SHA611 Course Transcript

SHA611: Financial Analysis of Hotel Investments
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SHA611: Financial Analysis of

Hotel Investments
What you'll do
Explore the varied motivations of owners, operators, and lenders in

pursuing real estate investments
Examine the different investment approaches taken by owners in the
hotel industry
Estimate the return on investment and the return on equity for a
prospective hotel investment
Estimate the value of a proposed hotel using a variety of methods
Analyze and evaluate investment projects from the perspective of
owners, operators, and lenders
Size a mortgage that meets the needs of different partners
Make informed decisions about the relative attractiveness of hotel
investments
Course Description
Investing in hotel real estate is a complicated and

rewarding endeavor. To be successful, hotel investors
must be equipped to determine the financial interests of
those involved in any project. This requires both
analytical skill and a thorough knowledge of the
objectives and needs of the investment participants.
In this course, Professor deRoos demonstrates several analytical tools

used by real estate professionals to participate in and evaluate hotel
investments. You will explore how owners, operators, and lenders
evaluate potential hotel projects. Using an Excel-based tool, you will
estimate the return on investment and return on equity for a hotel
investment. Debt and equity financing are critical to every project and in
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this course, you will learn how to estimate the size of a mortgage loan
given the lender's requirements. With real-world examples, practical
tools, and opportunities to practice, you will develop the skills necessary
to structure your own hotel real estate investments.
Jan deRoos
Associate Professor and HVS Professor of
Hotel Finance and Real Estate, School of Hotel
Administration, Cornell University
Professor Jan A. deRoos, on the faculty of the School

of Hotel Administration since 1988, has devoted his
career to hospitality real estate, with a focus on the valuation, financing,
development, and operation of lodging, timeshare, and restaurant assets.
He holds BS, MS, and PhD degrees from Cornell University, all with
majors in the School of Hotel Administration. Areas of teaching expertise
span the entire range of hospitality real estate topics: real estate finance,
real estate principles, hotel asset management, real estate portfolio
management, hotel and restaurant valuation, lodging market and
feasibility analysis, hotel/resort planning and design, hotel/resort
development and construction, and the analysis of timeshare/vacation
ownership projects. He teaches courses in the School of Hotel
Administration's undergraduate and graduate degree programs and
teaches extensively in the School of Hotel Administration's executive
education programs.
Author Welcome
Hotel investors are faced with many questions. Where to invest, how to
finance the investment and which brand, if any, is appropriate? And who
should manage the hotel? This course covers the fundamental tools that
are used by industry professionals as they evaluate prospective hotel
investments. In this course, you will explore several important aspects of
hotel investment decisions. You will learn how to evaluate hotel
investments with a focus on the equity returns. You will learn how to
value a hotel. You will learn how to finance a hotel. And most importantly,
you will learn how to structure deals that meet the needs of owners,
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operators and lenders. Based on my real world and academic

experience, I have developed a course that emphasizes the dynamic
nature of hotel investments, especially the notion that hotel investments
are both a science and an art that depend on a keen sense of the
investment goals and needs of all relevant stakeholders. A successful
career in hotel investments depends on a subtle and sophisticated
understanding of hotel investment motives, and negotiation strategies. In
this course, you will begin to develop that understanding.
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Table of Contents
Module 1: The Hotel Owner-Operator-Lender Partnership

1. Module One Introduction: The Hotel Owner-Operator-Lender
Partnership
2. Watch: Putting Together Hotel Real Estate Investments
3. Read: Lodging Investment Participants and Advisors
4. Read: The Partnership: Owner, Operator, and Lender
5. Tool: Hotel Investment Participants
6. Watch: Different Owners Have Different Reasons
7. Watch: Different Ownership Structures
8. Ask the Expert: An Owner's Perspective
9. Read: Different Types of Owners
10. Read: Matching Investment Projects with the Right Owners
11. Do the Interests Overlap?
12. Watch: How Owners Play The Real Estate Game
13. Read: Wealth Creation
14. Read: Income Enhancement
15. Read: Incremental Risk
16. Identifying Investment Strategies
17. Module One Wrap-up: The Hotel Owner-Operator-Lender
Partnership
Module 2: Evaluating the Deal: How Owners, Operators,

and Lenders Evaluate Proposed Projects
1. Module Two Introduction: Evaluating the Deal: How Owners,

Operators, and Lenders Evaluate Proposed Projects
2. Watch: Managing the Acquisition
3. Watch: How Owners Measure Returns
4. Tool: Rules for the Owner’s Investment Decision
5. Watch: How Operators and Lenders Evaluate the Project
6. Read: Operator and Lender Metrics for Project Evaluation
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7. Tool: Operator and Lender Project Metrics

8. Read: The Case of the Hungerford Hotel
9. Watch: Estimating Returns: The Case of the Hungerford Hotel
10. Watch: Market Valuation
11. Read: Market Comparison and Cost Approaches
12. Read: Income Approaches: Capitalization Rate Approach
13. Read: Income Approaches: Ten-Year DCF and Multipliers
14. Watch: Illustrating Valuations: The Case of the Hungerford Hotel
15. Estimating Value
16. Module Two Wrap-up: Evaluating the Deal: How Owners, Operators,
Module 3: Structuring the Deal: Current Equity and Debt

Financing Structures
1. Module Three Introduction: Structuring the Deal: Current Equity and

Debt Financing Structures
2. Watch: How Do You Raise The Money?
3. Read: Equity Financing: Real Estate Equity Funds
4. Read: Equity Financing: Joint-Venture Agreement
5. Watch: What Do Lenders and Borrowers Want?
6. Ask the Expert: The Importance of Relationships in Lending
7. Read: Project Presentation for Lenders
8. Watch: Sizing the Mortgage
9. Tool: Mortgage Worksheet
10. Read: The Lender's Response: Term Sheet
11. Tool: The Hungerford Term Sheet
12. Mortgage Sizing
13. Case Study of the Hungerford Hotel
14. Loan Recommendation
15. Tool: Financial Analysis of Investments Action Plan
16. Module Three Wrap-up: Structuring the Deal: Current Equity and
17. Read: Thank You and Farewell
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Module 1: The Hotel Owner-

Operator-Lender Partnership
1. Module One Introduction: The Hotel Owner-Operator-Lender
Partnership
2. Watch: Putting Together Hotel Real Estate Investments
3. Read: Lodging Investment Participants and Advisors
4. Read: The Partnership: Owner, Operator, and Lender
5. Tool: Hotel Investment Participants
6. Watch: Different Owners Have Different Reasons
7. Watch: Different Ownership Structures
8. Ask the Expert: An Owner's Perspective
9. Read: Different Types of Owners
10. Read: Matching Investment Projects with the Right Owners
11. Do the Interests Overlap?
12. Watch: How Owners Play The Real Estate Game
13. Read: Wealth Creation
14. Read: Income Enhancement
15. Read: Incremental Risk
16. Identifying Investment Strategies
17. Module One Wrap-up: The Hotel Owner-Operator-Lender
Partnership
Back to Table of Contents
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Module One Introduction: The Hotel Owner-

Operator-Lender Partnership
Successfully putting together a hotel real estate
investment is a complicated undertaking. The financial
analysis that supports hotel real estate decision-making
requires a nuanced understanding of what drives the
major participants.
In this module, you will determine the interests and

motivations of the three major participants in hotel investments: owners,
operators, and lenders. You will examine different types of owners and
will match investment projects with the appropriate owners. You will also
identify the investment strategies prevalent in the hotel industry and apply
them to differing ownership interests.
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Watch: Putting Together Hotel Real Estate

Investments
Putting together a hotel real estate investment usually involves bringing
together an owner, a hotel company or operator, and a lender. To
structure a successful investment, the requirements of each must be
factored into the financial analysis. In this video, Professor deRoos
introduces the objectives of each party involved in the project and how
they might evaluate a prospective deal. The owner often drives the
process and has a responsibility to help the operator and the lender each
meet their individual needs. On the next page, we provide a full
description of all of the parties involved in a typical hotel real estate
transaction.
Video Transcript
Fundamentally, this course is about how you put together a hotel real
estate investment. To introduce some of the issues, we'll begin by
imagining you have the opportunity to purchase a $30 million hotel. As an
owner, you don't have to have the $30 million available. It is reasonable
for you to expect to be able to borrow $20 million from a lender, leaving
you to invest $10 million of your own equity to achieve the necessary $30
million. Your next step is to determine if the annual returns justify that $10
million equity investment. But in order to do that, you need to make sure
that the lender receives an adequate return on their $20 million
investment. Otherwise, they won't lend you the money. And you need to
demonstrate that any hotel company you affiliate with receives a return
on their brand and their management expertise because that hotel
company may have other opportunities in the market and may not
consider your investment to be the best opportunity. While the owner
drives this process, they need to understand the other parties' business
models and ensure that at some level, each party is achieving their
minimum returns in order to be motivated into accepting this investment
opportunity.
Let's take the example of an owner working with a third party

management company and a lender to bring a new project to market.
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Consider the operator, or manager of the hotel. The operator is interested

in two things. First, is this deal consistent with the growth of the firm and
the identity of the brand, if it's present? Second, are the fees sufficient?
The manager's fees are generally some function of total revenues, called
the base fee, plus, some function of profits, called the incentive fee.
Consider an opportunity in which the operator expects fees that are 3%
of revenues, plus 10% of profits.
The first thing the operator wants to know before signing any contract is
whether the market's strong. A strong market drives high revenues and
high revenues drive high fees. The second question the operator needs
to answer is whether this hotel matches their style of operation. Can the
operator drive strong profits from the revenues, thus receiving a strong
incentive fee? Once the operator becomes convinced that the market is
strong and the hotel is compatible, they are much more likely to do the
deal. The owner helps that operator understand the market and the vision
for the property, facilitating their decision making.
Now the lender. The lender provides capital and expects to earn an
annual debt service, taken from the property's cash flows. The lender
incorporates a set of underwriting criteria into their interest rate and other
loan terms. These criteria include the strength of the market, the strength
of the hotel within that market, the strength of any brand, and the strength
of the borrower themselves. The essence of the mortgage is a promise to
pay coupled with a right to foreclose in a default. Thus, lenders are willing
to take a lower return than owners are. But in the end, cash flow from
operations needs to be some multiple of annual debt service or the
lender is not interested in participating in the deal. The lender closely
scrutinizes both historical and prospective cash flows to determine their
comfort level. The owner again plays a significant role by assisting the
lender in this evaluation. And finally to the owner, how does the owner
get paid, and earn both a return on and a return of their investment?
The general story is the owner gets paid after everyone else gets paid.
They have the rights to all of the cash flows after debt service, and after
the manager's fees. To realize their desired returns, the owner needs to
understand the required returns for the other two parties. The owner may
think that in isolation, I just want to achieve a 12% return on my $10
million investment. The owner cannot make this statement unless they
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understand that their 12% is achievable after everyone else gets paid.
Seasoned owners know that everyone has their eye on the same things;
the strength of the market, and the relative strengths that the other
participants bring to the deal. They make sure that the lender and the
operator are treated as partners and work hard to help them understand
the deal and to help them get to yes.
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Read: Lodging Investment Participants and

Advisors
• Owners contribute the equity
• Lenders provide the capital
• Operators provide the brand and the managerial expertise
Hotel real estate investments involve a range of different participants. In

addition to the primary participants—the owner, the operator, and the
lender—most hotel investments include a range of specialists who
facilitate the investment. Unlike the owner, operator, and lender, the
involvement of these specialists is usually limited to the transaction
(purchase and construction) of the hotel.
Let's take a deeper look at the three major partners before considering
the roles of the transaction specialists.
Owners contribute equity to a hotel investment. This equity is in the form

of cash contributions, the contribution of land, and the contribution of the
owner's "sweat equity." Sweat equity includes the effort and toil the
owner contributes to the project, as opposed to financial equity, in which
owners would pay others to perform the task.
There are many different types of hotel real estate owners, including:
Entrepreneurs: usually individual owners or small firms

