LEARNING THE LANGUAGE
When pitching investment ideas to owners as part of the budgeting process, it is important to understand the ways in which they make money through their participation in hospitality assets.
1. Operational Income
Operational income is the wealth creating mechanism with which hotel managers are most familiar. Any time a hotel charges a guest more for their room than they incur in costs to support the sale of that room, it generates income for the owners. As a rule of thumb, each dollar in revenue generated results in some portion of that dollar being recorded as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) on a hotel’s income statement.
2. Equity Paydown
Similar to the paydown of the mortgage on a single-family home, hotel owners build equity by paying down their note. Ideally cash flow from operations will cover any financing costs so that the owners of a hotel will not need to budget for additional financial resources to pay down the mortgage.
3. Asset Appreciation
Hotel owners also make money via the appreciation of their assets, which can take place via inflation, repositioning, and/or operational improvements. Given that hotel assets generally run a high gross profit margin, increases in revenue often have a much more substantial impact than refining the hotel’s expense model.
There are a number of ways that hotel owners can be categorized. Examples of hotel owner categories include private equity funds, high net worth individuals, pension fund investment funds, and real estate investment trusts (REITs).
Targeted objectives will vary considerably based on the type of organization involved. For example, private equity investors such as Blackstone often approach hotel investment by buying underperforming assets (either large hotels or entire branded portfolios) and improving operations before selling the asset at a market premium or unwinding their position via public offerings (IPOs). On the flip side, REITS may take a longer-term view when purchasing assets; buying assets with a lower risk profile in order to benefit from stable cash flows and the long-term potential for appreciation.
Economic cycles often also have a significant impact on the way in which hotel owners view investments. For example, when capital is cheap and hotels are trading at bargain levels, owners may prefer to invest in new assets rather than deploying their cash to improve the operations of existing hotels. Conversely, as interest rates rise and/or hotel asset values skyrocket, owners often prefer to generate returns through improvement of their current assets as it becomes increasingly more difficult to purchase new properties at compelling values.
Taking the time to fully grasp the incentives of your owner(s) will allow you to better understand the way they consider additional investments in technology, FF&E, or property enhancements. This understanding will allow you to ensure that you are pursuing the right investment strategies, thus making it easier to gain approval for future expenditures.
Once you have a strong understanding of the priorities of your owners, it is important to calculate the financial impact of any recommended investments in relation to any competing opportunities. Focal has created a detailed investment calculator to assist in your budgeting process.
By walking through the steps that follow, you will be able to calculate the financial impact of new investments and convey them in a language your owners understand.
1. Determine Available Options
Start by listing out all strategies for the upcoming year and the resources you will need to execute them. Perhaps you plan to renovate your suites in order to drive room type upsells. Or, perhaps you plan to deploy a new business intelligence system to reduce the time spent on menial data gathering tasks and free up your team for more strategic concerns.
Once you’ve identified the tools you’ll need to execute your business strategies, research a minimum of two to three providers for each tool. In addition to obtaining pricing for each, a thorough evaluation of features should be completed in order to determine the value provided.
2. Establish Performance Targets
Develop an estimate for any revenue increases or expense savings generated by the investment being analyzed. This step can be the most challenging as it relies on assumptions regarding both tangible and non-tangible benefits. For example, a business intelligence system may not reduce staffing expense materially. Instead, it will allow your current team members to repurpose their time towards deploying marketing campaigns, directing outbound sales efforts, and shifting to a more profitable business mix.
In cases where established benchmarks are unclear, it can be helpful to consider prior performance gains from similar initiatives or strategy deployments in the past. For example, if reducing the time spent on compiling and analyzing data via a new business intelligence system allows for the deployment of one additional marketing campaign and the acquisition of three new corporate accounts from your competitors, a 1-3% increase in hotel room revenues does not seem to be unreasonable.
Performance targets may vary for each option analyzed. When gauging the relative impact of each, it may be helpful to refer back to the feature evaluation completed in step one.
3. Calculate Total Cost of Ownership
When compiling your budget assumptions, consider all costs associated with implementation and continued support to ensure any hidden costs are accounted for. For example, often times business intelligence providers do not include any costs for property management system interface fees or additional servers needed to utilize their products. Fortunately, the industry is headed towards a more open pricing model, with new providers such as Focal Revenue Solutions including all associated costs in their price quotes.
It is also crucial to include any initial setup costs in addition to the recurring costs, as they will have a material impact on the total cost of ownership. In order to provide an apples-to-apples comparison, it can be helpful calculate all costs over the duration of the project or contract. Focal’s Investment Calculator allows you to compare total cost of ownership for multi-year periods.
4. Evaluate Return on Investment
In order to assess return on investment, any revenue increases established in step two should be marginalized in accordance with the hotel’s net profitability benchmarks in order to provide an indication of the additional money an owner can expect to take to the bank at the end of the year.
Once the profit impact has been calculated, Return on Investment (ROI) and Net Present Value (NPV) can be used to compare alternative options. Doing so will allow you to analyze the payback threshold for the investment as well as the cash flow the hotel’s owners can expect to receive, and adjusts for the fact that one dollar spent today is worth more than one dollar received a few years from now.
Focal’s Investment Calculator contains additional information regarding Total NPV and Annualized ROI, as well as the calculations for each.
5. Analyze the Impact on Asset Value
Hotel asset values are often calculated as a multiple of annual net operating profits using the capitalization (cap) rate from recent comparable transactions. In order to calculate the impact of a given investment on a hotel’s asset value, divide the increase in net operating income by the average cap rate for similar property types. If you’re unsure of the appropriate cap rate to use, ask your owner. They have likely been tracking recent comparable sales and can provide you with a benchmark rate for your location and property type.
You may notice that it’s possible for an investment option to have a higher ROI but lower impact on asset value than its alternatives. This may initially seem counter-intuitive. However, you’ll notice the ROI calculation highlights profitability in relation to expense without considering variability in total profit contribution from one investment to the next. For this reason, it’s important to consider both metrics when comparing the merits of competing investments.
For the true nerds reading this- while we’ve recommended the cap rate methodology for calculating asset value given its simplicity, there are a number of additional ways to calculate asset value.
By pitching budget initiatives in the language of your owners, you’ll find that it’s easier to align priorities and obtain investment.