Selecting the Right Appraiser
By: Thomas Pastore - Written for HotelExecutive.com
An interesting analogy can be drawn between hotels and oysters. Like an oyster, a hotel consists of several parts. The rock that the oyster lies on is analogous to the hotel's underlying land. The shell of an oyster is similar to the building of the hotel. Together, the land and building are the hotel's "commercial property." Finally, an oyster usually has no value without its pearl. Likewise, the combination of land and building in and of itself does not make a hotel. The value of the hotel is in the hotel's business, like the pearl to the oyster.
When valuing hotels, all three parts-the land, the building, and the business-need to be addressed. The land and building are usually appraised by real estate appraisers who utilize appraisal methods that are better suited for commercial properties. The business of the hotel needs to be valued by business valuation professionals, who are trained to appraise companies using approaches and methods that cater to the complexities and nuances of business operations.
This article focuses on three aspects important to hotel valuations: the differences between hotels and commercial properties; the approaches used to determine their respective values; and important considerations in choosing a qualified business valuation professional to appraise your hotel.
How Hotels Differ From Commercial Properties
A hotel with a going concern business should not be considered a commercial property. Significant differences exist between hotels and commercial properties that prevent them from being comparable. Hotels are actually more similar to service and retail businesses, such as restaurants and retail stores.
Consider the following differences between hotels and commercial properties. Hotels have short-term occupants, also referred to as "guests", who usually stay for a few nights or weeks (at most), while commercial property tenants reside for months or years. Hotel guests do not have the same rights as commercial property tenants, and these rights are usually inferior. Guests of hotels also cause hotel revenues to be much more volatile than commercial property revenues. In addition, hotel revenues come from a variety of sources, including laundry, catering, restaurant, bar, and miscellaneous room service. Hotel revenues are further supplemented by renting out facilities for conferences and banquets. These extra services provided by hotels are similar to other operating businesses, such as dry cleaners, restaurants, bars, cleaning businesses, and parking lot operations. Furthermore, hotel revenues are more volatile because hotel guests, unlike commercial property tenants, do not have leasehold rights to their rooms. Another important difference is that hotel guests come from all over the world, while commercial property tenants reside in neighboring areas. Hotel guests are thus attracted by brand names and management services provided by hotel management companies. These services result in extra expenses incurred by hotels that are not incurred by commercial properties. Commercial property expenses usually consist of maintenance, real property taxes, insurance, property management, and security costs. A hotel's additional operating costs include management salaries, advertising and marketing, wages for room cleaning and valet services, and other service costs. The intensive nature of a hotel operation results in volatile revenues and varied expenses-characteristics of operating businesses.
As illustrated, hotels and commercial properties differ substantially from one another and hotels are more similar to service and retail businesses. One can even argue that a hotel business operates several small businesses within its facility, such as a dry cleaner, a restaurant, a bar, and a conference services business. As a result, hotels should be valued as operating businesses in order to accurately assess all the complexities and nuances of a hotel business. Key appraisal factors for commercial properties, such as rental income and tenancy, are not the principal concerns in assessing the value of a hotel business. Like an oyster, a hotel needs to be valued for more than simply its land and structure; we are more interested in what creates value in the hotel's operations itself. Thus, valuing a hotel's commercial property and business usually requires both a real estate appraiser and a business valuation professional.
Three Approaches to Determine a Hotel's Value
Both real estate appraisers and business valuation professionals utilize three general approaches in conducting valuations. These are the cost approach, the market approach, and the income approach. While the same three approaches are generally used, each profession applies the approaches differently based on the appraisal assignment, whether they are valuing commercial properties or operating businesses.
1. The Cost Approach
Under the cost approach, the value of a hotel is calculated by aggregating the hotel's development costs as if it were to be constructed anew and then deducting depreciation and obsolescence based on the hotel's current condition. This results in a hotel value based solely on its tangible assets (the land and building) and ignores the hotel's intangible assets, such as management skills, profits from efficient operations, and brand recognition. Thus, the cost approach fails to recognize the value of a hotel's operations and the economics surrounding the hotel market.