Institutional investors: real estate corporations, real estate
investment trusts (REITs), real estate investment funds, insurance
companies, pension funds, and sovereign wealth funds
Owner-operators: the hotel operator or manager also owns the
property
Governments: governmental bodies, such as national tourism
organizations
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Owners-in-foreclosure: lenders who have been forced to take

ownership of the property due to the failure of the owner to meet
obligations
As we will see, different types of owners have different goals for their
hotel investments.
Lenders provide the majority of the capital needed to finance a real

estate transaction in the form of senior mortgage debt. These lenders
typically include commercial banks, conduit lenders, investment banks,
credit companies, and insurance companies. Hotel real estate
mortgages are generally of two types. The first are long-term loans
established at a fixed rate of interest. Lenders are willing to take the
interest rate risk associated with a fixed rate over a lengthy term. In
exchange, they extract significant penalties for terminating the loan
before maturity. For borrowers with a short-term need for funds, lenders
provide short-term loans with a floating rate of interest. In this case, the
borrower has the flexibility to terminate the loan in a short time, but must
take the interest rate risk.
The senior mortgage capital provided by commercial lenders is often

insufficient to finance the investment. In these instances, gap, or
mezzanine financing is employed to bridge the gap between the equity
and debt capital contributions. Suppliers of "mezz" financing are paid
after the senior mortgage has been paid, but before the owner is paid.
For absorbing this added risk, they extract a better interest rate than the
senior mortgage lender. Suppliers of mezzanine financing typically
include credit companies, specialty lenders, operating or franchise
companies, and often governments (frequently through a range of tax
incentives).
The third major participant in most hotel real estate transactions is

the Operator. While many hotels are owner operated, most large hotels
are operated either by a chain operating company or an independent
operating company under a third-party hotel management agreement
(HMA). Branded operators provide both the managerial expertise and
brand services needed to successfully run the hotel. Independent
operators provide the managerial expertise needed to successfully run
the hotel, often under a franchise license agreement from a hotel brand.
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In addition to the three major participants, a number of

transaction Specialists participate in the successful execution of the
investment. These include:
Brokers, who facilitate the sale of the property (sales brokerages) and
the financing of the investment (investment or mortgage bankers). Sales
brokers add value by knowing who might be a likely buyer. Investment
and mortgage bankers add value by knowing who has the money to lend.
Consultants or appraisers perform the market analysis of the proposed

property and estimate its value to help potential lenders better
understand the level of risk.
Legal service providers help "paper" the deal, by facilitating the many
necessary transactions, including land purchase, management contracts,
loan documents, and construction contracts.
Architects and designers help achieve the owner's vision for the
property, designing a physical structure consistent with the owner's
concept.
Finally, Governments often play a substantial role in hotel real estate

investments. In many parts of the world, government agencies, especially
tourism ministries, facilitate development and redevelopment of hotels. In
addition, local, state or provincial, and national governments exercise a
regulatory role in ensuring coherent and consistent development policy of
tourism, meeting and convention facilities, and transportation services.
Putting together a successful hotel real estate transaction involves a

large number of actors. The three primary participants, however, are
always the owner, the operator, and the lender. Let's take a closer look at
their interests.
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Read: The Partnership: Owner, Operator, and

Lender
• Owners are primarily interested in returns
• Branded operators' primary interest is in market presence and

market share
• Lenders need to achieve an adequate overall risk-adjusted return

on investment
Most hotel real estate projects involve a three-way partnership among

owners, operators, and lenders. Each of these partners has different
interests and different investment goals. Let's look at each participant
and their interests.
Owners
One of the primary interests of an owner is returns. These can come in

the form of income returns (operating cash flow) or appreciation returns
(an increase in the value of the hotel). Both forms of returns matter to
every owner, though one type will probably matter more, depending on
the investment goals of the owner. After returns, owners are interested in
owning a competitive hotel. They want a quality hotel

product, located in an appropriate market, managed by an appropriate
operator, with an appropriate brand.
Additionally, owners are interested in influence over the management

and operation of the hotel. They desire the influence necessary to
execute their strategic vision for the property. Owners also want the
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flexibility necessary to sell or refinance when they so choose. Owners

need this flexibility to harvest gains in appreciation. Finally, owners may
own hotels for a range of nonfinancial reasons. For many owners, owning
a hotel brings more prestige than other investments or other real estate.
It is important to recognize the full range of motivations to truly
understand owner behaviors.
Operators
The primary interest of the branded operator lies in market presence and
market share. This is true for five-star hotels needing a property in every
"gateway" city, and for budget chains needing a property in each market
where they have customers. Operators need a presence wherever their
customers are likely to look for lodging. Independent operators are
primarily motivated by earning compensation for their management
expertise.
To achieve their objectives, operators are also interested in operating a

quality hotel, one consistent with the standards of the brand, and one
likely to provide substantial fees to the operator. Good managers or
operators get paid for driving revenues (basic fees) and for running
efficient hotels (incentive fees). Operators also look for the maximum
possible level of discretion in managing the hotel in order to implement
their strategic vision (to keep the hotel consistent with the brand and
operator standards). Operators also want long-term stability, which can
be achieved by signing a long-term contract that inhibits the owner's
ability to terminate the contract at will or via a sale. Finally, operators are
interested in the financial ability and willingness of the owner to fund
renovations when needed and to supply working capital if circumstances
call for it.
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Lenders
The major objective of the lender is to be rewarded for the risk of lending
by achieving an adequate overall risk-adjusted return on investment.
Lenders manage risk by "underwriting" two critical items. First, the lender
must be sure that cash flows are significantly higher than debt service.
Second, the lender must be sure that the value of the property is
significantly greater than the loan amount. Lenders are also looking for a
quality, competitive hotel, managed by a first-class operator, as a means
to manage risk. Lenders seek influence over their investment to execute
their own strategic vision and to protect their investment. Finally, lenders
are looking for the flexibility to foreclose or reschedule the loan in difficult
times.
Owners, operators, and lenders must all prioritize their interests between
these often competing objectives. Real estate investments must be
structured to arrive at a reasonable accommodation of the interests of all
three participants. The trick is to identify the places where the interests of
owners, operators, and lenders may overlap. Arriving at such a position is
the art of hotel investment.
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Tool: Hotel Investment Participants
• Use this summary of hotel

investment participants when you
structure your hotel investment
project.
Hotel real estate investments include a number of primary and secondary

participants, and they often have competing goals and objectives. As you
begin to structure your own hotel investment project, familiarize yourself
with the key players and their primary interests to help ensure your
success.
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Watch: Different Owners Have Different Reasons

Now that you have explored the three major players in hotel real estate
investment projects, we can examine the owner's investment strategies
in greater detail. As Professor deRoos explains in this video, the owner
typically drives the investment process. Different types of owners have
different investment strategies and these differing strategies play a
crucial role in determining the shape of specific hotel investments.
Video Transcript
Different owners have different reasons for investing. It seems

counterintuitive, but the essence of the investment problem for hotel
investors is to take their reasons or objectives for investing and map
those onto an ownership structure that works for that set of reasons.
Here we are going to take a look at what those reasons might be, and
then introduce you to the most common ownership structures in the hotel
industry. We'll start with returns as the reason for investing.
Real estate returns have two fundamental components. The first is the
annual net operating income or cash flow, and the second is the change
in value of the property over time. Together they're called holding period
return. Long term, and that operating income tends to be somewhere 6%
and 10% per year. And the long term appreciation return, approximates
inflation, which in this country has been between 2% and 4% a year.
Appreciation returns are much more volatile than the operating income.
The best years in lodging have appreciation returns in excess of 10%,
while the worst years have seen value losses in excessive of 10%.
Beyond returns, there are other financial reasons for investing in hotels.
The three we will talk about here are taxes, inflation and fees. Tax
reasons for investing come from the depreciation deduction in real estate.
Hotels have significant depreciation deductions because of the large
amounts of personal property that are owned along with the real estate
itself. Depreciation is a non-cash expense, meaning it reduces your
taxable income in your tax, but it doesn't reduce your tax, but it doesn't
reduce your cash flows. Inflation is the next financial reason. Long term,
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one of the most remarkable characteristics of real estate, is that it is a

wonderful inflation hedge.
In the long run, both the cash flows and the value of real estate property,
appreciate with inflation, which provides a great hedging benefit. The last
financial reason to own hotels would be the fees. These would include
the development fees, which are fees that an owner would earn from
sourcing a deal then managing that from conception through beneficial
occupancy. Second, property managing fees, known as managing fees,
for lodging in which the operator operates that property over its holding
period efficiently. And the third, is asset management fees, which come
from managing the investment on behalf of other owners.
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Watch: Different Ownership Structures

Another important consideration for owners is the ownership structure of
the hotel. In this video, Professor deRoos describes the five primary
ownership structures. Each structure has a different combination of the
three fundamental decisions facing owners; owned real estate versus
leased real estate, owner-operator versus third-party operator, and an
independent hotel versus a brand-affiliated operation.
Video Transcript
Now we turn to the most common structures used by hotel owners. Each
structure has a different combination of the three fundamental decisions
facing owners: to lease the property or not, if not leased, to operate the
property one's self or hire a third party manager, and third, to affiliate the
hotel with a brand or not.
First, we have a real estate owner with a branded operator. In this

structure, the owner of the hotel does not operate the hotel on a day-to-
day basis. This owner is known as a financial owner. The owner
generally has a hotel management agreement with one of the major hotel
brands to operate the hotel and supply brand services for a fee. A
defining characteristic of this structure is that the hotel owner bears the
risk of failure, but obtains all the rewards of success, after paying fees to
the manager.
A second structure, similar, is a real estate owner with an independent

operator. Similar to the branded operator, but here the hotel owner has a
management agreement with the hotel manager not affiliated with one of
the major hotel brands. The hotel may be operated independently without
a brand, or could be franchised with one of the major brands. Again a
defining characteristic of this structure is the real estate owner bears risks
of failure, but obtains rewards of success after paying fees to the
manager and perhaps the brand.
A third structure, is a real estate owner with a leased hotel. In this

structure, the owner of the hotel acts as landlord and leases the hotel to a
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tenant, most typically this tenant is the hotel manager. These leases tend
to be very long term, generally 20 years or more. But the defining
definition of the structure is that the tenant takes significant financial risk.
The tenant is obligated to pay rent, but they obtain all the benefits or lack
thereof, after paying rent. In general, hotel managers are very resistant to
operating hotels under leases due to the significant negative impacts of
leases on the tenant's balance sheet.
A fourth structure, would be a hotel owner operating the hotel

themselves, in a franchise arrangement. I'll call this a real estate owner-
operator with a franchise hotel. In this structure, the real estate owner
builds a new hotel, or purchases an existing hotel, with the intent to
operate the hotel business themselves. Thus, the owner earns both the
real estate return and the management fee. The brand, or brand services
are obtained via a franchise license agreement with one of the major
branded hotel companies. The last structure we'll discuss is a real estate
owner, owner-operator again, but this time with an independent hotel. In
this structure, the real estate owner builds a new hotel or purchases an
existing hotel with the intent to operate the hotel business themselves,
earning both a real estate return and a management fee. However, unlike
the franchise hotel the owner-operator intends to run this hotel without
the use of a brand. A very risky proposition for those who are just starting
out, but an increasingly popular option.
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Ask the Expert: An Owner's Perspective

