Hospitality industry continues to grow at a rapid pace. In addition to the major markets including business and luxury hotels, motels and country inns, recent growth has been fueled by the addition of privately owned establishments that tend to focus on lucrative niche markets. These include specialty bed and breakfasts, destination location inns, fitness oriented resorts, golf course and vacation properties.
Similar to other real estate based operations, hospitality businesses are cyclical in nature. Since much of their income is generated by renting the property, size truly matters.
An industry rule of thumb is that a property needs to have at least 10 rentable units to provide adequate returns for its ownership. Most small privately owned hospitality businesses fall into the 10 – 200 unit range.
Unique factors that drive hospitality business value
These businesses have a number of characteristics that have a major impact on their value:
- They share the features of both business and real estate investment.
- The business tends to be quite labor intensive.
- Multiple profit centers are very common. In addition to property rental, restaurants, gift shops, fitness facilities and lounge are common.
- Repeat and referral business is critical to revenue generation.
- Rental rates are flexible and can be adjusted seasonally and even daily. Successful hospitality operators are quite skillfull in packaging their product to reduce vacancy rates.
- Aggressive and continuous advertisement is essential.
- Effective online presence is increasingly vital, including participation in reservation systems and membership in destination marketing organizations.
- Capital requirements are quite high.
- Businesses demand competent, hands-on management.
Buying a hotel or motel: key success factors
If you review what makes business acquisitions in the hospitality industry successful, you will find that they tend to share a few traits in common:
- Typical leverage is 20% buyer down payment the balance being financed by debt.
- Debt service of under 30% of gross rental income is industry norm. This effectively sets a safety ceiling on the acceptable cost of debt capital.
- Ownership must allocate sufficient capital for hard asset replacement such as Furniture, Fixtures and Equipment.
- Seller financing often makes or breaks a deal.
Determining the business value
When valuing a business in this industry, you should consider these essential elements:
- Property expansion potential. In hospitality industry, business revenues are derived from rent, which is driven by property size.
- Equipment condition and maintenance status. Watch our for deferred maintenance expenses.
- Location. Needless to say, this has direct impact on the business earning potential – both in terms of room rent and vacancy rates.
- Access to acquisition or expansion capital.
That said, you have 3 ways to value a business in this industry:
- Cost (Asset) approach.
- Market approach.
- Income approach.
Cost approach to business valuation
The basic idea behind the asset based business valuation is this: business value equals the current property replacement cost less an allowance for physical, functional and economic obsolescence.
Note that cost based business valuation does not account for the business earning capacity or risk.
Market approach to valuing a business
Under the market approach to valuation, you determine the business value in comparison to actual selling prices of similar properties. Since many private hospitality businesses are quite unique, meaningful comparison may be a challenge.
Business valuation based on income
Under the income valuation approach, you have a number of capitalization and discounting methods to valuing a business. Typical ways to estimate business value are multiples of gross rental income and net operating income. You need to factor in both the property rental income as well as earnings from the other profit centers, such as the restaurant or on-the-premises gift shop.
Multi-year financial analysis is the choice of savvy business investors. A key factor which determines business value is the internal rate of return.
Capitalization rates vary across the business types in the hospitality industry. Typical values are in the 11% – 14% range.
If you need a reliable business value estimate, it is a very good idea to combine the results from several business valuation methods.