Chapter 17 Valuation of Hospitality Real Estate

Objectives Define Market Value Describe the user of appraisals Identify the major steps in the real estate valuation process Describe the Cost approach to valuation Explain the Sales Comparison approach to valuation Outline the Income Capitalization approach to valuation

Valuation of Hospitality Real Estate Of interest to both buyer and seller Valuation is a subjective process Valuation varies with the purpose of valuation Many definitions of value

Market Value Definition “The dollar amount a property should bring in a competitive market under conditions requisite to a fair sale, which would result from negotiations between a buyer and seller, each acting prudently with knowledge and without undue pressure.” May Alice Henis, Real Estate Appraisal, (New York: MacMillien, 1981), p.53

Book Value The amount shown on the company’s books No necessary relationship to market value

Assessed Value Value assigned to property for tax purposes Often defined in terms of market value

Insurable Value Based on replacement cost Market value of the property minus the land value

Liquidation Value is the value an owner is compelled to accept for a property in a forced or quick sale. Revision Value refers to the market value of a property to the owner at the end of an investment holding period.

Market value is the objective of many real estate appraisals. Appraisals are used: Extensively in transfer of ownership For property tax matters For insurance purposes For setting lease rates

Steps in the Valuation Process Define Problem Preliminary analysis and data selection and collection Highest and best use analysis Land value estimate Application of appropriate approaches Reconciliation of value indications Report of defined value

Three Approaches to Valuation Cost Sales Comparison Income Capitalization

Steps in the Cost Approach to Valuation Estimate land value Estimate value of FF&E Estimate reproduction cost Estimate amount of depreciation Determine net reproduction cost Add land value to net reproduction cost

Estimate Reproduction Cost = Original cost X Current Index Original Index Example: Original Cost = $2,500,000 Construction Index in 1992 = 100 Construction Index in 2006 = 150 Estimated reproduction cost = $2,500,000 x 150 100 = $3,750,000

Estimating Accrued Depreciation on Structure Reproduction cost x years of estimated life Assume: Reproduction costs = $3,750,000 Life of property = 30 years Appraisal performed at the end of the 10th year of property’s life Accrued Depreciation = $3,750,000 x 10/30 = $1,250,000

Steps in Sales Comparison Approach Obtain reliable current information of sales of similar properties Determine relevant units of comparison Compare subject property and make adjustments Establish an appraisal value

Determining Appraisal Value Under Cost Approach Reproduction cost $3,750,000 Accrued Depreciation (1,250,000) Net Reproduction cost 2,500,000 Estimated FF&E Value 125,000 Estimated land value 450,000 Appraised Value $3,075,000

Sales Comparison Approach Based on comparison of subject property to comparable recent sales Key is finding the “Comparables” Need for various adjustments

Income Capitalization Approach Determine value of capitalizing the future income stream for the property

Steps in Income Capitalization Approach Project property’s income stream over its life Derive appropriate capitalization rate Apply capitalization rate to income stream

Market value approach to capitalization rate using the recent sales of comparable properties Annual Income Stream Sale price of property Example: $200,000 = 8% $2,500,000

Bond of Investment Approach to Capitalization Rate Rate = DF% x MC + (1-DF%) x ER Example: DF% (Debt financing rate) = 60% MC (Mortgage Constant) = .08718 ER (Required equity rate) = 16% Capitalization rate = (.4 x .08718) + (.6 x .16) = 13.09%

Mortgage Constant is the capitalization rate for debt. The ratio of annual debt to original loan payment. Example: Original Loan = $2,000,000 with annual payment of 7% for 25 years Mortgage Constant = $2,000,000 = $171,621 11.6536 = $171,621 = .0858 $2,000,000

Comparison of the Three Approaches Each has its limitations No approach is perfect Each method requires good judgment

Rushmore’s Approach Uses 2-5 year projection using equity divided Uses simultaneous valuation formula

Gross Income Multiplier Approach Multiplies annual sales by a multiplier Multiplier derived from sales prices of comparable properties

Summary Many definitions of value exist Market value is the key There are several approaches to market value Valuation studies serve many purposes