Hotel owners and investors have many reasons for developing and
operating hotels. In these videos, Mark Wolman describes the primary
benefits of investing in hotels, the differences between acquiring a hotel
versus building a new hotel, and his top rules for investing in hotels. He
also discusses some of the challenges of investing in hotels and lessons
he has learned from his wide-ranging experience.
Mark Wolman
is a Principal and Director of Waterford Group, a leading hospitality
company specializing in the development, ownership and management of
hotel, gaming and venue projects. He has more than 30 years of
experience in land development, residential and commercial construction,
hospitality development and operations, as well as asset management. In
his role with Waterford, Mark has been integrally involved in the
development and supervision of projects totaling more than $3 billion.
Waterford has successfully owned and/or operated more than 80 hotels
and convention centers, from small to large, as well as independent to
virtually all major national brands. Notable projects include the world-
renowned Mohegan Sun; the Front Street District, a $775 million mixed-
use development in Hartford, CT; as well as, numerous Marriott, Hilton,
and Starwood branded hotels throughout the United States. (The job title
listed above was held by our expert at the time of this interview.)
Tell us about your business and how you are involved in hotel
investing and management?
Video Transcript
So, we're in the investment in multiple facets of hotel industry. So, we

invest personal and private equity. We also develop our own hotels. We
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manage hotels, and we also work with franchise companies. So, we're
vertically integrated, and so we feel like we have our fingers on the pulse
in many different parts of the industry. And we enjoy it, and we've been in
this business for a very long time. Our management company's over 30
years old, as we speak. We celebrated that this year.
As a hotel investor, what are your greatest rewards from investing?
Video Transcript
So, naturally we're in business so, financial rewards are behind

everything we do. But, we are very passionate about creating stuff. So,
whether it’s a new build, that you start with a piece of land and a year or
two later you step back and realize, wow this is something we've created
and then the people come in, you know, that enjoy this facility. So that
gives us a lot of pleasure. The other is taking a potentially broken asset,
that's not functioning well, maybe not financially viable, and reinvesting in
it and then seeing how this asset comes back to life with a new brand or
an independent approach to it, but clearly is more competitive and is
more viable again. And that's what we enjoy doing. And then the
associates are the big part of the business. So, having people's lives
changed when they come in and work and this becomes their new world.
And that's what we really enjoy about the business.
What are the major differences in acquiring an existing hotel versus

developing a new hotel?
Video Transcript
So, acquiring an asset that already exists, the major change, there is
potentially governmental approvals and a timeline to acquire or start new
construction. And so, what I mean by that, is you can quickly renovate an
asset in three, or six months, or nine months and have cash flow, and
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you can even do the renovation while the asset is still open. New
construction is a whole different ball game, and that could take you two or
three years. Money going out and then money coming back potentially in
two years time. So it's a very different investment criteria and the risk
factors are higher in terms of a new construction process. Bank financing
could be different, the guarantees that are required with new
construction, because you're loaning somebody money without a real
asset and you have to create this asset, so there's a completion
component that's very high risk for a potential lender, whereas an
existing asset that you convert is very different. So, you know, it's
depending on what the opportunities are out there, but those are
essentially the two big differences.
What are your top three rules for hotel investment?
Video Transcript
So you've heard this adage, location, location, location. We still feel

location is critical. With that comes barriers to entry in the market that
you're going in to. And then if it's a new build, affiliating yourself with the
right brand or right product. If it's a conversion, again, also making sure
there's not a lot of obsolescence in this building, because as time has
gone by, the market and the public are very demanding. And building and
renovating something that is obsolete before you even start is very risky.
So those would be our top priorities.
What is the most important aspect of hotel investments that people

outside of this business can underestimate?
Video Transcript
Hotels are an operating business and so it's not real estate per se, and
one has to really understand how you operate a hotel. It's a 365 days a
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year, 24-hour service that is provided and we really see that as the
component, and that's why we have our own management company, that
you can make a big difference. It's not just investing in real estate and
then assuming that the returns will be there. So, we think it's critical you
understand you're not getting into real estate per se, but it's real estate
with an operating component.
Tell us about a project that didn't go as you expected. What did you
learn from it?
Video Transcript
So, we've done a number of deals very large and small. And I would say
that the timing to do deals is probably one of the biggest questions one
has to ask oneself. We were involved in a very big project that we thought
would take five years. We invested a lot of money in that. It was a
downtown project that was more of a pioneering project. And it's now, the
last piece of that project's now being done, and it's 17 years later. So, we
think making sure that you invest with a horizon that's more controllable
would be very good to do. And, you know, this investment will be
successful; patience is a big deal. In real estate, our view is you have to
really be patient and if you've got the staying power, ultimately, you
should be fine. But if the horizon is something you are under pressure
with, that is an issue one should think through carefully. But those have
been, probably our biggest challenge is investing thinking you're going to
get a return on a short term and you find that you have to stay in it for a
long term.
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Read: Different Types of Owners
• Different owners prefer different

levels of risk and return
• Owners work with with different

operators and capital
partners depending on their
needs
Companies invest in and own hotel real estate for varying reasons. Let's
meet three different hotel ownership interests, and consider how they will
evaluate potential hotel investments. While there are other types of
owners, the three under discussion represent the archetypes of real
estate investors.
John Dough is VP of acquisitions for Black Hall Lodging, a fictional real

estate private equity firm based in New York. Black Hall invests in
hotels by sponsoring opportunistic real estate funds on behalf of their
foundation, endowment, insurance company, sovereign wealth fund, and
pension fund clients. Black Hall typically buys assets they deem are
mispriced in the market. They are very good at identifying acquisition
targets, making improvements to reposition the property in the market,
operating the hotel via third party management for a short period, and
then selling to realize their gains. This combination of skills has the
potential to produce high returns, but comes with a risk of failure every
time an investment decision is made.
Sophie Smith is VP of Hotel Investments for the Actuarial Insurance

Group of Hartford (AIGH), a fictional large life insurance company.
Sophie’s firm looks to put money to work earning consistent returns over
a long period by investing in stocks, bonds, and real estate. They partner
with capital providers (generally foundations, endowments, and pension
fund clients) to own real estate in a comingled fund. AIGH seeks high
quality, safe investments that will yield consistent cash flows; real estate,
including hotels, is a partial solution to her needs. Sophie invests in
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hotels to provide a diversified real estate portfolio as an additional route

to smooth portfolio level cash flows.
Alexandra Rodriguez works for TarHeel Development, a

fictional developer in the North Carolina Research Triangle. She works
to put two- and three-star products such as Comfy Suites, Sleep Right
Inns, and Courtway Hotels in both the growing suburban markets and the
urban cores of Raleigh and Charlotte. TarHeel identifies great locations in
markets with growing demand for transient lodging. They buy land before
its value is recognized, develop the property, then either sell it or operate
it themselves under a franchise license from a major hotel brand. TarHeel
is reluctant to partner with other capital partners during the development
phase of a project; rather, their strategy is to consider selling or
refinancing their investment after they have created value by delivering a
high-quality, profitable real estate investment in their market.
You can download a description of these owners for your reference.
An Investment Opportunity
John, Sophie, and Alexandra are all considering an opportunity in the

Charlotte area. An established three-star, branded, 300-room property,
managed by the fictional International Hotel Company, is located in the
urban core of Charlotte. The property has 10 years remaining on the
management agreement, but it can be terminated by paying the operator
a fee. The property is scheduled for a full guest room and public area
renovation in one year. The property's location makes it an attractive
target for repositioning to a four-star hotel. There is also a lack of two-star
properties in the Charlotte urban core. International Hotel Company is
keen, however, to keep the property and perhaps reposition the hotel to
its four-star Regal Crowne brand.
Next, we will consider what factors determine how each potential owner
evaluates the property.
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Read: Matching Investment Projects with the Right

Owners
• Owners consider many issues when
evaluating projects:
• Management contracts and operator

concerns
• Strength of market and the potential of the

hotel
• Potential returns and cash flow and/or

possible sale
A fictional three-star branded hotel in Charlotte is available for acquisition

from International Hotel Company. The hotel is in need of renovation.
How might John, Sophie, and Alexandra evaluate the property?
John Dough, of Black Hall Lodging, is very interested in repositioning the

property from three-star to four-star status. The needed renovations are a
plus, because folding the renovations into a repositioning story allows
Black Hall to add value to their investment in the hotel.
Two key factors drive John's decision. First, he wants to secure a

manager who is willing to operate under a "termination-upon-sale"
arrangement, because many potential buyers would wish to operate the
hotel themselves. Second, he must be convinced that there are buyers
for the property once the repositioning effort is complete.
Sophie Smith, of AIGH Insurance, is interested in long-term cash flow

and needs to know three things before committing:
Does the hotel bring a diversification benefit to other hotels in her

portfolio?
Is Charlotte a strong hotel market in the long-term?
Is the manager capable of producing consistently high cash flows from
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a well-maintained asset?
She is deterred by the costs of the upcoming renovation, but might be

induced to sign a long-term management contract if International Hotel
Company offers financial inducements.
Alexandra Rodriguez, of Tarheel Development, is interested in the

ability to terminate the manager and to manage the property under a
franchise arrangement. Her plans call for redevelopment of the property.
The 300-room three-star hotel would be transformed into two hotels: a
150-room Life Hotel, International's lifestyle brand, and a 75-room Comfy
Suites, International's midscale extended-stay brand. Using cluster
management would provide significant opportunities for operational
efficiencies by using one staff to run both properties. TarHeel would earn
development fees from the redevelopment and would have two new
properties in the market that could be held for the long-term or sold for a
profit.
Who Acquires the Property?
Well, it may not be a single buyer. Situations may develop in which John,
Sophie, and Alexandra could all be involved in the redevelopment of the
property. Here are a couple of possible scenarios:
Alexandra might enter into an agreement with Sophie in which

Alexandra agrees to take the risk of repositioning the property,
performing the renovations, and replacing management. Once
the property has restabilized, Sophie agrees to purchase the property
from Alexandra at the prearranged price that reflects the anticipated cash
flows. Alexandra's firm will make significant returns if the repositioning
effort succeeds. But Alexandra's firm takes significant risk,
because Sophie's firm is not obligated to purchase the property if it does
not achieve the anticipated cash flows, and her firm is not responsible for
cost overruns on the repositioning effort.
Alexandra might enter an agreement with John's firm to acquire and

redevelop the property. John's firm supplies the majority of the capital
needed to fund the acquisition and redevelopment effort. John and
Alexandra agree that the property will be refinanced two years after
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the development is complete, with Alexandra buying out John’s interest in

the property using the refinancing proceeds. Alexandra's firm supplies a
minority stake and the development expertise to execute the
redevelopment effort. John's firm makes a healthy return for supplying
the short-term bridge capital needed to redevelop the property.
Alexandra's firm owns the project in the long-term, and has the option to
continue to operate the hotel or to sell their interest should
more interesting opportunities come along.
The question of who will own the property does not have a simple or
single answer. The ultimate answer depends on how each potential
owner evaluates the property. It also depends on how the operator and
the lender evaluate the potential owners.
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Do the Interests Overlap?

