a NPV of zero i.e. the point at which the project becomes untenable. This figure is normally measured against the company’s weighted average cost of capital (WACC) and if the IRR is greater then the company would approve the project. This is by far the most common method adopted by companies especially in Europe.
ROI/ROCE - Is the net present value of a project’s cash flows divided by the cost of investment or capital employed. This is then compared to the company’s desired rate of return and if higher, approved. The difficulty with this method is that not all or a disproportionate amount of shared resources may be attributed to a project, thus distorting the true return. In addition there are a number of variations in calculating this, for example, some investors just look at the returns on equity or debt employed rather than the combination.
The desired IRR/ROI can vary from company to company and from region to region. Invariably the ultimate decision will depend on the company’s gearing and the investor’s risk profile. As an indicator the average IRR for hotel investments in Europe ranges from 12.4% to 16.1% with an average of 14%.
In addition it is evident that discount rates applied to investment decisions depend on a company’s WACC or desired level of return. Invariably, in most instances this tends to be greater than the risk free returns that say ten-year bonds generate. To this a premium is added to reflect execution risk.
Exit multiples used in valuations are traditionally the inverse of the discount factor for example an 8% discount rate would give a 12.5 times earnings multiple. One way of looking at how much a hotel is worth is by applying this multiple to the earnings. The multiple depends on whether the asset, for example, is a trophy or not. As such multiples can range from 6 to 18 times earnings, with an average of 14. This has tended to be on the higher side in recent years as hotel assets continue to be attractive. In addition it is not unheard of investors paying over 20 times earnings for properties (usually one-off trophy assets) in some instances.
In the table below we highlight a select number of recent European transactions that clearly demonstrates the range of values, and premiums, that investors are willing to pay for different asset classes. It should be noted that the opaqueness of the European market continue to be a deterrent to a true benchmark of hotel value and the following, while generically true, may not represent expected values.
Clearly the value an investor is willing to pay for a five-star hotel is well above that of say, a four-star or a budget property. This underlines the desirability of this asset class and, at least in most instances, investor confidence in that a five-star property is able to deliver higher earnings with less risk. The decrease in value per room in 2007 could be explained by the fact that during this period the number of unusually highly desirable five-star assets traded was less than that of 2006.
Other methods
Whilst the measures above provide a good indication of whether a project is desirable or not, it does require some detailed analysis and assumptions both in regard to the project and the investor. In addition these measures tend to be project and company specific and would not therefore necessarily reflect market norms. As such highly desirable projects can be ignored for not passing the initial hurdle rates.
In addition to the above there are two other methods that are increasingly being looked at by investors in determining the attractiveness of a particular investment. This partially stems from the type of investor that is entering the market, for example property and private equity, who may have different techniques in evaluating projects.
Payback – Is the simplest of the measures and is often used as a quick check on the attractiveness of an investment. It is probably one of the most popular techniques among individual investors. This calculation is simply the number of years it would take for the project’s cash flows to ‘pay back’ the initial investment. The theory being that after the original cost of investment is recuperated the remaining cash flows goes towards creating shareholder value.
Cap rate/Yield – This is an increasingly popular method of evaluating hotel investments. This is reflective of the metamorphosis that the hotel industry has been through in recent years with these assets becoming highly desirable. Yields are derived by dividing a hotel’s earnings by its market value. The lower the yield the better it is for the seller. The idea being that a buyer will be prepared to pay more for an asset given the current level of earnings. This could be due to a number of factors ranging from how desirable the asset is to a company’s strategic fit and other emotive factors. By way of example an asset in a major city or a ‘trophy’ could be expected to sell at a lower yield than say a property located in the regions.
The drawback with this approach is understanding what is a good yield. Whilst a more transparent market in the US, for example, provides good benchmarks, this is not the case in Europe unless the buyer/seller has/had a portfolio to refer to. As such, in Europe, at least, this method remains muted. Additionally the opaqueness of the transaction market makes it that much more difficult to benchmark comparable transactions. However, the golden rule is, at least for the seller, is that the lower the yield the better. For the buyer an asset will only be attractive if the yield outweighs the cost of debt.
The table below not only illustrates this but also provides an indicator of hotel investment sentiment over recent years. Average cap rates for Europe range between 5.7% and 8.8%, with an average of 6.9%, with key destination cities such as London tending to be on the lower side at 5.7%. Clearly as indicated above the more desirable locations and assets would tend to have lower cap rates/yields than other less desirable investments.
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