Top 5 Metrics for Investors Conducting Hotel Due Diligence
Discussed Are NOI, RevPAR, Occupancy, ADR and the Competitive Set
Hotel properties are management intensive real estate assets that present both exceptional opportunity and considerable risk. Clean rooms, fresh linens and responsive customer service are the foundations of a positive night’s stay and account for most of the operating expenses associated with a property. But on the revenue side, too much competition in a neighborhood or submarket can make it hard to keep “heads in beds,” undermining reliable cash flow.
Before investing in a hotel asset, a potential owner should begin by examining several important metrics as they conduct due diligence (i.e., examine risks) associated with purchasing and operating a hotel asset.
To understand the basic data a potential hotel purchaser should examine, LoopNet spoke with Jan Freitag, national director, hospitality market analytics at CoStar. (CoStar is the publisher of LoopNet.) Freitag indicated that the assessment should be divided into two primary areas. “One has to do just with the property, and the other has to do with the competitive set or how the property in question compares to its peers,” he said. The indicators he focused on include the following:
- NOI (Net Operating Income).
- RevPAR (Revenue Per Available Room).
- ADR (Average Daily Rate).
- Target property vs competitive set.
Net Operating Income
“On the property side, profitability is the first, most important [indicator] and you can measure that through net operating income or NOI,” said Freitag. This measure (and others like it, such as EBITDA or earnings before interest, taxes, depreciation and amortization) indicates how much revenue is left over for the owner after expenses have been deducted from revenue.
NOI for real estate is calculated by starting with the total income generated from a property and subtracting the operating expenses. NOI does not examine costs associated with financial factors such as mortgage interest or taxes so it merely clarifies the operational strength of the asset. It can be calculated across various time increments including annually, monthly or weekly—or in case of the hotel industry on a daily basis. Total income includes revenue generated from room sales, but if additional fees are generated, those too should be included. Additional fees can come from parking, laundry and vending machines, and in larger properties sales can be generated through food and beverage purchases, spa treatments, etc.
“The difference for service-level, such as luxury versus economy, is that you have different line items in your expense lines,” said Freitag. “For luxury hotels … you find, they generate a lot of revenue from banquets for weddings and from food and beverage. So, you want to understand if food and beverage is a loss leader or if you can actually make some money [from it].” With luxury properties, Freitag asked, “are you making money in your spa? Maybe not, but … you know that the guests are expecting it and you're charging them a lot more on the room side to have the amenity.”
Operating costs refer to any costs associated with running and maintaining the property and generally include payroll, insurance costs, utilities, maintenance fees and repair costs. Thus, a property that generates $10,000 per month in revenue and $6,000 per month in expenses has an NOI of $4,000.
RevPAR, Occupancy and ADR
The next metric an investor is likely to look at would be revenue per available room or RevPAR. “Specifically, an investor should examine the RevPAR change over time,” said Freitag. An investor should determine if revenue per available room has gone up or down over time on a percentage basis.
“The reason I'm looking at RevPAR is because revenue per available room is a combination of two other metrics: occupancy, [which is] the utilization [of rooms] and the ADR or average daily rate. So, RevPAR is an easy snapshot to give you a sense, specifically, of how both the utilization and the room rates are trending overall,” said Freitag.
Revenue Per Available Room. To calculate RevPAR, total room revenue is divided by the total number of available rooms. Revenue in this case includes just payment collected from an overnight stay in the room and does not encompass additional fees generated from things such as parking, mini bar items or taxes related to the occupancy of that room. If some rooms at the property are under construction, damaged or otherwise not suitable for a guest to occupy, they are not considered available and excluded from the calculation.
Occupancy. This measure indicates the percentage of available rooms sold during a specified time period. Occupancy is calculated by dividing the number of rooms sold by the number of rooms available. Note that if a room is sold but no one sleeps in it, it is still counted as occupied. For example, some rooms are sold to guests in conjunction with other rooms, some rooms are used to store items for a few days or some guest rooms may be used to hold meetings.
Average Daily Rate. ADR is a measure of the average rate paid for rooms sold. It is calculated by dividing room revenue by rooms sold. Calculating this average is important because rooms sell for different rates. For example, weekday and weekend rates can be different for the same room and different size rooms command different rates. Understanding the average across all types of rooms and rates helps an investor get a feel for cash flow.
Target Property vs Competitive Set
Comparing the performance of one property against a group of peers is a critical exercise when contemplating a hotel investment. Publications such as the dSTAR Report and the Trend Report are compiled and sold by CoStar's hospitality analytics firm and they allow users to compare properties across numerous metrics, such as RevPAR, occupancy and room rates.
In the dSTAR Report, a single property can be compared to the average of a group of properties. It is available only to the owner of the subject property, but qualified investors can request it from the owner during due diligence. A Trend Report is available to anyone. “It is a self-selected competitive set. A user can pick five or six or 10 hotels," and the report will convey how they are performing as a group, said Freitag. Individual property identity is always kept confidential, but based on property attributes one can generally select true peers against which meaningful comparisons can be made.
Both reports enable users to create their own competitive sets by selecting properties based on attributes such as submarket, total number of rooms and service level. What constitutes a true competitive set is subject to debate and the set may change based on the attribute one is examining. However, Freitag generally recommends looking at factors such as distance, customer makeup and price point. He posited, “how far away is the competition from the subject property? Is the competition targeting the same customers as you are? Are rooms in the competitive property priced similarly to your own on weekdays and weekends?”
The dSTAR Report, with an individual line for a subject property, includes an index which enables the user to easily see if the subject property is performing better or worse than the competitive set. A measure called the RevPAR Index (also referred to as the Revenue Generating Index (RGI), will compare the RevPAR of a single property to the RevPAR of the competitive set. If the comparison yields an RGI above 100, that means the target property is performing better than the properties in the competitive set. If the RGI is below 100, that means the property is doing worse than its competitors. Similar indices exist for average room rate and occupancy.
Performance data on competitive properties is available through providers such as STR. However, pipeline data about hotels that are planned, permitted, under renovation, etc. can come from a variety of sources, such as the U.S. Census Bureau, as well as the planning, zoning, construction and permitting departments of local municipalities.