Instructions:
You are required to participate in all discussions in this course.
Discussion topic:
On the previous two pages, you learned about owners, John, Sophie,
and Alexandra, and the proposed investment property in Charlotte. Each
owner may be interested in investing in the proposed three-star branded
property in Charlotte under the right circumstances. Create a post in
which you discuss the following:
1. Which of the proposed owners seems the most likely to seek a deal? Why?
2. Comment on the prospective investments outlined for John, Sophie,
and Alexandra.
3. Contribute your own proposed investment and respond to at least
one proposal of a classmate.
To participate in this discussion:
Click Reply to post a comment or reply to another comment. Please

consider that this is a professional forum; courtesy and professional
language and tone are expected. Before posting, please review
eCornell's policy regarding plagiarism (the presentation of someone
else's work as your own without source credit).
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Watch: How Owners Play The Real Estate Game

We've seen that owners have different investment objectives and that
these objectives can result in different investment structures. Now, we
explore the specific strategies owners use to realize their returns. In this
video, Professor deRoos explains the three basic approaches to
achieving high, risk-adjusted returns through hotel real estate
investments: wealth creation, income enhancement, and incremental risk.
Video Transcript
We've seen that owners have a myriad of different structures and

objectives when they invest. But what strategies do owners use to realize
their investment goals, and how do they realize their return goals? In this
topic, we introduce three approaches for achieving proper risk-adjusted
returns in real estate portfolios. The approaches an owner chooses are
influenced heavily by the type of owner investing and by the type of
property or investment available. While owners have different
approaches, certain properties also lend themselves to certain strategies.
So ask yourself as we explore these approaches which ones John,
Sophie, and Alex are likely to pursue.
The first strategy is called wealth creation. In this approach, value is

created through new development, or the redevelopment and
repositioning of existing properties. This strategy requires significant
investment before returns are achieved, but well executed investments
have the ability to create significant wealth.
The second strategy is called income enhancement. The income

enhancement strategy is driven out of the ability to produce higher cash
flows relative to what others are able to produce from the same property.
This is possible by having superior operating and marketing talent. With
this strategy one is able to realize immediate cash flows upon acquiring
and improving an existing property.
A third strategy is called incremental risk. Here, the investor chooses

investments that are much higher on the risk return continuum and seeks
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to use other people's money, high leverage, in a way that produces

potentially high returns and equity. The basic story for lodging, is that one
seeks leverage in excess of 75% of the capital stack to achieve very high
returns on the remaining less than 25% equity investment.
In the end, what you will see is there's absolutely no right or wrong
strategy. What is right for one owner; wrong for another, vice versa. A
strategy that works for one property would not be appropriate for another
property. The strategy that a firm embraces depends on its needs. As we
will see, each strategy produces very different cash flow and appreciation
profiles. Some strategies are consistent with very long-term holding
periods while other strategies are very consistent with producing high
appreciation returns and a quick sale.
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Read: Wealth Creation
• The strategy is primarily a buy or

build and flip strategy with short-
term hold periods
• Success often depends on timing

the market
• Returns are based primarily on

market value, not cash flows
In real estate, almost all wealth creation arises from development and
redevelopment. Wealth creation strategies are driven primarily by market
dynamics, particularly growth in population, employment, and income.
Examples of favorable market changes for each of the major real estate
property types include:
Robust job growth in office-sector employment and changes in

workplace technology create demand for new or redeveloped space.
Changing demographics and increasing wealth create demand for new
and different apartment space.
New retail formats drive demand for new or redeveloped space.
Expanding business activity and increased segmentation drive demand
for new or redeveloped lodging facilities.
New development focuses on creating wealth by providing above-
market-quality space to satisfy unmet demand.
Typically, redevelopment creates wealth by repositioning a property to, or

above, the new and improved market quality. The plan is to increase
rents, decrease vacancy, or both, and hence improve cash flow.
Graphically, the wealth creation strategy looks like this:
There are some important issues to keep in mind when employing the
wealth creation strategy.
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During the development or redevelopment phase, you experience

negative cash flow and illiquidity.
Timing plays a critical role in success. In the long-term, disposition
decisions must be made while the property still commands a quality
premium to the market. In the short-term, the "exit" value is very
sensitive to market conditions at sale.
To succeed, you need high-quality acquisition talent, individuals skilled
at finding opportunities or value that others do not see.
Much of the total return is tied up in market value at exit, not ongoing
cash flow.
Extended holding periods will depress total returns, so this is essentially
a buy or build and flip strategy.
This strategy, therefore, appeals to owners such as Alexandra at TarHeel

Development. Alexandra is good at identifying assets misplaced in the
market, repositioning them, realizing the gains brought with increased
cash flow, and then selling before the property is again below market
standard.
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Read: Income Enhancement
• Income enhancement is the

primary strategy used by owner-
operators
• Success depends on operational

efficiencies, marketing skills, and
strong asset management
• The focus is on producing higher

cash flows with longer holding
periods
The ability to actively participate in decisions at the property level is one

of the distinguishing features of real estate, as opposed to traditional
equity or bond investing. The income enhancement strategy focuses on
asset management and property management skills to enhance cash
flows. It is the dominant strategy for owner-operators of real estate.
Since the strategy is focused on income enhancement, it is seen as

consistent with long-term holding periods. To overstate the case, since
the current owners are more efficient operators than "any other"
operators, they produce a higher cash flow than "any other" operators.
Hence they have the highest valuation for the property, and hence they
can never sell it for what it is worth to them because "any other" potential
investor has a lower valuation.
The key to a successful income enhancement strategy is to deliver on

one or more of the following:
1. Lift revenue through rate increases or occupancy increases. The

key is superior marketing skills and operational efficiencies.
2. Economies of scale.
3. Strong asset or property management skills with excellent expense
management.
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4. Extending the "market life" of properties.
Issues with the Income Enhancement Strategy
It is easy to be trapped into thinking that you are a "better than average"
operator. It is important to ask from time to time if the property is worth
more to someone else.
Strong asset and property management skills are needed. It is difficult
to overestimate their importance.
In general, this strategy does not rely on superior transaction skills, only
that properties be traded at the market price. Typically, a rolling
investment tactic is employed, structured to stabilize cash flows across
a portfolio and neutralize business cycle risk. In a large fund, purchase
and sale proceed slowly, but continuously, as aging properties are
disposed of and new ones purchased to refresh the portfolio.
Total return is driven by income, not appreciation. Although some of the
increased income can be capitalized into the property price, the market
may not view the enhanced income as transferable to new owners.
This strategy produces high "cash-on-cash" returns relative to the
wealth creation and value-added strategies.
Income enhancement is a strategy likely to appeal to investors such as

insurance companies that are interested in long-term, dependable cash
flows. Sophie at AIGH would place income enhancement at the
foundation of her investment strategy.
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Read: Incremental Risk
• Seeks out riskier investment

projects
• Adds debt to increase equity

returns, capitalizing on good
lender relationships
• Requires a risk-adjusted return

metric to correctly assess
investments
Using terminology from modern portfolio theory, this strategy is focused

on making property investments that have a high "beta." That is, relative
to a "market" portfolio of real estate, this strategy seeks to embrace risk
in a systematic fashion, and be rewarded for taking on additional risk.
The two traditional means of embracing risk are:
1. Invest in riskier property types such as hotels, raw land

development, or speculative office projects.
2. Add debt to increase equity returns.
Investors who have special relationships with lenders often implement

this strategy. In many cases, not only does the special relationship result
in lower interest rates, it can also result in higher loan-to-value ratios.
This strategy also may seek to reduce the risk of individual properties, or
portfolios of properties, which might work as follows:
An investor purchases an asset that is misplaced in the market. The

investor takes actions that reduce the risk and the risk reduction boosts
the value of the investment.
The investor continues to hold the asset, and borrows against the new,
improved value. The investor harvests some of the equity investment
and makes a nice return by continuing to hold the asset.
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With lenders and capital providers in the business of evaluating risk and
pricing leverage accordingly, the combination provides a mechanism for
owners to participate in potentially extraordinary returns to equity capital.
Issues with the Incremental Risk Strategy
It is the intrinsic nature of the investments (the riskiness of the lodging)

that provides the mechanisms for excess returns, not any special skill
on the part of the manager. This is both a good and a bad thing.
Performance measurement must explicitly allow for the increased risk
of investments, some sort of risk-adjusted return metric is needed.
Owners need to have an appetite for increased risk.
This strategy would appeal to John at Black Hall. Due to his firm's strong
relationship with lenders (debt capital), and the large number of real
estate investments in Black Hall's portfolio, John would have the
necessary appetite for additional risk. The appeal of strong returns would
lead John to embrace this incremental risk approach.
Summary
This taxonomy of wealth creation strategies is meant to stimulate your

thinking about the linkage between individual property investing and
portfolio management. The three strategies represent different
approaches, tradeoffs, risks, and styles of ownership. Clearly, investors
in the real world employ more than one of these approaches to achieve
their goals. Different properties, or different investment possibilities, lend
themselves to one approach or another. The perspectives contained in
each approach should assist you in assessing a given firm's approach to
the market.
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Identifying Investment Strategies

In this required evaluation, identify the types of owners and the
investment strategies pursued in these actual hotel transactions drawn
from the "Hotel News Now", a unit of STR Global.
You must achieve a score of 100% on this quiz to complete the

course. You may take it as many times as needed to achieve that
score.
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Module One Wrap-up: The Hotel Owner-Operator-

Lender Partnership
The science and art of hotel investment lies in a thorough understanding
of the interests and motivations of hotel owners, operators, and lenders.
A successful investment must find common ground between the major
participants. Owners have a range of investment models that they
can follow in pursuit of their interests. These interests and strategies all
play a role in shaping the contours of hotel investments.
In this module, you determined the interests and motivations of the three
major participants in hotel investments. You examined different types of
owners and matched investment projects with the appropriate owners.
You also identified the investment strategies prevalent in the hotel
industry and applied them to differing ownership interests.
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Module 2: Evaluating the Deal:

How Owners, Operators, and
Lenders Evaluate Proposed
Projects
1. Module Two Introduction: Evaluating the Deal: How Owners,
Operators, and Lenders Evaluate Proposed Projects
2. Watch: Managing the Acquisition
3. Watch: How Owners Measure Returns
4. Tool: Rules for the Owner’s Investment Decision
5. Watch: How Operators and Lenders Evaluate the Project
6. Read: Operator and Lender Metrics for Project Evaluation
7. Tool: Operator and Lender Project Metrics
8. Read: The Case of the Hungerford Hotel
9. Watch: Estimating Returns: The Case of the Hungerford Hotel
10. Watch: Market Valuation
11. Read: Market Comparison and Cost Approaches
12. Read: Income Approaches: Capitalization Rate Approach
13. Read: Income Approaches: Ten-Year DCF and Multipliers
14. Watch: Illustrating Valuations: The Case of the Hungerford Hotel
15. Estimating Value
16. Module Two Wrap-up: Evaluating the Deal: How Owners, Operators,
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Module Two Introduction: Evaluating the Deal: How

Owners, Operators, and Lenders Evaluate
Proposed Projects
Evaluating a potential hotel investment requires a
thorough understanding of the financial implications of the
deal. Producing accurate estimates of the returns for
owners, operators, and lenders is a crucial first step in
assessing the viability of a specific investment.
Owners, operators, and lenders must be able to

accurately estimate their returns before they can decide whether to
proceed on a prospective investment. Owners drive the process. They
must estimate their own returns and determine whether the returns for
the operator and lender are sufficient to entice them into the deal.
In this module, you will explore how owners, operators, and lenders
evaluate possible hotel investments. You will estimate the return on
investment and return on equity by calculating the net present value and
the internal rate of return. You will also examine the three approaches to
value property and apply each method to produce estimates of value.
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Watch: Managing the Acquisition

