Beta and WACC in the Hotel Industry

In our Hotel valuation models we generally compute WACC with Cost of Equity based on re-levered industry Beta and target's risk premium specifics and after-tax cost of debt as we use NOPAT and Unlevered Operating FCF. As all these parameters differ should we value the company that owns the real estate or the company that manages the hotel. Let's see them both.

Beta and WACC in the Hotel Industry: the Real Estate asset

The first entity that we might be asked to value is the company that owns the property of the Hotel, say that owns the Real Estate where the Hotel operates. Generally this entity represents the interests of an investor such as a Bank, an Insurance company, a Real Estate fund or any sort of institutional investor with a typical Real Estate type of return expectation. This investor requires a low and stable cash flow so that it may leverage up its investment and expects a long term capital appreciation. WACC for these investor is lower than WACC of the leisure and hotel industry. We usually calculate WACC for the company that owns the property of the Hotel based on appropriate real estate Beta for the country and region where the hotel is located. Then we adjust this general expected return to consider four specific risk premiums associated with the target: location of the building, quality of the building, type of tenant, type of contract. We calculate a scoring for each of these parameters that produces a risk calculated in basis points.

As leverage level and cost of debt are key value drivers in the valuation for the company that owns the property of the Hotel, we should also calculate the appropriate re-levered Beta and investigate about the long term cost of debt, based both on current mortgages and long term contracts. In addition we also consider the interest rate swap curve to understand how the Hotel's cost of financing may change in the long term.

Beta and WACC in the Hotel Industry: the Hotel management company

The second different entity is the Hotel management company, which is the company that operates the Hotel and pays a rent or a lease to the Real estate owner. This company may represent the interest of a vast type of investors, including international operators specialized in the Hotel industry but also individual operators running a few or even a single hotel, often supported by a management contract with an international hotel operator chain. WACC for the Hotel management company is rather high as this entity runs the full industry risk and has no Real Estate asset protection. But let's come to numbers.

To calculate the appropriate Beta and WACC we may start from industry data. In first quarter 2015 industry average unlevered Beta was 0.83 in the US plus UK (that we personally calculated based on Reuters data on companies such as Marriott International, Starwood Hotel & Resort, Hilton Hotel Corp, Intercontinental Hotel Group Plc) and 0.79 in Europe (that we calculated based on Reuters data on companies such as Accor SA and NH Hotel Group).

Country risk may be simply based on 10 year gov bonds yield and a liquidity premium should also be applied

Once calculated the hotel market risk in the specific country, we deal with target's specifics.

Risk might be higher than the market if the target hotel does not own a strong Hotel brand that assures recurring business. We usually calculate the appropriate WACC for the Hotel management company starting with industry Beta and considering in addition the following specific risk premiums for the target Hotel: the attractiveness of the location, clientele loyalty (the type of clientele, recurring clients, competitive advantages vs other hotels nearby), type of contract with the real estate owner and type of contract with the international hotel chain. We calculate a scoring for each of these parameters that produces a risk calculated in basis points.

Finally leverage is added to both obtain re-levered beta and cost of equity and of course the final target WACC. Take into consideration however that leverage for an Hotel management company may be very low and the Cost of Debt portion of WACC might be close to irrelevant.

Hotel value split among the RE Owner, the Hotel Operator and the Hotel Chain.

When assessing the Value of an Hotel we face an increasing complexity due to new legal structures among the various components of the Hotel business, including the Real Estate owner, the company managing the Hotel and the International chain that applies its label and its marketing support. This short articles deals with the splitting of the Hotel Value as a consequence of new legal structures among these players. Cesare Carbonchi reports from Milan, Italy.

One hotel, three owners

We are often involved in assessing the yearly performance and updating the current market value of an Hotel on behalf of International operators and real estate investment funds. We analyse the market trend, we prepare an economic model tailored to the specific situation and we analyse current performance and potential improvements. Planning includes full economic and financial projection for the Hotel that we use as a basis for the Hotel financial control and for the hotel valuation.

