Defending Value: Due Diligence Procedures for Hotel Appraisals
By: Thomas Pastore
What is the first thing that comes to mind when you hear the phrase “business valuation”?
Mathematics? Formulas perhaps? Maybe even WACC (weighted average cost of capital) for those of you with a MBA. The end product of an appraisal is often a numerical value and people sometimes perceive the process to be math intensive. Although it is true that the use of formulas and equations is essential to the valuation procedure, due diligence procedures encompass far more than mathematical models. The importance of due diligence research cannot be overlooked because of its crucial role in justifying the outcome of a valuation.
There are many factors that directly influence the value of a subject business or hotel, and they can generally be classified under the following three main areas contributing to value: company environment, industry dynamics and economic conditions. These factors then form different aspects of due diligence research. In the following paragraphs, we will discuss the three areas of due diligence research in more detail.
Company research encompasses several different factors, and in most cases, these have the most direct impact on a company’s day-to-day operations. Some examples of company research are customer demographics, management/directorship structure, suppliers, advertising and intellectual property. In order for the appraiser to gain detailed understanding of a business from a financial standpoint, extensive reviews of the financial statements are required. Site visits and management interviews are also standard practices for the appraiser to obtain critical information on the operations side of the business. In particular for the hotel industry, it is vital to grasp the nature of the subject business since there are many industry segments with various income sources, such as lodging, casinos, restaurants and spas to name a few. On a site visit, the appraiser inspects the location of the subject hotel property, which can greatly affect its visibility and customer base. One well-known example of that is the difference between being on “The Strip” and off in Las Vegas. Management, intellectual property, supplier and employee relations are just some company-specific items that can generate positive or negative results for the company’s bottom line.
When it comes to industry research, one of the most significant factors is competition. In a fiercely competitive environment such as the hotel industry, it is imperative for the appraiser to identify all the competitors within the market segment and assess their influence over industry dynamics. Some of this can be accomplished over the management interview. However, more often than not, rigorous independent market research and analysis prove to be necessary for the valuation process. Other considerations for research on the hotel industry include occupancy rates and prices, related industries, customer makeup, seasonal and regional trends, and growth outlooks. The impact of e-commerce and the changing demographics of the U.S. population are further topics that should be taken into consideration.
Based on data compiled by the American Hotel & Motel Association (AHMA), the U.S. lodging industry had roughly 4.4 million guestrooms at approximately 47,000 properties in 2004, about one hotel room for every 68 U.S. residents. The lodging industry totaled $113.7 billion in sales in 2004 with $52.90 revenue per available room. The overall occupancy rate averaged about 61.3%, and the average room rate was $86.24 in 2004, up from $82.52 in 2003 and just under the high of $88.27 achieved in 2001.
The tourism industry and the airline industry are two lines of business highly correlated with the hotel industry in the U.S. According to AHMA, approximately 50% of lodging industry customers were leisure travelers, while 50% stayed at hotels for business reasons, including conferences. Since leisure travelers pay out of their own pockets and have a choice when to travel, they tend to pay lower room rates and can be easily deterred by expensive airline fares. Therefore, when the valuation professional conducts an appraisal for a hotel, he or she not only has to consider the forecast for the lodging industry, but also has to study the market interactions of other related businesses, and sometimes even the entire economy.
This brings us to the economic research area of valuation due diligence. It is no coincidence that the overall occupancy rates in hotels and motels dropped from 63.7% in 2000 to 60.3% in 2001 to 59.1% in 2002 and finally bottomed out at 50.42% in 20031 while the U.S. economy took a dramatic downturn from the bull market of the late 1990’s. More so than most other industries, a hotel’s revenue stream can be greatly influenced by broad market conditions. If the overall economy is healthy, more business deals are generated, and this translates into more business travelers. At the same time, higher compensation as a consequence of higher business volume leads to more leisure travelers. Both of these results help to elevate the revenue of the hotel industry as a whole. The opposite is painfully true in a bear market as seen in the data from 2000 to 2003.
Economic research should cover, but not be limited to, the following topics: GDP growth trends, unemployment figure, consumer confidence level, taxable sales, core inflation rate and U.S. as well as regional outlooks. Most of these topics can be researched from various federal and state government agencies and consumer surveys. However, it is up to the appraiser to decipher all this information and put the numbers in context of the hotel industry, and sometimes in company specific terms.
The field of business valuation employs many different disciplines to achieve its objective, namely finance, market research, economics, mathematics and statistics. Proper research and due diligence blends these disciplines to obtain a logical valuation conclusion. Because of the nature of business valuation, there is always a certain amount of subjectivity to the outcome of an appraisal, and the hotel industry is of no exception. As a result, conducting due diligence research is of paramount importance to every single valuation professional out there. In order to defend the valuation, there needs to be enough evidence to support an appraiser’s assumptions. Without strong research backing the fundamentals, valuation conclusions are meaningless.
The author would like to thank Alex Hsu for his excellent research and contributions.
1 American Hotel & Lodging Association, Yearly Lodging Industry Profile 2001 to 2004.