Now that we have considered what motivates owners, and examined
some of the strategies owners employ to create wealth, it is important to
explore how owners evaluate a potential project. In this video, Professor
deRoos provides a four-step acquisition process that can help owners put
together a successful hotel real estate project. The process allows the
opportunity to envision the project and confirm that the project is feasible
before any real investments are made.
Video Transcript
Here we introduce an acquisition process, generally has four phases.
First is a vision or ideas phase, where an owner decides what the project
will involve. The second is a feasibility phase, where you determine
whether the project is economically, politically, and physically possible.
Third comes a commitment phase, where the owner obtains the
commitments necessary to make the project successful. And finally a
closing phase, where the owner perfects those needed commitments.
Let's examine each one briefly in turn. The acquisition process starts with
a vision. The developer has to have a vision for why they are acquiring
the property and what they want to achieve in the end. Is this a new
hotel, a repositioning or redevelopment story? How is success defined?
What is my exit strategy? Developing this vision involves a study of the
competitive market, the relative and relevant macroeconomic factors, and
the objectives and goals of the owner. The vision is usually expressed as
an investment plan for the property. The next phase is feasibility. The
outcome of the feasibility phase is a go or a no-go decision on the
investment.
There are three legs to the feasibility stool, any one falls down, your
project falls down. The first leg is financial feasibility, the major focus of
this course. The big question here, are the financial benefits greater than
the cost anticipated for acquisition? Will this project meet the financial
needs of the owner? The second leg is political feasibility. A big question
here is, do I have, or can I obtain, the entitlements to do what I wish to do
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with the property? What are limitations on changes to the property, and
can I successfully bargain with political entities, and with the public, to
achieve my goals? And the third leg is physical feasibility.
The big question here is will the site itself support the improvements that I
would like to make. Again, each of these feasibility questions needs to be
answered positively before a project is allowed to proceed. Assume now
that we've answered yes. The project is financially feasible, politically
feasible and physically feasible. So, now we seek our commitments. This
can also be visualized as perfecting that three-legged stool where
feasibility is turned into firm commitments. Financial feasibility must
become commitments from lenders and partners to fund the project.
Political feasibility evolves into firm commitments from public officials to
issue permits and approvals necessary to complete the project. Physical
feasibility becomes a commitment from an operator to manage the
project, as well as a myriad of engineering and construction matters.
Once the commitments are obtained, there's a closing phase. This is
simply the phase where you perfect all of the commitments. You borrow
the money from the lender, sign the management agreement or franchise
license, obtain the needed permits and approvals, and purchase and
develop the hotel with title changing hands from a seller to a buyer, and
then once complete, take beneficial occupancy. Done rigorously, the
process allows ample opportunity to test assumptions, and most
importantly, to not commit huge amounts of funds without being very
certain that the commitment will result in a positive outcome for all
stakeholders. At each stage before commitment, it is possible to proceed
or to cancel the project and return to the vision phase or look for a
different opportunity.
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Watch: How Owners Measure Returns

An important part of the acquisition process is determining whether the
project is financially feasible. To make this determination, owners must
be able to precisely estimate a return on their investment. In this video,
Professor deRoos discusses two ways to model returns, including a
return on investment model and a return on equity model. He provides
some decision rules for evaluating an investment and you will be able to
download these on the next page.
Video Transcript
In this video, we look at how returns are measured. We'll start with, how
do owners evaluate an investment? To make informed investment
decisions, you must be able to estimate a return on your investment.
There are a number of ways to go about this. In this section, we look at
two ways to model returns; return on investment model and return on
equity model. The return on investment model is appropriate when we
want to assess the returns for the entire investment, debt and equity both
included. The same technique can be used to estimate the value of a
property.
For the return on investment model, we discount cash flows at a

weighted average cost of capital that includes the required returns to both
debt and equity. The discount rate is often characterized as a hurdle rate,
or minimum required rate of return. In a corporate setting, this hurdle rate
represents the firm's risk adjusted cost of capital. Projects must earn this
minimum rate, or they destroy value for the firm. In a valuation setting,
the hurdle rate is that rate that represents the average returns for
investors in analogous properties. Again, it is the minimum return
required to induce investors to invest in the property.
So now let's take a look at a timeline, which lays out symbolically how the
cash flows happen. An arrow down is money out of your pocket into the
deal, a cash investment. Arrows up are money out of the deal into your
pocket, that is the cash returns. In our simplified model at time zero, we
buy the property using both debt and equity capital. The property then
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produces cash flows on an annual basis. For hotel investments, this is

called a net operating income, or NOI, as shown in the arrows up for
years one, two, through the end of the holding period. Then at the end of
the holding period, we sell the property to complete our investment cycle.
The investment analysis proceeds by assuming that the property will be
sold at the end of the holding period, often modeled as 10 years. This is a
device to monetize all of the future flows beyond the end of the holding
period into a single flow. The sale price is estimated to be the market
price at the end of the holding period. From that, we deduct any selling
expenses or other fees associated with unwinding the deal, which for a
hotel, might include a management contract buyout, a franchise license
buyout, and certainly legal costs and brokerage fees.
So, we have a set of positive cash flows from years one through the end
of the holding period. We discount those at our hurdle rate each year
starting in year one and continuing through the end of the timeline. Well,
then we add these values to the negative total investment in year zero.
The sum of all of these cash flows is called the net present value of the
project. Later in the course, we will do this using an example with specific
numbers. And now we have a decision rule. If the net present value is
greater than or equal to zero it indicates a positive investment. If it's less
than zero, it indicates negative, do not invest. Alternatively, we can
calculate the internal rate of return, which is that discount rate that makes
the net present value equivalent to zero. Here the decision rule is to
compare the internal rate of return to our hurdle rate. If that IRR is greater
than or equal to our hurdle rate, we invest. If it's not, we don't invest. So,
that was the return on investment model.
Now we turn our attention to the return on equity story. Here, we look at
specific financing arrangements for a specific investor. An equity
investor's primary concern is the return on their own equity investment.
We don't look at the cash flows to the entire property, rather we look at
the flows to equity after considering the debt service. At the beginning of
the investment you invest equity, which is generally the total project cost
less any debt capital that you have borrowed. You obtain the cash flows
after debt service for each year on the timeline. The annual cash flow
after debt service is the NOI from the previous example, less the
obligation to the mortgage lender, which is their annual debt service. At
the end of the holding period, the equity investor receives what's called
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the equity reversion. It starts in the same place as a return on investment

model. We sell the property, we have selling expenses, and we have all
the cost to unwind like the management contract buyout or a franchise
license buyout. In addition, we have to pay back our lender any
outstanding mortgage balance and any fees associated with paying off
the loan balance at the end of the holding period. What's left is the equity
reversion to the equity investor.
Calculating the net present value now proceeds by discounting the equity
cash flows. The discount rate used now is called the before tax equity
hurdle rate or an after tax equity hurdle rate. In this course we'll be using
after tax equity, hurdle rate. It is generally higher than the discount rate
used on the return on investment model seen previously. We take those
cash loads to equity, discount those at the equity discount rate, calculate
an MPV, calculate an IRR, apply our decision rule, which is a positive
NPV, or an equity IRR above our hurdle rate, indicates a positive
decision is warranted.
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Tool: Rules for the Owner’s Investment Decision

• Use the rules for the owner's
investment decision to help
evaluate your hotel real estate
investments.
Owners must conduct a thorough analysis of the returns on a potential

hotel investment before deciding whether to proceed with the project. As
Professor deRoos described, there are two models for this analysis: the
return on investment model and the return on equity model. Each model
has decision rules that help an owner determine whether or not to invest
in a hotel property. Use these decision rules when you are evaluating
your own hotel real estate projects.
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Watch: How Operators and Lenders Evaluate the

Project
Just as owners need to determine if a hotel real estate project is
financially feasible, operators and lenders need to perform a similar
analysis. In this video, Professor deRoos outlines the methods that
operators and lenders use to determine whether an investment will meet
their return or yield requirements. Then, he provides more detail on the
specific metrics that operators and lenders use to evaluate potential
investments on the next page.
Video Transcript
Now that we've explored the owner's returns, it's also important to look at
the returns of the operator and the lender. However, they use different
benchmarks to evaluate a prospective hotel investment. So we'll examine
them separately. Operators have two sets of criteria by which they
evaluate a prospective consignment. The financial criteria are dominated
by their interest in earning management fees from the hotel and in
earning those fees over a very long time. An owner committed to the
hotel's manger and brand standards results in a stream of management
fees that allow an operator to earn a healthy return on their time and
investment in the property. Operators calculate a net present value. They
don't calculate internal rates of return.
As we'll see, the internal rate of return is not a good measure of the
operator's returns. The financial metric that operators are most interested
in is a net present value per room or a net present value per key.
Additionally, operators have non-fee oriented evaluation criteria. What
operators want to know is the following; is this hotel consistent with my
growth plans, and if I have a brand, is this hotel consistent with the brand
quality and the long-term growth of a brand in the market? Lastly, is this
owner likely to support the brand and be a positive influence. Other
qualitative factors include the owner's willingness and ability to fund cash
shortfalls and capital expenditures as well as the owner's anticipated
holding period. Their commitment to this hotel is certainly measured by
how long they want to own the hotel.
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All of the things being equal, an operator looks for an owner who is
committed to the project for a very long time. Lenders, on the other hand,
are yield-driven beasts. They look at the return on investment measured
as the internal rate of return on this loan, relative to the internal rate of
return if the funds were lent to another borrower on another project. The
metric they use is the risk-adjusted rate of return. Lenders use a process
called underwriting to make their decision. They underwrite three basic
items as they evaluate project. First, what is the quality of this borrower?
Second, what is the quality of this market? And third, what is the quality
of this project within the market, including their evaluation of any
manager or any brand affiliated with the project. Positive answers to
these three questions provide the lender with confidence that the cash
flows will exceed the annual debt service by a significant margin of
safety. A quality project in a good market with a superior borrower
assures a lender that the project is safe and in the rare chance that bad
things happen, there will be some flexibility on how the loan might be
restructured. And finally, a good borrower gives a lender some influence
on operation and recognizes the lender's significant interest in the
property.
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Read: Operator and Lender Metrics for Project

Evaluation
• Operators and lenders use different calculations
• Operators evaluate based on NPV
• Lenders determine the yield they can expect to realize on the loan
As you've just seen, operators and lenders use their own calculations to
evaluate a prospective investment. Here we provide greater detail on the
metrics they use to evaluate potential hotel projects.
Operators
For operators, the evaluation is purely fee-driven. It is driven by the net

present value (NPV) of the property, not by yields. The operator wants to
know if this is the right hotel compared with other potential projects. Do
the fees from the management agreement provide proper compensation
for the operator's services? If it is a branded operator, does the brand fit
with the project? If it is an independent operator, the brand is moot. It is
all about execution. Given that the operators cannot participate in every
hotel opportunity, they must determine if this is the best deal.
The operator must first determine the hurdle rate. Large firms know the
hurdle rate in advance. It is the firm's weighted cost of capital plus any
risk premium for a specific deal (though this risk premium may not be
included for certain low-risk deals). An independent operator is unlikely to
know their cost of capital. They generally use a discount rate in the range
of 10%-15% to compensate for risk and the opportunity cost.
Look at the diagram below:
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We determine the NPV of the property by taking the management fees,

deducting the direct costs, and then discounting for each year at the
operator's hurdle rate. The fees include pre-opening fees paid to the
operator and pre-opening expenses paid by the operator. They include
the management fees received by the operator each year (including base
and incentive fees) less the operator's overhead costs. Finally, they
include the contract termination fee paid to the operator at disposition. All
these fees are discounted at the hurdle rate and the resulting sum is the
NPV.
Given the nature of the operator’s business, the NPV is always a positive
number; remember the operator is operating the hotel on behalf of the
owner and most of the operator’s costs are paid by the owner; the
exception is the cost of the operator’s central offices and overhead.
Thus, a positive NPV is not an indicator that the operator should say yes
to the deal. Rather, operators calculate the NPV per room and compare
this to an internal benchmark that is calibrated to the fees they earn at
other hotels. If the NPV per room at the subject hotel is above the
internal benchmark, the decision is to proceed with the deal, if it is less,
the decision is made to decline the deal.
Lenders
For lenders, the calculation is quite different. Lenders like hotels because
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they get a yield premium (higher interest rate) due to the added risk.
Hotels are the riskiest of the major real estate options (which include
office, multifamily, retail, and hotel) with the highest rate of delinquency
and default. Because of this, hotels have the highest returns to lenders,
as the lender incorporates the risk into the loan via a higher interest rate.
Hotel owners looking for loans must recognize that they are competing
against other real estate opportunities, not just other hotels.
For lenders, the key for any given hotel loan is clearing the hurdle rate.
Lenders are not concerned with NPV. Instead, they focus on the
internal rate of return (IRR). Here is a good illustration of how lenders
go about evaluating potential investments:
Lenders determine the yield they can expect to realize on the loan. The
major cash flow out for the lender is obviously the mortgage principle, but
it also includes evaluation and administration expenses incurred before
the loan is issued. The lender obtains annual debt service, including any
contingent interest, over the course of the holding period. Administrative
expenses are subtracted from this debt service. The lender calculates the
IRR for each of these annual flows. If the IRR calculation results in a yield
larger than the lender's hurdle rate, the lender is likely to find the loan
attractive.
An owner interested in successfully negotiating a hotel investment must