Finally we get to the “split” issue: the potential economic value of the Hotel as a whole is often split between the value of the Real Estate and the value of the company that manages the hotel, as these may be separated entities. The split clearly derives from the type of contract signed between the entity that owns the Real Estate and the entity that manages the Hotel: the higher the rent is, the higher the value assigned to the Real Estate portion and the lower assigned to the Hotel management portion.

In recent deals the situation is getting more complicated as we have a third entity: the large international hotel chain. Thanks to its well-known hotel brand, the international hotel chain enters into a marketing agreement with the hotel management to provide international reservation system, hotel management skills, financial control and system support. For these services the entity that manages the hotel pays the chain a remuneration based on a fixed amount plus a percentage based on sales and operating profit of the Hotel, with a vast case of different economic and contractual structures.

Going back to splitting the Hotel performance and value, we are therefore facing a complex structure. We deal with three entities that to some extend are all the “owner” of the same Hotel.

How do we assess the performance and the value?

The performance for the Real Estate investor is typically valued in the long term as we would expect some yearly cash performance after all taxes have been paid plus a long term asset capitalisation. The Hotel Valuation assigned to the Real Estate investor may be calculated as the NPV of the stream of cash flow deriving from the rent, taking into account operating expenses related to the Real estate, taxes, leverage plus a relevant portion as Terminal Value. Leverage and cost of debt is the key element to manage.

The performance for the hotel management company is typically valued on the short to medium term. Accurate monthly financial control is the key element: performance may change for minimum details such as what breakfast is served or the way room cleaning headcount is managed during week-ends. Hotel management and valuation is based on cash performance. Value may be calculated as the NPV of the FCF of the Hotel business, net of the rent paid to the Real estate owner and net of the cost of services paid to the Hotel chain.

We may also calculate the hotel performance and its value to the International hotel chain. It may be calculated as the NPV of the stream of services net of the additional costs that would be incurred to produce them. What is interesting to note is that this third piece of value is not totally visible, as it is not that easy to assess what the real value of the service is. The accounting principles used to value the goodwill associated to affiliated hotels may be different among large operators chains and may not be easy to read in their financial reports.

The conclusion

As a conclusion, today's Hotel management requires a complex economic and contractual structures that imply different financial control systems and financial valuations. The more complex the corporate and contractual structure is, the more attention we must pay in assessing what the economic and financial performance really is besides the usual RevPar and GopPar indicators. When coming to value assessment, we must estimate not only what the Hotel performance and value is but also to whom it really belongs.

Cesare Carbonchi

Managing an Hotel in Italy

International management techniques in the hotel industry follow precise standards and are applied the same way worldwide. Hotel managers are used to speak about Occupancy ratio, RevPar and RGI and financial valuations based on FCF are commonly applied. However there are some peculiarities in the Italian hotel industry and in the Italian Real Estate market that deserve some attention in order to set and manage the appropriate business value drivers of an Hotel and for Hotel M&A deals..

Italy is a wealthy country with high density of population, no surprise if Real Estate in Italy is generally expensive

Italy in one of the European country with the highest density of population , with over 200 inhabitants for square kilometers, the double of France and Spain and just lower then the UK and Germany. However if we take into consideration that there are Italian regions that have few inhabitants because of the mountains (Valle Aosta, Trentino, Alto Adige, Sardinia) we find out that the density varies from 200 to 400 inhabitants for square kilometers not to talk about cities of course. As elsewhere, when a wealthy country has a lot of people in a limited space then the value of the space and the real estate value are high.

Average hotel premises quality is low and their renewal is expensive and requires time and efforts

Although Italy has a huge offer of rooms and beds, only recently built or renewed 4 to 5 stars hotel have more than 100 key and up-to-date energy and technology systems. Most of the hotel industry offer is still represented by hotels with less than 30 keys, built more than 40 years ago, with poor technology and poor services. Regulatory issues might be relevant if the building is located in ancient city centres, so the necessary restructuring is an important issue: costs may be high, time may be long.

and therefore the cost of financing the RE is a relevant issue

As the real estate portion of the hotel business is so expensive in Italy, then the first and main issue is how to finance it, both for the premises acquisition and for their renewal. There are very few real estate investment funds ready to invest in hotel assets in Italy and banks are reluctant to extend long term financing unless the leverage is low. Which means that the hotel manager will have to invest more equity than he might expect elsewhere.