2. The Market Approach
Under the market approach, a real estate appraiser analyzes sales of comparable, nearby properties to estimate the value of the hotel's commercial property. A business valuation professional utilizes the market approach by analyzing sales of comparable hotel businesses. While the approach yields satisfactory results when used to value commercial properties, it is unreliable for appraising hotels when sufficient sales of similar hotels are not available. Oftentimes, hotel transactions data include only the value of the commercial property and not the business. Thus, the market approach may be less effective for valuing hotel businesses when data on similar hotel business sales are not available.
Due to the shortcomings of the cost approach, and the oftentimes unavailable data sources needed to utilize the market approach, the income approach is more widely used to value hotels.
3. The Income Approach
Under the income approach, a property or business' expected future benefit or income stream is divided by a capitalization rate, or an investor's desired rate of return. While both real estate appraisers and business valuation professionals utilize the income approach to estimate future benefits and risks associated with owning properties or businesses, valuing a business is more complex than valuing a commercial property.
First, it is more difficult to estimate the benefits of owning a business than a commercial property. The cash flows from a business are more volatile than the cash flows from commercial property. Additionally, the risks associated with owning a business, which is directly related to its rate of return, are more complex to assess and quantify than the risks associated with owning a commercial property. Therefore, because the selection of an appropriate capitalization rate for an operating business is more complex and difficult, an appraiser needs a broad understanding of appropriate economic and industry factors, business management, capital market conditions, and accounting. When valuing commercial properties, real estate appraisers do not consider many of these factors, and they are not specifically trained to estimate the benefits and risks associated with a business' operations.
As stated above, hotels share few similarities with commercial properties and are more similar to service businesses. Valuing a hotel as a service business requires an experienced professional who can assess the benefits and risks associated with owning an operating business. A hotel's business is different from its land and commercial property. Thus, determining the value of the hotel's business, or the oyster's pearl, requires the training of a business valuation professional. Although business valuation professionals are trained to value businesses, all are not equal.
Choosing the Right Business Valuation Professional
All business valuation professionals are trained in varying degrees and possess differing credentials. Depending on their training and experience, certain business valuation professionals are more knowledgeable about the complex field of business valuation than others. Professional designations play a critical role in determining a business valuation professional's depth of knowledge and experience.
There are four main designations for business valuation professionals in the United States. These are the Accredited Senior Appraiser (ASA), Certified Business Appraiser (CBA), Certified Valuation Analyst (CVA), and Accredited in Business Valuations (ABV).
Obtaining each designation requires the applicant to possess varying levels of experience, pass specific exams, and maintain differing degrees of business valuation knowledge. Unmatched by any other designation and also acknowledged as the most prestigious, the Accredited Senior Appraiser (ASA) designation from the American Society of Appraisers requires the applicant to have five years of full-time experience, complete four three-day courses, pass four half-day exams, an ethics exam, a USPAP (Uniform Standards of Professional Appraisal Practice) exam, and engage in a thorough interview process. The prestige of the ASA designation is due in part to the American Society of Appraisers' longevity, reputation in the industry, and strict prerequisites for obtaining the ASA designation. Other designations, such as the CBA, CVA, and ABV, have less stringent prerequisites and inferior experience requirements.
Choosing a trained, knowledgeable, and experienced business valuation professional to accurately assess your hotel's business value is very important. An appraiser not trained in business valuations, or one without significant experience or knowledge, may incorrectly value your hotel. Incorrect values can result in sellers leaving millions of dollars on the table, taxpayers subject to substantial penalties and interest charges, and buyers getting a below market rate of return on their investment. Make sure you select a business valuation professional with the proper training and knowledge to accurately value your hotel's "pearl."
Mr. Tom Pastore is Chief Executive Officer and co-founder of Sanli Pastore & Hill, Inc. He has been involved in financial consulting for more than 20 years, specializing in investment and financial analysis, litigation consulting and public accounting. Extensive experience encompasses valuing numerous businesses in a wide range of industries including retail, services, manufacturing and holding companies. He has served as an expert witness in federal and state courts for business litigation cases in California, Arizona and Nebraska. Thomas E. Pastore can be contacted at (310) 571-3400 or firstname.lastname@example.org.