be able to estimate the returns for each of the major partners; remember,
not only does the owner need to have a positive decision for their financial
analysis, but the operator and lender need to have positive decisions as
well.
Note that you will be able to download these diagrams on the next page.
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Tool: Operator and Lender Project Metrics
• Use the operator and lender

metrics to structure investments
that meet everyone's objectives.
On the previous page, you saw that operators and lenders use different
calculations when evaluating a prospective hotel investment. An owner
needs to be able to estimate the returns for each party to put together a
project that meets the everyone's objectives. Use the summary of the
operator and lender project metrics shown on the previous page to help
you structure successful hotel investment projects.
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Read: The Case of the Hungerford Hotel
The Hungerford Hotel
Now that we've examined how owners, operators, and lenders evaluate
projects to determine if they will receive their desired returns, let's look at
how this works out in a real-world situation. Here we introduce an
investment possibility facing Alexandra Rodriguez and her firm, TarHeel
Development. We use this fictional example throughout the rest of the
course both to illustrate the concepts we are considering, and to keep
ourselves rooted in a realistic scenario. We begin with some necessary
background and context.
Case Background
Alexandra Rodriguez sits in her office at TarHeel Development (THD)

reviewing the proposed fictional Hungerford Hotel in Grandville, a
growing southeastern city in North Carolina's Research Triangle.
Recently, THD has concentrated on developing Hungerford Hotels, a
200-unit chain similar in concept to Hilton Garden Inns and Courtyard by
Marriott. THD has just successfully opened three Hungerford Hotels in
the Southeast. They operate the hotels under a franchise license from
Hungerford, a US-based hotel company. The proposed project is THD's
first Hungerford in the Research Triangle region.
TarHeel Development
THD is a family-owned business started about 40 years ago by Gus

Chung, a Chinese immigrant. Gus started the business with a small
roadside motel and the firm grew with friendly service and a "hands-on"
management approach. The firm has grown from two small independent
motels to a portfolio of 15 branded hotels plus other real estate holdings.
What was a small owner-operator of independent small hotels is now a
respected regional developer and owner of branded select service hotels.
Alexandra has worked at THD for 10 years. Her primary role has been
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that of vice president of development, responsible for finding new

development sites and building the appropriate hotel on the site.
The Investment and Financing Decision

THD has submitted a loan application for the project to the local
commercial bank (LCB). The following summary data has been
developed:
THD's development department has estimated the cost to develop as

$36,000,000. The construction costs have been verified by a general
contractor, and the furniture, fixtures, and equipment (FFE) costs are
based on those of a similar hotel that opened recently. The bank's
appraiser prepared a forecast of hotel operations, and used that to
generate an estimate of market value of $37,500,000. Alexandra feels
that the Grandville economy is much stronger than indicated in the
market study and appraisal report. She is convinced that property
performance will be stronger than the bank's appraisal pro forma
indicates. However, LCB insists on using the appraisal report's estimate
of market value in their evaluation. The bank's conservative approach is
evident in the size of the loan they are willing to extend, which is 75% of
the costs of development, not 75% of the appraised value.
Last week, Alexandra submitted her loan application to the local

commercial bank. The bank responded favorably, indicating that the
project would be considered for a loan, given the success of THD's two
recently completed projects. The senior loan officer provided a term
sheet with the following loan terms:
Development
$36,000,000
cost
$27,000,000, based on a
Loan size
75% loan-to-cost ratio
Interest rate
4.75%
on mortgage
Amortization 25-year term, monthly
term payments
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THD has a long relationship with the LCB and feels that continuing to
"shop" the loan would not be productive. Both Gus and Alexandra believe
in the Hungerford concept and feel that a new hotel in Grandville would
be a great success, especially in light of the firm's recent experience with
the brand. To support the investment decision, Alexandra must calculate
the returns on the investment, using the current loan terms from LCB. To
do so, she will need to answer several key questions:
What is the net present value (NPV) of the overall investment decision,
not considering borrowing?
What is the NPV of the equity investment decision, after taxes?
What is the NPV of the management contract, as THD pays its
management subsidiary a management fee to manage the property?
What is the lender's yield on the mortgage loan?
Gus would like to have the answers to these questions within a week, as
he is anxious to make a decision about the project.
You can download the description of the Hungerford Case Study for your
reference.
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Watch: Estimating Returns: The Case of the

Hungerford Hotel
Alexandra Rodriquez has several questions to answer so that the fictional
TarHeel Development firm can decide whether to pursue the Hungerford
Hotel project. In these videos, Professor deRoos uses an Excel-based
tool that calculates the answers to these questions.
Revenue and Expenses
First, Professor deRoos will review the investment assumptions and

examine the pro-forma, which includes a projection of revenue and
expenses.
Video Transcript
Alexandra Rodriguez is faced with the investor's classic feasibility

dilemma needing to answer the question, is the value greater than the
cost? She'll need to answer some very key questions: What's the NPV of
the overall investment? What is the NPV of the equity investment
decision? What is NPV the management contract? And, what's the
lender's yield? To answer these questions requires a thorough analysis
using the best available information at the current time. We're going to
start by taking a look at a pro forma that Alexandra has prepared
modeling the expected performance of the property over the first 11
years.
We'll start with the first year, obviously. In this case, at the very top are
some property metrics. It's a 200-room property with a 66% occupancy,
and $154.50 average daily rate in the first year. These get transformed
into four sections below. There's a revenue section with rooms revenue,
food revenue, beverage revenue, and some rentals. Below that,
departmental expenses directly related to those revenues. And then the
two sections below that are two buckets of overheads that are charged
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against the property that are very, very difficult to allocate to any
individual department, everything from administrative and general
expenses to energy costs. And then down in the fixed charges, we have
the management fee, property tax, insurance, and our reserves for
replacement. The way that the uniform system accounts is built is the
manager is responsible for generating revenues, controlling departmental
expenses and controlling these undistributed opportunity expenses. The
owner is responsible for these fixed charges down below.
Note that this property is expected to have a 66% occupancy in the first
year and exhibits a classic occupancy trajectory for a new hotel, which is
it stabilizes after two or three years of operation. In this case, 66 the first
year, 68 the second year, 70 the third year, and the fourth year of
operation, we stabilize at a 71% occupancy rate. Note that the property
improves its efficiency over time with the efficiency measure as what
percentage is the EBITDA, or net operating income, as a percentage of
total revenues. In the first year, we have an NOI $2,584, I'm sorry
$2,584,000, which is 22.9% of total revenues. This efficiency, or NOI
margin, grows from 22.9% to 25.8% in the fourth year of operation. It's
vital to include this increase of efficiency as a proper modeling technique
as we look at the way the hotel operates over time. Once the hotel
reaches stabilization, note that this percentage stays constant over time,
as there's no way to increase the efficiency of the operation without costs
going up at a slower rate than revenues are.
Video Transcript
So, Alexandra has just completed her 10-year projection of cash flows.
She is now ready to do her investment analysis. Let's take a look. We
start with a first page of investment analysis assumptions. We start with a
little description of the property and the cost, $36 million. Overall
assumptions include a holding period of 10 years. We're going to sell this
building for 12 1/2 times cash flows at the end of the holding period,
equivalent to an 8% cap rate. I won't read the rest of the assumptions;
you can read these on your own. I'll highlight a few important ones,
however. The total property discount rate is 11%, meaning if we own this
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property without debt we would want to earn on a before tax basis an

11% rate of return. However, Alexandra is borrowing 75% of the funds
needed to build this hotel. And out of her remaining 25% equity, or $9
million investment, she'll want to earn 16% on an after tax basis. We've
put in a series of lending parameters. The key, in this case, is a $27
million loan from the bank at 4.75%.
We have a tax environment that's necessary to compute our income

taxes. And then finally we have a set of parameters, a very small set, to
value the management contract. We have the overall desired rate of
return from the manager, 12%. The margin on the manager's fees,
meaning this manager earns 50% of the gross fees get converted into net
fees. And the manager has a valuation for this managerial contract,
approximately four times the most recent 12 months' fees. Now, let's take
a look at how this all is executed when we lay this out into our investment
analysis. We'll start by looking at the operating cash flows over time.
Here we have a 10-year equity cash flow projection. This is supported at
the top of the spreadsheet with a set of cash flow projections that just
simply gather cash flows for us to look at.
Again, the most important part of this is our 10-year equity cash flow
projection. We've separated this into a tax calculation and a cash
calculation. The tax calculation is formidable, I won't go through it in
excruciating detail, but we start with our bottom line, our net operating
income. We make a series of additions and subtractions from that to be
able to calculate, in the end, our ordinary taxable income. Apply a tax
rate to that income to determine or estimate our income tax in the first
year and beyond. Now to our cash calculation. This is the most important
calculation on this sheet. We start with our net operating income, deduct
the annual debt service to the lender, deduct our income tax to get a net
cash flow equity. In this case, we're projecting $504,000 the first year of
operation and that grows to well over $1 million by the end of the 10th
year, as we see. These cash flows are again, after tax, after debt, these
are the net cash flows that Alexandra is expecting to achieve over a 10-
year holding period. But that's not the only cash flow we have.
We have to now take a look at the cash flow from sale. So here we have
it, we have a calculation of a simulated sale at the end of the holding
period. This first panel, listed A, calculates our sale price. We're
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estimating this property is worth $52 million at the end of the holding
period. Contrast this to our $36 million cost to build. Alexandra thinks this
hotel will sell for $16 million more than it cost to build. Probably a very
reasonable assumption. She subtracts from this $52 million figure some
selling expenses, which will be the cost of a broker and counsel to help
sell the hotel. So she nets $50,629,000. From this, she needs to deduct
the remaining mortgage balance on the loan to get to a before tax equity
version of $30,000,000.
Again, think about what's going on here. We sell the property for 50
million net. We have to pay off our lender any funds owed at the end of
this holding period. To get to it to a before tax reversion, $30 million. The
remainder of this sheet, C and D, help us calculate our taxes due on sale.
In the end, the bottom line is for a $30 million sale, Alexandra will have to
pay $5.3 million of taxes. We subtract this $5.3 million of taxes from the
$30 million before tax equity reversion, to get an after tax cash flow or
reversion from sale, $25.5 million dollars. Again, it's important to step
back from this and say what's going on here? Alexandra invests $9
million in year zero, 10 years later, she's able to sell the hotel and take
out a $25 million cash flow.
Note that all of the $16 million increase in value flows to the equity, which
helps to drive the returns. The only other information on this sheet is the
valuation of the management fee at the end of the holding period. We
have our management fee flows, $811,000. Four times that is the
expected selling price of that management contract if it were sold. Deduct
a little bit of selling expenses to, for legal and perhaps a brokerage fee,
the value of this contract at the end of the holding period net, $3.1 million.
So now we're ready to put everything together, and take a look at our
valuation returns.
Cash Flow and Sale Projections
Next, Professor deRoos uses a spreadsheet tool to review the cash flows
over the 10-year holding period and the equity cash flow projections
including tax and cash calculations. Here, he also examines the projected
after-tax proceeds from the sale of the hotel at the end of the holding
period. You can download this spreadsheet if you want to follow along.
You will also have the opportunity to download the tool later in the
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course.
Putting It All Together
Finally, Professor deRoos reviews the analysis to answer the questions

