Asset valuation continues to be a primary interest
of investors with holdings in hotel real estate. The hotel industry
in Canada has seen numerous hotel transactions over the past couple
of years. There were 48 transactions in 2002 representing total
sales of $540 million and in 2003 there were 50 transactions amounting
to $488 million. Owners and investors increasingly require valuation
expertise for new development financing, mortgage renewals, acquisition
and property tax assessment appeals.
The value of hotel real estate
property is usually determined by direct capitalization using
the Income
Approach.
The Appraisal Institute of Canada (AIC) defines the Income Approach
as “a set of procedures through which an appraiser derives
a value indication for an income-producing property by converting
its anticipated benefits (cash flows and reversion) into property
value. This conversion can be accomplished in two ways. One year’s
(stabilized) income expectancy can be capitalized at a market-derived
capitalization rate or at a capitalization rate that reflects a
specified income pattern, return on investment, and change in the
value of the investment. Alternatively, the annual cash flows for
the holding period and the reversion can be discounted at a specified
yield rate.” Capitalization involves converting income from
a property into an expression of capital value. To estimate value
with direct capitalization, a property’s stabilized net operating
income is divided by the market capitalization rate.
Capitalization rates can vary according to interest
rates, specific investor return requirements, financial/managerial
risk, degree of liquidity, and management. These, and other business-specific
factors will all affect the rate of return acceptable to a given
investor.
Risk is commensurate with return,
therefore, when an investor is considering the acquisition of
a business,
the degree
of risk in alternative investments such as bank rate securities,
government bonds, stocks, and other selected enterprises - all
of which are in competition – will also be considered.
Comparable properties in the income
approach should have the same degree of risk as the subject property.
Although
sales transactions are frequent in today’s market, some
hotel sale transactions do not have comparable market transactions
to
provide an equivalent capitalization rate. Under these circumstances
appraisers determine the capitalization rate through a process
that involves an assessment of the various risk components that
an investor would consider.
This approach begins with determining
the risk free rate – broadly considered to be the average
yield on Government of Canada marketable bonds. To the risk
free rate is
added an equity risk premium, or an additional factor to represent
the perceived risk of the investment over and above the risk
free rate.
The AIC identifies the components that may be
evaluated for purposes of determining the equity risk premium for
a specified investment to be: Market risk; Financial risk; Capital
market risk; Inflation risk; Liquidity risk; Environmental risk;
Legislative risk and Management risk. These are defined by the
AIC as follows:
Market risk
Market risk is a reflection of changes in market conditions such as shifts
in the demand and supply of accommodations. This is usually influenced by
the type and location of the property and its stage in the business cycle.
Financial risk
Financial risk relates to the use of debt to finance an investment (e.g. financial
leverage, financing terms).
Capital market risk
Risk that relates to how changes in capital markets affect market value. This
is influenced by changes in interest rate levels, availability of capital
and rate of return for alternative investment opportunities.
Inflation risk
Inflation risk is the risk associated with fluctuations in inflation rates,
which cause changes in purchasing power.
Liquidity risk
Liquidity risk relates to the ability of the property to be converted into
cash at market value in a timely manner.
Environmental risk
Environmental risk is related to how the market value of a property is affected
by its physical environment. This is influenced by such things as perceived
health hazards, potential environmental problems and acts of nature.
Legislative risk
This is the risk associated with the potential for the introduction of new
legislation or legal factors that would curb the ability of the business
to generate revenues, or result in significant operating cost increases.
Management risk
Risk that management is unable to execute the defined goals of the property.
Each of these types of risk can apply to a property
separately or in combination. Although the risk evaluation process
is subjective, individuals with significant expertise are able
to reasonably determine the equity risk premium, and hence the
capitalization rate to be utilized in circumstances where comparable
sales transactions are not available.
Ed Landry, Consultant
PKF Consulting, Vancouver
Candidate member of the Appraisal Institute of Canada
