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How to Determine a Hotel’s Feasibility and Land Value in 60 Seconds

How to Determine a Hotel’s Feasibility and Land Value in 60 Seconds

Several times a month, I get a call that usually goes like this: “Hi Steve, Hope you are doing well. I have a “golden” opportunity to purchase this amazing hotel site in an incredible hotel market. It's being offered for $10 Million- should I buy it?”

I know they are not looking to retain me for a full-blown hotel market study (at this time)- they just want a “quick and dirty, go or no-go” response.

This is how I can provide them with an answer in just about 60 seconds.

I start by asking a few simple questions and then perform some quick calculations.

Let me show you how.

All I need to know are the answers to the following four questions:

  • How many hotel rooms do you want to build on this site?

  • What will they cost to build?

  • When the hotel opens, what will be its stabilized occupancy?

  • How about its average daily rate?

Let’s assume my friend provides the following answers to these questions:

  • Number of hotel rooms: 200 rooms

  • Cost to build, including land: $250,000/room

  • Stabilized occupancy: 75%

  • Average Daily Rate: $250

The first step is to see if the land cost is reasonable. If the cost of land is out of the ballpark- there is no need to perform any further analysis.

Calculations to Determine the Economic Land Value for a Hotel

  • (Number of Rooms x Average Daily Rate x 365 x Occupancy x 4%) /.07 = Economic Land Value

Calculations:

  • (200 x $250 x 365 x 75% x 4%) /.07 = $7,820,000= Economic Land Value

Based on this formula the Economic Land Value for a 200-room hotel is $7,820,000. With the offering price of the land at $10,000,000 the hotel project does not seem to be economically viable. So, I would then tell my friend, “Forget about it!”

However, the usual response is- “But this is an incredible hotel site- what needs to be done to make it work?”

There are basically two levers that can enhance the Economic Land Value: Increase the room count or upgrade the quality of the hotel so it achieves a higher average daily rate or a combination of both.

In this example, to achieve an Economic Land Value of over $10,000,000, the room count needs to increase from 200 to 260 rooms. Or the quality of the hotel needs to be enhanced so the average daily rate will rise from $250 to $325.

Here are the two calculations:

  • 260 x $250 x 365 x 75% x 4%/.07 = $10,168,000

  • 200 x $325 x 365 x 75% x 4%/.07 = $10,168,000

As you can see, by either increasing the room count or average daily rate, the $10,000,000 land cost is reasonable.

While it seems easy to “Make the numbers work.” This is not always the case. Increasing the room count by 60 rooms might not be feasible based on the size of the site or zoning regulations. Also, increasing the quality of the hotel so that its room rate will rise by $75 might not be justified by the local market and competitive environment. In these situations, you need to convince the land seller to reduce the price or look for another site.

Now, let’s look at the logic behind my Economic Land Value formula. Occasionally the land under a hotel is not owned by the owner of the hotel building but leased from the owner of the land. This is called a ground lease. The owner of the hotel building pays ground rent to the owner of the land. Often, the amount of the ground rent is calculated as a percentage of the hotel’s annual Rooms Revenue. This percentage ranges from a low of 3% to a high of 10% of Rooms Revenue. The typical ground rent percentage is 4%.

To determine the annual ground rent, you first calculate the Rooms Revenue: Number of Rooms x Average Daily Rate x 365 x Percentage of Occupancy = Rooms Revenue. The annual ground rent is then calculated by multiplying the Rooms Revenue by the ground rent percentage. Once you have the annual ground rent, you can convert that into the Economic Land Value by dividing the annual ground rent by the land value capitalization rate, which in this example is .07. The land under a hotel is a fairly safe investment because the owner of the hotel building is unlikely to stop paying ground rent and allow the landowner to evict the building owner. As a result, I typically base the land value capitalization rate on the 30-mortgage rate in this example is 7% or .07.

Let’s continue with the example. My friend determined that another 60 rooms can be constructed on the site which means the $10,000,000 land cost is economically viable. Now, we need to determine the economic viability of the overall hotel project- this is called a Feasibility Analysis. For a hotel project to be feasible, its Total Economic Value upon opening needs to be greater than the Total Cost of Development (including land).

The Total Cost of Development is calculated by taking the estimated cost to build the hotel plus land which this case assumes to be $250,000/room and multiplies this number by the room count of 260 rooms which totals $65,000,000. Thus, if the Total Economic Value is equal to or greater than $65,000,000 then the hotel project is feasible.

The Total Economic Value can be quickly estimated using the following formula:

  • Average Daily Rate x 1,000 x Room Count = Total Economic Value

Using the data in the case, the Total Economic Value is calculated as follows:

  • $250 x 1,000 x 260 = $65,000,000

In this example, the Total Economic Value is identical to the Total Cost of Development (including land) so the project is barely feasible. Most hotel developers would like to see the Total Economic Value between 5% to 15% above the Total Cost of Development.

So, what is the basis of the Total Economic Value calculation? There is a long-standing rule of thumb in the hotel business that happens to be fairly accurate. A hotel’s Total Economic Value per room can be estimated by taking the average daily rate and multiplying it by 1,000. In this example, the $250 average daily rate would create a Total Economic Value of $250,000/per room. Since the hotel will be 260 rooms the Total Economic Value would be $65,000,000.

This rule of thumb is fairly accurate for stabilized occupancies ranging from 60% to 75% with the normal number of amenities such as food and beverage outlets, etc.

Going back to my 60-second calculation. I start by calculating the Economic Land Value to determine if the land had a reasonable cost. I then look at the average daily rate and the Total Cost of Development on a per-room basis to see if there was enough average rate to support the cost. If both of these calculations result in a positive finding, then the project is probably feasible.

Some Final Observations

Let’s say that the $10,000,000 land cost is supported by sales of comparable land and zoning only allows for the construction of 200 hotel rooms and the local hotel market can only support an average daily rate of $250, why is this land price too high (for a hotel)? This is an example of a real estate term, “Highest and Best Use.” To estimate the “Market Value” of land- you need to base it on the use that will produce the highest economic return to the landowner. In this example, the highest and best use might be a residential development, fast food restaurant, strip shopping center, etc.- but not a hotel. You might have noticed that during my discussion of the hotel’s land value and the ground lease approach, I used the term “Economic Land Value” not “Market Land Value.” Specifically, the Economic Land Value in this example is the value of the land for the development of a hotel which might not be the highest and best use of this site.

Caution- Rules of Thumb and the quick and dirty calculations set forth in this newsletter are no substitute for a thorough hotel market analysis, financial projections, and valuation made by a skilled hotel consultant. If you want to learn this process and become a hotel consultant, take a look at my online course- “How to Perform a Hotel Market Analysis and Valuation,” visit this link.

Stephen Rushmore
Creator of the Hotel Valuation Methodology and Founder of HVS

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