facing TarHeel Development:
1. What is the NPV of the overall investment?
2. What is the net present value of the after-tax equity investment
decision?
3. What is the value of the management contract?
4. What is the lender's yield?
Video Transcript
We start at the very top. This panel is noted as the overall property
investment decision, I won't highlight it too often. Let's see what's going
on. A $36 million investment in year zero, cash flow from operation from
years one through 10, and then a cash flow from sale, $50 million dollars
at the end of the 10th year. These are summed at the bottom and then
discounted at an 11% hurdle rate to determine their present value. When
we sum these together, what we find is a net present value of $1.48
million, meaning, this property generates $1.4 million of wealth over and
above the 11% hurdle rate. The IRR of 11.61% is above our hurdle rate
of 11, again indicating a positive investment. But that's not what
Alexandra's really interested in. What she wants to know is what is the
net present value of her equity investment.
Let's take a look. She invests $9 million in year zero, obtains the cash
flow from operations after debt and after tax for years one through year
10 and then sells the hotel at the end of the holding period, pays the
capital gains tax and other taxes at sale. Pays the lender any remaining
mortgage balance and takes home $25 million. These are discounted at
our 16% equity hurdle rate to produce a net present value of $1.11
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million. Again, the interpretation of this is this property produces $1.11

million of wealth over and above a 16% after tax equity discount rate. Our
IRR of 17.75% is above our 16% hurdle rate. Both of these metrics,
positive NPV, IRR above our hurdle rate, indicate that this is a positive
investment decision. But she's not done. She needs to calculate the
value of the management contract, and the lender's yield.
Let's take a look at those. She estimates that the manager of this hotel
will earn, on a net basis, fees starting at $283,000 in the first year,
drawing to roughly to $394,000 at the end of the 10th year. And this
contract is worth $3.1 million at the end of the 10th year. She discounts
those at her assumed discount rate of 12%, she feels that the manager
would discount those at a 12% rate, to determine the manager contract
value of $2.88 million, or the ultimate metric $14,400 per key. She
compares this to her thumb rule. She feels that managers are very
interested if the management fees are in the range of $12,000 to $15,000
per key and they're much, they're even more interested if they're above
that rate, but this is well within the range that managers would consider to
be attractive. Her last task is to compute the lender's yield. The lender
invests, or lends, $27 million, obtains annual debt service, $1.87 million
per year for 10 years.
In this case, we're assuming that this lender will earn 1.5% of total
revenues every year starting in the fourth year. So that's 198,000 of extra
interest in the fourth year, 204 in the fifth year, etc. The last flow we need
to worry about is the remaining balance. Recall that Alexandra borrows
$27 million, or the bank provides $27 million. At the end of the 10th year,
the bank's remaining balance is $19.79 million. So we would pay that
back to them. The yield or IRR implied by all of these flows is 5.26%,
significantly above the 4.75% rate on the loan. And what Alexandra
knows is this is above the equivalent rate that could be earned at
apartment buildings or other commercial property. She's very convinced
the lender would be interested in this loan given this yield and the quality
of the project.
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Watch: Market Valuation

To make informed decisions about a prospective or an existing hotel
investment, all parties need to have accurate estimates of the value of
the hotel property. There are a range of different methods used to
produce these estimates, each with different strengths and
weaknesses. In this video, Professor deRoos explores why it is important
to understand the value of a hotel and reviews the three key approaches
to estimating value: the market comparison approach, the cost approach,
and the income approach.
Video Transcript
Recall from our Hungerford discussion that the lender had appraised the
proposed hotel for $37.5 million, above the $36 million cost of
development. This is a very key event in the development of the property
as an independent appraiser has produced an opinion of value. It helps
support the bank's decision to lend. Specifically, the bank finds comfort in
knowing that the $37.5 million market value helps to secure their $27
million mortgage. In this section, we'll be looking at the classic real estate
problem. How do we determine the value of a property in the absence of
selling it? What is the property worth both pre-development and post-
opening in the absence of a sale to support the value? Why would
anybody be interested in knowing the value of the property that's not for
sale?
As we've just seen, the first reason to value a property is to inform the
investment decision and lending decisions about a property. Investors
and lenders hire appraisers to produce an estimate of the market value of
the proposed property so that the initial investment and lending
underwriting can proceed. The second reason to value the property is an
absolute bedrock piece of information needed to calibrate a hold versus
sell decision in an asset management context. Investors traditionally
decide on an annual basis whether or not they should continue hold
properties and continuing to earn the expected returns or to sell that
property and redeploy the capital to better opportunities. You cannot
make that decision without an estimate of the market value today. A third
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reason to value the property is to inform the calculation of holding period

returns. We know what the income returns are, they're the cash flow from
the property. But the second piece of the return is the change in value
over time, or appreciation return. Without periodic estimates of market
value, we can't calculate the change in value to calibrate our appreciation
returns. A fourth reason to value a property is to inform portfolio
decisions. In this context, what is needed is an estimated market value to
inform whether or not the property contributes to the portfolio risk and
return as expected.
So now that we've motivated the need for appraisers. How do appraisers
go about producing estimates of market value? Recall that we're in an
environment where we don't have information on what the price is
because we haven't sold the property. Appraisers rely on three traditional
methods to produce an estimate of market value: a market comparison
approach, a cost approach, and an income approach. Let's start with the
market comparison approach. My property, the subject property, should
be worth the same amount of money that a similar property recently sold
for. So, we collect data on what similar properties have sold for, adjust
them for differences amongst the properties, and determine a value
estimate for the subject property.
Using the cost approach, the subject property should be worth what it
cost to build, less any depreciation that's accumulated. The property
won't be worth much more that what I can spend to build it new, including
a developer's profit. So, the cost approach provides a useful upper bound
on value. The third approach, the income approach, is the present value
of all the future income streams or cash flows that I expect to achieve
over some holding period. This can be done in a variety of ways as we'll
see. Appraisers and investors use all three sets of information to inform
the market value estimate. In the United States, appraisers are required
to do this as part of the Uniform Standards of Professional Appraisal
Practice or USPAP. Internationally, the Royal Institute of Chartered
Surveyors, RICS, provides the standards for industry practice. Appraisers
in both cases use all three approaches, because each carries different
and important information used to inform the market value estimate.
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Read: Market Comparison and Cost Approaches
• Market approach is useful if there are a number of analogous

properties for comparison
• Cost approach is useful for properties built according to chain

standards or for new properties
Here we look at two of the three main approaches used to estimate the
market value of a hotel property. First, we consider the market
comparison approach, where the property should be worth what an
identical property just sold for. Next, we consider the cost approach,
where the property is worth the cost to construct a replacement, less
depreciation.
The Market Comparison
The market comparison approach is useful if there are a number of

analogous properties for comparison. Taken step-by-step, a market
comparison is conducted as follows:
1. Research the hotel transaction market to find recently sold, similar

properties (called "comparables") and determine accurate data
such as price, room count, amenities and condition of the property,
and conditions of sale from each of the comparable properties.
2. Reject comparable properties that may not be good value
indicators for the subject property. This is usually due to non-arms
length transactions (related party or seller financing) or partial
interests that are sold.
3. Compare the physical characteristics, location, time of sale,
condition of the property, and financing of the comparable
properties with those of the subject property.
4. Where the subject property and the comparable properties differ,
adjust the comparable property's selling prices according to the
market reaction to those differences.
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5. From this analysis, estimate a final value for the subject property.
The strength of the market comparison approach is based on the

availability of data from similar properties sold recently. The approach
does have distinct limitations. First, its use is limited by any rapid or
extreme changes in market conditions that affect price. Second, no two
properties are ever truly comparable, a problem that gets worse with
unusual or unique properties and with higher-quality properties.
The Cost Approach
The cost approach is especially useful for properties built according to

chain standards and for relatively new properties. Again, let's take a step-
by-step look at this approach:
1. Estimate the new cost to reproduce or replace the structure and

other improvements, not including the land value. A reproduction
refers to a complete replica. A replacement refers to a building of
similar utility or usefulness applying currently used materials and
building techniques. The replacement cost is most often estimated
as it is easier to apply in practice, especially for older buildings.
2. Estimate the loss in property value (depreciation). This may be
done using a straight-line method based on the property's age as a
percentage of its useful life, or a breakdown method that takes into
consideration physical deterioration, functional obsolescence, and
economic obsolescence.
3. Deduct total depreciation from the estimated replacement cost.
4. Estimate the value of the land as if it were vacant, typically using
the market comparison approach.
5. Add the land value to the depreciated replacement cost to obtain a
total value estimate via the cost approach.
Even in circumstances when the cost approach is most applicable, it still

has limitations. Cost estimates may be inaccurate, and depreciation
estimates are highly subjective.
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Read: Income Approaches: Capitalization Rate

Approach
• Income approach is based on the

present value of future cash flow
• The capitalization rate is a

weighted average of the cost of
mortgage financing and the cost
of equity financing
• This technique is very useful for

stable properties in stable
markets
Income approaches are used to value a hotel property based on the

present value of the future cash flows the property is expected to
generate. There are a number of different ways to value these flows. We
will examine the most common approaches.
Let's begin with valuing the flows using the capitalization rate approach.
First, we'll look at the model, and then at an example (Note: the colors in
the calculations are keyed to the analogous lines in the Los Angeles
Appraisal example below). In the model, the value is equal to the
stabilized net income divided by the capitalization rate.
Stabilized Net Operating Income (CFFO)
Model: Value = __________________________________________
Capitalization Rate
The stabilized net operating income is derived from a forecast of

revenues and expenses, with the cash flows estimated using the
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appraiser’s estimate of long-term equilibrium conditions for the property.

The net operating income used for the appraisal is not the most recent
figure, rather it results from the appraiser’s careful evaluation of the
revenues and expenses that would result from competent management
running the hotel in a long-run equilibrium. Now, let’s look at how the
capitalization rate is calculated.
Capitalization Rate Calculation
The capitalization rate is a weighted average of the cost of mortgage

financing and the cost of equity financing, with the weights based on the
proportion of each type of capital in a typical hotel investment. Each
component is estimated separately and the two components are added
together:
(Leverage times Rate)

(Loan-to-value Mortgage
Mortgage Component x
ratio Constant)
(Equity-to-value Equity Dividend
Equity Component x
ratio Rate)
Overall Capitalization
Sum of the Two Components
Rate
First, take the loan-to-value ratio (LTV ratio) and multiply it by the
mortgage constant. Second, take the equity-to-value ratio (ETV ratio) and
multiply it by the equity dividend rate. Lastly, summing these two
numbers gives an estimate of the capitalization rate.
Let's see how this looks in a real world example, not related to the
Hungerford. Imagine an appraiser charged with valuing a proposed hotel
in Los Angeles, California. She does her research and finds the following
information is applicable to the assignment:
Market Information for Los Angeles Appraisal
The model produces a very precise answer, estimating the value down to
the dollar. Remember, however, that this is an estimate. The capitalized
value of the property is approximately $122.7 million.
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What are the strengths and limitations of the capitalization rate

approach? First, the model is analytically compact. It doesn't require a
multi-period forecast and relies on clearly observable capital markets
information, a clear plus. Second, the property and capital market
information needed is very supportable. The only difficulty is finding data
for the equity dividend rate. The technique is very useful for stable
properties in stable markets. On the limitation side of the ledger, the
model doesn't recognize changes in the market or the asset. If future
cash flows are different than those in the past, estimates of the stabilized
year are notoriously difficult. Also, it is not a yield-driven model, it is a
dividend model, and investors are driven by yields. Finally, keep in mind
that it does not consider cash flows over the holding period and sale at
end; it is just a single-year model.
Market Information for Los Angeles Appraisal
eighted
verage
.0395215
.0420000
.0815215
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Read: Income Approaches: Ten-Year DCF and

