Hotel is a Real Estate play or it’s an operating business?

BUSINESS MODEL of real estate development and hotel are poles apart in the economic scenario, even though both deal primarily with land & building. However, we need to understand both in isolation on the basis of its key functionalities.

In real estate if one is developing a residential asset then it’s a business which will keep generating cash flow with pre sales during the development phase and subsequently, within 3 to 4 years one can fully cash out from the project. In commercial asset class, which can either be office space or retail space development, one can lease out the facility and enjoy fixed rental, which at a later stage, can be discounted to raise liquidity from banks & financial institutions. One may even consider to comfortably taking an exit from the operational project, since rental earnings are fixed. Pre-leased projects can attract investors at prevailing market rates.

Hotel business at the same time has a longer gestation period, which is usually 7 to 8 years. Its development cycle can take 3 to 5 years from land acquisition stage to construction and approvals. Post commencement of hotel operations it will take around 24-36 months to stabilize its revenues. In the business of a hotel, the average room rate (ARR) and occupancy can take considerable amount of time to build up. Further, hotel cash flows are directly linked to seasonality, market conditions, competition, travelers’ pattern, micro and macro economic conditions. Conceptually hotel business is a like any other day to day operating business such as textiles, automobile, IT etc. In any operating business, real estate is an essential infrastructure for product manufacturing or to deliver services.

However, hotels are mistaken as a real estate asset class, and therefore, while arriving at the valuation of a hotel, investor/owner intend to calculate it on the basis of prevailing land price and price per sq ft for the total built up area of the hotel. Even in the case of most of the banks and financial institutions, - their empanelled valuation experts would determine the value the hotel on basis of these parameters. But in the real transaction world, potential buyers would value the hotel on the basis of its operating earnings or potential earnings in the case of under construction hotels. In some cases we have witnessed that promoters over leverage the hotel with debt while constructing it in anticipation of the fact that they can command a premium price and can make a quick exit on completion of the hotel. When analyzed minutely, these are high-risk business propositions, which affect the financial health of the promoters, and in some cases, their group companies as well. With over leveraged bank loans, construction period interest gets capitalized, thereby escalating the project cost. Hotels, which perform reasonably well at the operational profitability level, and have a positive EBITA, would fetch a fair valuation on the basis of financial performance. Usually an investor would expect a yield of around 7% to 9% for a hotel, which has operational stability. In this scenario, risk attached to the project is limited mainly to external factors. In case of brownfield projects or non-stabilized assets, an investor would expect a yield of around 10% to 12%,

since development and operational risks are attached to the project. In the previous quarter, Noesis Capital Advisors successfully completed two hotel sale transactions in Pune; both projects were located in the strategically located micro market - Viman Nagar, which is close to Pune airport. Both the hotels were in the mid segment space with similar inventory. A Hotel, which was only two years old and had a stabilized revenue stream with a GOP of 46%, got transacted at 7% yield and the asset which was 10 years old with weak financial figures and which required substantial refurbishment got transacted at a yield of 10% on projected cash flows.

Hotel is a business of ‘patience’, like any other operating business. We strongly recommend our clients to treat real estate as a part of infrastructure only, and not to expect its valuation on the basis of the prevailing land price or commercial rate per sq ft. A Hotel is fairly valued as per its potential business earnings & future profitability. To command a premium value for a hotel, one needs to ensure that its operations are profitable and it has a positive cash flow every month.