Hotel underwriting has some nuances to it that are mixed between hospitality and real estate. This is because you have quite extensive operating expenses for staffing, food, and things that don't normally hit the pro forma of something like self-storage or multi-family real estate.
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When I build the template to analyze new hotel model, I made sure to give it dual functionality so it works great for new developments or acquisitions as well as fully integrated assumptions for the option of a joint venture with LP/GP, GP fees, and a preferred return cash flow waterfall.
Hotel underwriting is a process by which lenders or investors assess the risks and potential returns of financing a hotel project.
Here are the main factors integrated to the model:
- Room types that drive revenues. Hotels use daily rates (ADR), much different from a property that has units which pay a fixed monthly rent amount / lease. You have to account for monthly seasonality for hotels and adjustments to the ADR in different times of the year as well as different occupancy rates over time and over different times of the year.
- Hotel operating expenses encompass a wide array of costs associated with running a hotel and ensuring it provides guests with the expected level of service. These expenses can be broadly categorized into staffing costs and property costs. Property expenses remain relatively stable, such as property taxes, insurance, and certain utilities. Staffing costs include labor, which is often the largest expense for hotels, encompassing wages for staff such as receptionists, housekeepers, and managerial staff. Other significant property costs are the maintenance and supply costs, which cover everything from cleaning supplies to the upkeep of guest amenities. Marketing and advertising expenses are also key, as they are crucial for attracting guests. Additionally, hotels incur costs from the provision of services such as in-house dining, laundry, and concierge services. Utilities that can vary, like water and electricity, also contribute to operating expenses, as do the costs associated with reservation systems and technology used in managing the hotel. Effective management of these operating expenses is critical for maintaining profitability and ensuring the hotel can continue to provide quality service while also investing in maintenance and improvements.
- I put in a schedule to help organize the initial investment requirement so the user can enter ongoing development / construction costs by month, the percentage each line item is financed, and the related debt for that. The debt configuration starts with an interest-only construction loan, that rolls into a regular p+i loan, that has an option to then REFI at some defined future month. If it is an acquisition, you can 0 out the interest-only loan and it will roll to the P+i loan directly. The amount of leverage used and purchase price or acquisition costs / renovations are important to understand in comparison to the expected operating income and future exit value.
- IRR hurdles. In most joint venture real estate underwriting, there are IRR hurdles or a preferred return waterfall that look at how the investor(s) are going to be paid back. This model is no different and I included a 3-tiered IRR hurdle waterfall distribution schedule with monthly granularity. The user selects the % of the total investment contributed by the LP / GP, and then the IRR hurdle rates the LP must reach in order for cash to be split at certain levels. If the project is not a joint venture, that is no worries and you can just put 100% for one of the sides and have all cash flows go to that party. Also, if it is a joint venture, but the cash flow splits don't involve hurdles, and rather a fixed percentage contribution and distribution between two parties, there is a cap table and distribution schedule for that.
- I made sure to put all pro forma statements, cash flow waterfalls, and DCF Analysis work on monthly granularity, with annual summaries. Showing the details by month makes it more accurate for the timing of cash flows.
- Don't forget about key metrics. One of the most important things in any underwriting model is debt service coverage. I include visuals that show NOI vs debt service as well as the ratio between the two over time. Anything below 1 means the property is not producing enough cash flow to cover debt.
- When looking at the exit value, I defined this as an exit cap rate that is applied to the trailing 12 month NOI as it relates to the selected end month of the forecast (up to 10 years). The user can choose to include an exit value in the projections or not with a simple 'yes/no' selector.
Here are several key considerations involved in hotel underwriting (beyond just the numbers):
Location: The hotel's location can significantly affect its potential success. Underwriters examine factors like the local economy, tourism trends, accessibility, competition, and proximity to attractions.
Market Analysis: A thorough market analysis is crucial, including occupancy rates, average daily rates (ADR), and revenue per available room (RevPAR) of comparable hotels in the area.
Brand and Management: The reputation and experience of the hotel brand and management team can influence the hotel's performance. A strong brand can command higher rates and occupancy.
Financial Performance: Historical financial data, if available, including income statements, balance sheets, and cash flow statements, are reviewed to assess the hotel's past and current financial health.
Physical Condition: The condition of the property may affect future revenue potential and capital expenditure requirements. An assessment of the property's age, design, amenities, and any deferred maintenance is conducted.
Capital Structure: The mix of debt and equity financing and the terms of any existing loans are considered. This includes loan-to-value (LTV) ratios, debt service coverage ratios (DSCR), and interest rates.
Projections: Pro forma financial statements are developed to project future income, expenses, and cash flows. These projections help estimate the hotel's ability to service its debt and generate returns for investors.
Economic and Industry Trends: Broader economic indicators and hospitality industry trends are analyzed. This includes considering the impact of economic cycles, changes in travel patterns, and new market entrants.
Legal and Regulatory Compliance: Ensuring the hotel meets all zoning, licensing, and regulatory requirements is essential to avoid potential legal issues that could affect operations or lead to unexpected costs.
Environmental and Operational Risks: Factors such as environmental liabilities, potential for natural disasters, and operational risks like labor relations are assessed.
Exit Strategy: Underwriters evaluate the potential exit strategies for the investment, including a sale or refinancing of the property.
Special Considerations: For hotels, specific issues such as seasonality, event space utilization, and food and beverage operations can have significant impacts on revenue and costs.
Each of these considerations contributes to the overall risk assessment and determination of the loan terms or investment conditions. It's a complex process that requires a deep understanding of both the hospitality industry and real estate finance.
Article found in Real Estate.
