The Case for Lower Current Capitalization Rates in Hotel Valuation

By Gavin Davis Managing Principal, H-Fin Capital Advisors | February 15, 2010

If your gut reaction to paying an 8%, 7%, or 6% cap rate or even less is one of nausea, you have probably been comfortably sitting on the sidelines over the past couple of years. Today's capitalization rates can not be viewed in a historic vacuum. A confluence of three forces has driven hotel valuations to where they are today:

How long capitalization rates remain this low is a function almost entirely of what happens in the US Treasury market, assuming the operating environment continues its robust forecasted growth and supply remains constrained by historical standards due to higher real construction costs.

The Hotel Capital Glut

The largest net buyers of hotel assets based on transactional value are public and private REITs, public C-Corps and institutional real estate private equity funds. Each of these vehicles is beholden to the return criteria they have implicitly (public REITs and C-Corps) or explicitly (private equity funds, private REITs) promised their respective investors.

Based on forecasted improved operating fundamentals over the next several years and the general overall lodging recovery post-9/11, public hotel companies saw an expansion of their trading multiples as early as 2003. These companies capitalized on an opportune time to raise equity capital through follow-on offerings. At the same time, the IPO market was still largely closed to hotel offerings.

Ashford Hospitality Trust, who originally filed to go public in May 2003, had trouble finding a blue-chip Wall Street investment bank to lead manage the offering because of the blind pool nature of the offering. The eventual lead underwriter, Friedman Billings Ramsey (FBR), was able to lead a successful IPO for Ashford that closed in August 2003, which opened the window for the bulge bracket investment banks to bring to market several other successful hotel IPOs on behalf of quality companies and management teams with institutional real estate holdings.

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Eco-Friendly Practices: Corporate Social Responsibility

The hotel industry has undertaken a long-term effort to build more responsible and socially conscious businesses. What began with small efforts to reduce waste - such as paperless checkouts and refillable soap dispensers - has evolved into an international movement toward implementing sustainable development practices. In addition to establishing themselves as good corporate citizens, adopting eco-friendly practices is sound business for hotels. According to a recent report from Deloitte, 95% of business travelers believe the hotel industry should be undertaking “green” initiatives, and Millennials are twice as likely to support brands with strong management of environmental and social issues. Given these conclusions, hotels are continuing to innovate in the areas of environmental sustainability. For example, one leading hotel chain has designed special elevators that collect kinetic energy from the moving lift and in the process, they have reduced their energy consumption by 50%  over conventional elevators. Also, they installed an advanced air conditioning system which employs a magnetic mechanical system that makes them more energy efficient. Other hotels are installing Intelligent Building Systems which monitor and control temperatures in rooms, common areas and swimming pools, as well as ventilation and cold water systems. Some hotels are installing Electric Vehicle charging stations, planting rooftop gardens, implementing stringent recycling programs, and insisting on the use of biodegradable materials. Another trend is the creation of Green Teams within a hotel's operation that are tasked to implement earth-friendly practices and manage budgets for green projects. Some hotels have even gone so far as to curtail or eliminate room service, believing that keeping the kitchen open 24/7 isn't terribly sustainable. The May issue of the Hotel Business Review will document what some hotels are doing to integrate sustainable practices into their operations and how they are benefiting from them.