Classified as income-producing assets, hotels are mainly valued based on their recurrent income-generating potential. Similar to other forms of commercial real estate, one fundamental indicator of their percentage profit is the capitalization rate (cap rate). So, is a higher cap rate always the sign of a great deal? Not entirely.
What Are Cap Rates?
A cap rate, or capitalization rate, is an equation that determines how much an investor could make or lose after purchasing a particular property. In the hotel industry, it indicates the rate of return expected on a hotel investment. Cap rates are the most popular way to help you assess a hotel’s return and profitability potential before buying it.
This metric helps to show how much a hotel would have yielded after a year, assuming you buy it in cash with no loan. Cap rates can help you know the asset’s intrinsic, natural, and un-levered rate of return early on.
Hotels typically have the highest capitalization rates of any asset class, with most cap rates ranging between 7.5% to 10.5%, depending on the type of asset and market factors. However, even using a cap rate does not predict the future profitability of the asset, since it is using historical data to determine the value.
How to Calculate Cap Rate?
The most common formula involves a division of the hotel’s net operating income (NOI) by its current market value.
Capitalization Rate = (Net Operating Income / Current Market Value) X 100.
The formula above refers to the income that the hotel is expected to generate in a year. You can obtain it by checking the expected revenue amount and deducting all the expenses necessary for the hotel to operate optimally. This includes utilities, staff wages, property taxes, maintenance and repair costs, and insurance, among other operating expenses.
(Total NOI = Total Revenue – Operating Costs).
The hotel’s current market value refers to its value today in line with the prevailing market estimates. It is also worth noting that the NOI does not include Interest Expense, Amortization, Depreciation, and Income Taxes that an individual or the corporation has to pay.
Capitalization Rate Calculation Example
Calculating the cap rate is simple, and you can do it on your own with or without using a capitalization rate calculator.
Case Scenario 1.
Consider that you are looking to invest in a hotel located in a famous tourist destination, consistently attracting numerous guests throughout the year. Its revenue streams include an on-site restaurant and bar, room rentals, spa services, and conference facilities.
After digging into the hotel’s financial statements, you discover that it generates total revenue of $1,500,000 annually. You also determine that its total operating expenses, including staff wages, maintenance and repair,
marketing, utilities, and other costs, add up to $600,000 annually. The hotel is estimated to have a value of $10,000,000 presently.
To calculate its cap rate, you must:
- First, determine its NOI, which is $1,500,000 – $600,000 = $900,000.
- Then, apply the formula; Cap Rate = (NOI/Current market Value) X 100.
- In this case, it will be $900,000/$10,000,000 = 0.09 X 100 = 9%.
Case Scenario 2.
Perhaps you are considering buying a hotel set up in a busy metropolis with a continuous stream of guests throughout the year and an estimated value of $30,000,000. Its features include a rooftop restaurant with stunning city views, a spa center, and luxurious accommodations.
After thoroughly scrutinizing the hotel’s financial statements, you discover that its total operating expenses, ranging from marketing to staff wages and other costs, amount to $2,500,000 annually. The hotel has an annual revenue of $5,000,000.
To calculate its cap rate:
- First, determine its NOI, which is $5,000,000 – $2,500,000 = $2,500,000.
- Then, apply the formula; Cap Rate = (NOI/Current market Value) X 100.
- In this case, it will be $2,500,000/$30,000,000 = 0.0833 X 100 = 8.33%.
Calculating the cap rate using the asset’s purchase price is also possible using the formula:
Capitalization Rate = (Net Operating Income / Purchase Price) X 100
However, this method is not as popular as the one that uses the hotel’s current market value. This is because it can lead to unrealistic results for old hotels purchased at lower prices. It is also impossible to apply the formula to calculate the capitalization rate of inherited hotels since their purchase price is zero.
are cap rates important?
There are several reasons why hotel investors calculate cap rates. One major reason is to assess the current and expected performance of similar hotels in the same property market to determine the one with the highest rate of return. Consider this case scenario, for instance:
- First Hotel: $900,000 NOI / $10,000,000 Market value = 9% Cap rate
- Second Hotel: $1,000,000 NOI / $12,000,000 Market value = 8.33% Cap rate
- Third Hotel: $1,500,000 NOI / $15,600,000 Market value = 9.62% Cap rate
Another huge reason is to establish a fair valuation of the hotel based on net operating income. Here, you can make a calculation using the formula below:
- Market Value = Net Operating Income/Capitalization rate
- $800,000 NOI/.84 or 8.4% Cap Rate = $952381 Market Value
Finally, investors evaluate cap rates to use the net asking price of the hotel to calculate its net operating income. You should consider that:
- NOI = Cap Rate X Market Value
- .75 or 7.5% Cap rate X $2,500,000 Market Value = $1,875,000 NOI
When to Observe and When to Ignore Cap Rates
Cap rates can help you determine the relative attractiveness of different hotels by doing an investment and market analysis. For instance, you can assess the relationship between the hotel’s current value and NOI to determine its performance over time or compare different hotel properties. Furthermore, using cap rates to analyze market trends can help you understand the level of risk and demand associated with a particular market.
However, it can be unnecessary to calculate at certain times when making a hotel purchase. For instance, unique properties, such as luxury resorts and boutique hotels, could have distinct operational dynamics and revenue streams requiring a finer analysis. Development projects also do not require cap rate calculations since they lack an existing NOI and rely on projected costs.
Looking For Expert Guidance During Your Hotel Purchase?
Knowing the capitalization rate of a hotel you are interested in can help you quickly assess its profitability and determine whether it is a great investment. NewGen Advisory can guide you through the process of evaluating various hotels based on their cap rates and picking those that suit your investment strategy.
If you are in the market for a hotel property or are simply comparing the performance of various hotels, our hospitality brokerage professionals can help. Contact us today to learn more.