What a hotel is worth, and why the price per square metre says nothing about it

A seller we advised some years ago had derived his price expectation from the usable floor area and from the square metre prices of the flats in the building next door. The arithmetic itself was correct, only the reference figure was the wrong one for a hotel.

A price per square metre describes an area that somebody wants to use, whereas a hotel is a business that generates earnings out of that area. Two houses with identical floor area can therefore differ in value by a factor of two without the area explaining any part of it.

It starts with a result that will come back next year

Every hotel valuation begins with a single figure, namely the result that the business earns sustainably, where sustainable means that it will still be there in the year after the sale.

In a leased house that figure is the rent, adjusted for the costs that remain with the owner. In an owner operated house it is the operating result before rent and depreciation, known in the industry as GOP, likewise adjusted for the owner's costs.

The difficult part is the adjustment. A managing director's salary that was never paid in a family business has to be included, while a one off subsidy, a good trade fair in spring or a year without maintenance has to come out. What remains is a result that an unrelated third party with unrelated staff could repeat.

Three years rarely suffice for this, because one also needs the structure behind it, which is to say occupancy, average room rate, revenue per available room and the question of where the guests come from.

The reserve for furniture is part of the calculation

One point is almost always missing from sellers' documents, namely that a hotel wears itself out while it operates.

Carpets, beds, bathrooms, kitchen equipment and IT have a service life that can be measured in years, and if they are not replaced, what is being sold in the end is substance and not earnings. Every robust calculation therefore deducts a reserve for furniture, fixtures and equipment, known in the market as the FF&E reserve, measured as a share of turnover.

A house that has not renovated any rooms for three years shows a higher result than a well kept house of the same size and is nevertheless worth less. The buyer sees that difference at the latest during the technical review and then negotiates it twice, once over the result and once over the investment backlog.

The figure per room is a comparison, not a valuation

Instead of the price per square metre a price per room is often quoted, which is more useful in so far as it at least reflects the use. As a yardstick it is still not adequate.

A room in a city hotel with year round occupancy and a room in a seasonal business open for five months earn very different amounts, so that the same figure per room means something different in the two cases. It becomes useful only at the end, as a plausibility check on a result that comes from the earnings.

The same applies to transactions in the neighbourhood, because a price that somebody else paid contains his financing, his tax position and his plans for the house, and therefore rarely serves as evidence for one's own value.

The multiple is a judgement on risk, not a market price

The sustainable result becomes a value by way of a capitalisation rate. Put simply, the result is divided by the rate or multiplied by a factor, and there is no more arithmetic behind it than that.

The rate is the actual statement, because it contains the level of interest rates, the location, the operating structure, the remaining term of the contract, the standing of the operator and the question of how easily a successor could be found for this house. Each of those quantities shifts it by fractions of a percentage point, and that is precisely where the price arises.

Worked example. A house with 80 rooms earns 1.1 million EUR in sustainable rent. At a capitalisation rate of 6 percent that gives around 18.3 million EUR, at 7 percent around 15.7 million EUR. A single percentage point moves 2.6 million EUR here without anything at the house having changed.

Whoever negotiates over a hotel price is therefore almost never negotiating about the property, but about how secure that result is.

Work in ranges, not in a single figure

A valuation report that names a single figure withholds its most important information, namely how sensitively that figure reacts to assumptions.

An assessment becomes robust only through sensitivities. What happens at five percentage points less occupancy, and what happens if the tenant does not extend in four years. If energy costs stay at the level of last winter, that is a third scenario, and three scenarios worked through say more than three decimal places.

For sellers this has an agreeable side effect, because anyone who knows his own range is not taken by surprise by the buyer's calculation.

The land value is the floor, not the value

There is one case in which the area does count: if the business permanently earns less than an alternative use of the site, then the yardstick is no longer the hotel but the land less demolition and risk.

At that point it is no longer a matter of valuing the house but of establishing that the business as a use has come to an end. For owners this comparison is uncomfortable and useful at the same time, because it shows where their own floor really lies.

The other way round, every discussion about square metre prices of comparable flats remains without meaning as long as the income value lies clearly above the land value.

The price of a business is not the value of a property

With leased houses a distinction is worth drawing that often blurs in conversation, because the value of the property from the owner's point of view and the value of the business from the tenant's point of view are two different quantities.

The owner values the rent and its security, the tenant values what is left for him after the rent. Both figures hang on the same house and move in opposite directions, because a higher rent lifts one and lowers the other.

Where a house is sold together with the business, both calculations have to work, because a purchase price that reflects only the seller's view finds no buyer who wants to run the business afterwards.

What an assessment has to deliver

A first assessment needs no box file, but size and category, the operating structure, the contract with its remaining term, three years of figures and an honest sentence about the condition of the house.

Out of that comes a range with reasons, and everything further, which is to say the valuation report, the technical review and the tax structure, follows only once the assessment has turned into an intention.

A hotel is worth as much as its result is repeatable. If you would like to know where your house stands in this calculation: confidentially, in a conversation.