Hotel Occupancy may have a strong seasonality therefore yearly based averages may be misleading.

Weather and incoming are not constant during the year: each region and city has some seasonality. Even Milan, a business oriented hotel offer, suffers from low demand in January and August. Revenue and cost planning, especially number of hours worked and labour cost in each department, require accurate different month-by-month budget and financial control as the yearly average is nice for statistics but does not help to run business.

The value of the location is high and the value is persistent over long time period

Art, climate and food are probably considered the main incoming client attractiveness for Hotels in Italy. These factors tend to be persistent in the long time much more than business, fairs, sport facilities or events that may move from one place to another. This means that the incoming interest for Italy was relevant one century ago, it is relevant today and will be relevant one century from now. I would think that only Paris in the world can claim such a prerogative. For the hotel business this means that in Italy the value of the location is very high and this value is persistent over long time period.

Hotel Valuation from RevPar to DCF 2015 update

The “Hotel Valuation from RevPar to DCF” article that I wrote in 2009 and has been widely read and copied explained why DCF methods were preferable to income capitalisation methods in the valuations of an hotel. As almost everybody in this industry now agrees on this, let's discuss now about income based DCF vs after-tax cash flow based DCF valuations, which is still an aspect differently treated by international hotel consulting firms.

RevPar and income capitalisation valuation techniques limits

Price multiples based on hotel industry indicators were a simple, powerful and fast way to value Hotels in the past. We could apply multiples derived from the local market relating to RevPar (Revenues Per Available Room), GopPar (Gross Operating Profit Per Available Room) and NoiPar (Net Operating Income Per Available Room). Multiples also varies according to Hotel category and specific location (such as the price per room for a four stars hotel in Venice Giudecca), that is a smart way to summarise in one single criteria a more complex set of Price multiples. There are however issues that strongly limited this Hotel Valuation approach: rents and Hotel Capex among the others. Rents are no longer a fixed amount as they may change depending on the hotel performance, so we cannot capitalize a fixed average profit if the rent cost is variable. Hotel Capex are increasingly relevant both because of higher energy and tech requirements and for the need to create proper unique styling to deal with a stronger competition. Today everybody agrees that a DCF methodology is more accurate than a income capitalization valuation as it deals with these and other issues.

Income based vs Cash Flow based DCF: what's wrong with income?

DCF means Discounted Cash Flow so a DCF valuation discounts a stream of cash flows: we have to calculate Revenues, Ebit, NOPAT and Unlevered Free Cash Flow. Quite surprisingly I often incur in valuations were a sort of gross income adjusted for Capex is discounted instead of UFCF. What's wrong with it? The difference is that no taxes and no working capital requirements are properly included.

Income based vs Cash Flow based DCF: what's wrong with Taxes?

We do not live in a no tax environment and taxation severely impacts Hotel income: in a high taxation environment such as Italy, Hotel have a strong local taxation for Irap that is even stronger if labour cost is high, which is common for 4 and 5 star hotel. In addition Hotel pay the ordinary state income Ires tax. Say that half of Pre-tax Profit may be paid as taxes. In addition taxes will be paid on the Terminal Value should the hotel be sold: in this case the taxation level might be different from ordinary taxes as capital gain rules might apply. In few words: taxation in the international hotel business it's a mess that we must take into account as it may easily change the final hotel valuation even more than our occupancy or RevPar assumptions.

Income based vs Cash Flow based DCF: what's wrong with Working Capital?

We may avoid calculating Working Capital financial needs should we live in a place were hotels were able to collect all their revenues immediately: unfortunately for hotels this is not the case, especially if any internet based booking service such as Expedia is used. The client pays in advance, the hotel gets paid in arrears. The time lag requires financing, which is cash flow. The impact differs case by case and it may be relevant.

In conclusion, DCF is a powerful methodology but it requires additional expertize and efforts compared to traditional income based methodologies.

Cesare Carbonchi, President EqS Equity Studio