Multipliers
• 10-year DCF considers cash flows over the holding period
• Depends on having good forecasts
• Multiplier models are generally not very precise
10-Year DCF
Now let’s turn to a second income approach to valuing the flows, a 10-
year discounted cash flow or 10-year DCF. To perform a 10-year DCF,
one applies similar calculations to those used when estimating property
returns. First, estimate annual net operating income (CFFO) over the 10-
year holding period. Then, estimate what the property would sell for at the
end of the 10th year and subtract any selling expenses (called the net
sale proceeds). The sale price is estimated by dividing the Net Operating
Income (NOI) for the 11th year by the terminal capitalization rate. Cash
flows and sale proceeds are all discounted by an overall discount rate.
The totals are then summed to arrive at the total valuation.
Let’s look at this through an example. For this example, we’ll return to the
appraiser charged with estimating market value of a Los Angeles hotel.
The appraiser finds the following information; investors have a 10.5%
hurdle rate (or minimum return) for hotels; the hotel is likely to command
a capitalization rate of 8.15% at the end of the holding period (with 3%
selling expenses). The appraiser has done a market analysis, has
estimated revenues and expenses, and has thus derived an estimate of
NOI each year for 11 years; starting with the first year income of $10
million and an 11th year income of $12.776 million. Lastly, the appraiser
has estimated the selling price by capitalizing the year 11 NOI by the
8.15% cap rate and deducted selling expenses to arrive at a net sale
proceeds of $152.062 million in the 10th year.
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To arrive at the valuation, divide each year’s cash flows by the discount
rate to arrive at the discounted cash flow for each year (1-10) of the
holding period. The discount factor is calculated as one divided by the
discount rate raised to the nth power, where n is the year of the cash flow.
For example, the discount factor of 0.818984 for year 2 is calculated as
1/(1.105)2. The value of the hotel is the sum of the annual discounted
cash flows. In this example, the value is $119.889 million, rounded to
$120 million.
Value Estimate Using a 10-Year DCF (in 000's)
10th Year Reversion Calculation—

Hotel
Assumptions Estimated Hotel NOI in the 11th
Overall Discount Year Divided by the Cap Rate
10.5%
Rate Estimated Year 11 NOI $12,776
Hotel Capitalization Rate 8.15%
Capitalization Rate 8.15%
Expected Sale Price $156,765
in Year 10
Less: Selling Expenses $4,703
Selling Expenses 3.0%
Net Sale Proceeds $152,062
Growth in NOI
3.0% Property Valuation
after 5th year
Net Operating
Year Cash Discount Discounted
Income (NOI) Year
Flow Factor Cash Flow
1 $ 10,000
2 $ 10,100 1 $ 10,000 0.904977 $ 9,050
3 $ 9,500 2 $ 10,100 0.818984 $ 8,272
4 $ 9,800 3 $ 9,500 0.741162 $ 7,041
5 $ 10,700 4 $ 9,800 0.670735 $ 6,573
6 $ 11,021 5 $ 10,700 0.607000 $ 6,495
7 $ 11,352 6 $ 11,021 0.549321 $ 6,054
8 $ 11,692 7 $ 11,352 0.497123 $ 5,643
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8 $ 11,692 0.449885 $ 5,260

10 $ 12,404 9 $ 12,043 0.407136 $ 4,903
11 $ 12,776 10 $ 164,466 0.368449 $ 60,597
Value of the Hotel $ 119,889
What are the strengths and limitations of the 10-year DCF? The 10-year
DCF is an accurate, supportable model that explicitly considers flows
over a holding period. It can also explicitly account for a cycle, unlike the
snapshot approach of the cap rate model. On the other hand, the 10-year
DCF requires a forecast of cash flows and is only as good as those
forecasts. Also, although the cap rate today is observable, the cap rate in
future (terminal cap rate) is more difficult to forecast. Changes in the cap
rate over the 10-year term would change the value of the property.
Room Rate Multiplier Models

In addition to the capitalization rate approach and the 10-year DCF, we
will consider two multiplier models. Both are very quick, rule-of-thumb
models. First, the room rate multiple. You simply take the average room
rate and multiply it by $1,000 to get the value of each room (or key).
Then, take the value per room and multiply by the number of rooms to
arrive at your valuation. Let's take the simplest example, a 200-room
hotel with an average room rate of $100:
Average room rate ($100) x $1,000 = $100,000 value per room
$100,000 per room x 200 rooms = $20,000,000 value for hotel
What are the strengths and limitations of the room rate multiplier? On the
plus side, it is a simple, quick, and easy method that provides a solid,
rule-of-thumb estimation of a hotel's value. It is essentially a room
revenue multiplier, setting the value of the hotel at 3.5 to 4.5 times the
annual room revenue. On the other hand, any rule-of-thumb estimate is a
blunt instrument, unable to gauge value with any rigor or precision. More
specifically, this method poses a dilemma: what ADR do you use? Last
year? This year? A stabilized year? In practice, most people in the
industry use the current year, which can pose serious problems if this
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industry use the current year, which can pose serious problems if this
year is anomalous in any way.
Coke®-Can Multiplier
On a lighter note, let's look at a fun method we might call the Coke®-can
multiplier. Basically, this is the price charged for a soda multiplied by
$100,000 = the value of the room. Think about it: at your average Red
Roof Inn, sodas are available at a vending machine for about a dollar. As
you move up the star chain, the soda becomes pricier. At a Hyatt you
may pay $3 for a soda from the in-room mini-bar. At the Four Seasons
you pay $5 for the soda from room service.
Obviously, you should use this technique sparingly. Some properties

seriously "misprice" soda in relation to property value!
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Watch: Illustrating Valuations: The Case of the

Hungerford Hotel
Now that you understand the three approaches to estimating the value of
a hotel: the market-based approach, the cost approach, and the income
approach, we can use the example of the Hungerford Hotel to explore
each approach in greater detail. Alexandra needs to have reliable
estimates of value to facilitate her decision about the proposed project. In
this video, Professor deRoos reviews the data for the Hungerford using
each appraisal approach. Note how market-based information is used in
each approach to help inform the market value opinion.
Video Transcript
We've just finished exploring the three approaches to estimating market
value. Now we take a look at how they apply in practice, using the
example of the Hungerford Hotel. So how would the appraiser approach
the Hungerford assignment? The appraiser is charged with going to the
market and finding the information necessary to support the three
different approaches to value. Note how market-based information is
used in each approach to help inform the market value opinion.
We start with a market comparison approach. Here the appraiser has

gone to market and they've found three hotels similar to the Hungerford
that have sold recently. Hotel A is a Hungerford Hotel in a different
market, hotel B is a high quality hotel in the current city, Hotel C is a
lower quality hotel in the same city as the proposed Hungerford. The
appraiser determines information in each one; age, location, date of sale,
brand, quality, and makes an adjustment to these based on the
appraiser's feeling of how they relate to the Hungerford. In the first case,
Hotel A is systematically worse than the Hungerford and so that is
adjusted up by 8%. Similarly, Hotel B is systematically better than the
Hungerford, so that price is adjusted down 5%. Hotel C also has Brand C
on it, is a much older hotel, and so we make a significant adjustment up.
If it was the Hungerford, it would trade for much more. And you'll see that
in each case we make an adjustment that produces an adjusted sale
price in a tight range from $187,200 per key to 188,800 per key. They
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average at 188,000, and multiplied by 200, which is the size of our

Hungerford, we have an estimated value of approximately. $37.6 million.
So that's our market comparison approach.
Our next approach would be the cost approach. In this case, the
appraiser goes to the market and finds out what would the cost of land be
for this hotel, how much is construction, how much is the FF&E, and then
we have soft costs and pre-opening. They produce a credible estimate
for each one. They total to $36.5 million. No deduction for depreciation is
necessary in this case, as the Hungerford is a brand new hotel. So our
indicated value via the cost approach is $36.5 million. Our next two
approaches use the income approach to value. Our first is the
capitalization rate, built up from a mortgage of 4.5% for 30 years, which
results in a mortgage constant of 6.08%. Equity investors expect to earn
a 12% cash return on their investment, 65% of the weight is put on the
mortgage constant, meaning lenders are willing to lend 65% of the
capital. The remaining 35% earns a 12% return. The weighted average
cap rate Is 8.1521%, expressed here as a decimal. We take that cap rate
and apply it to a stabilized net operating income.
In this case, we use $3.1 million of stabilized net operating income, which
is the fourth year discounted for three years to obtain its current value.
Valuation via the cap rate approach, $38.12 million or roughly $38.1
million. The second income approach is a 10-year discounted cash flow
or a 10-year DCF. We estimate the net operating income or the cash
flows from the property. A sale at the end of the holding period and we
discount those at a 10.5% discount factor to produce an estimate of the
cash flows. These are summed, over our 10-year holding period, to
produce an estimate of value, via the 10-year DCF, of $38.2 million. So
now we're basically done with our valuations. The appraiser does one
more check though and does a room rate multiple. This is a thumb rule in
the industry that says the value per room is $1,000 times the average
daily rate in the first year. Well, from our appraisal we see that the
appraiser has estimated our room rate in the first year, $168.83 times
1,000, 168,830 per key times 200, indicated value via the room rate
multiple is 33.8 million, much lower than our other indicators showing that
this is not a reliable valuation tool.
Our next model is a little tongue-in-cheek, but we've noticed over time,
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that there's a relationship between the price of a can of Coca-Cola, and

the value per key in a room. So in this case, the Hungerford brand
standard is that Coca-Cola is sold for $2 per can in the vending machine,
indicating the value is $100,000 times the cost of a Coke. So our value
per key in this case is $200,000 times our 200-room hotel, our
remarkably accurate valuation of $40 million, again this is very tongue-in-
cheek, but we hope that you enjoy the fact that there is some relationship
between the cost of a Coke and the value per key. The appraiser ends
the assignment by reconciling in the value indicators. Here we pull
together our cap rate model, 38.1 million, our 10-year discounted cash
flow, 38.2 million, our market comparison approach, 37.6 million, and our
cost approach, 36.5, and feel that none of these dominates the other.
Based on these value indicators, these appraisers' market value estimate
is 37.5 million and it's supported by two income approaches, the market
comparison approach and a cost approach.
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Estimating Value
Assess the usefulness of different valuation methods and apply them as
needed to estimate the value of hotel properties in this required
evaluation.

score.
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Module Two Wrap-up: Evaluating the Deal: How

Owners, Operators, and Lenders Evaluate
Proposed Projects
Before owners, operators, and lenders decide whether to participate in a
hotel investment, they need to have an estimate of the returns of the
investment from their own perspective. Owners, operators, and lenders
all have different criteria by which they evaluate an investment and an
owner interested in successfully negotiating a hotel investment must be
able to estimate the returns for each of the major partners. Another
critical piece of information in putting together a successful project is the
estimate of the value of the property, which is used to inform both
investment and lending decisions.
In this module, you explored how owners, operators, and lenders

evaluate possible hotel investments. You estimated the return on
investment and return on equity by calculating the net present value and
the internal rate of return. You also examined the three approaches to
value property and applied each method to produce estimates of value.
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Module 3: Structuring the Deal:

Current Equity and Debt Financing
Structures
1. Module Three Introduction: Structuring the Deal: Current Equity and
2. Watch: How Do You Raise The Money?
3. Read: Equity Financing: Real Estate Equity Funds
4. Read: Equity Financing: Joint-Venture Agreement
5. Watch: What Do Lenders and Borrowers Want?
6. Ask the Expert: The Importance of Relationships in Lending
7. Read: Project Presentation for Lenders
8. Watch: Sizing the Mortgage
9. Tool: Mortgage Worksheet
10. Read: The Lender's Response: Term Sheet
11. Tool: The Hungerford Term Sheet
12. Mortgage Sizing
13. Case Study of the Hungerford Hotel
14. Loan Recommendation
15. Tool: Financial Analysis of Investments Action Plan
16. Module Three Wrap-up: Structuring the Deal: Current Equity and
17. Read: Thank You and Farewell
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Module Three Introduction: Structuring the Deal:

Current Equity and Debt Financing Structures
Real estate investments require large amounts of capital
and hotel owners use both equity and debt financing to
raise the funds necessary to finance their investments.
Different owners have different investment objectives and
utilize different equity financing arrangements based on
their needs. Once equity financing is secured,
owners use debt financing to complete the capital stack.
Understanding the implications of different financing arrangements
is critical to the success of any real estate investment.
In this module, you will explore the different options for financing hotel
real estate projects and will connect them to the different types of
owners. You will examine the loan-sizing process and will forecast the
size of a loan for a given project using the lender's underwriting criteria.
You will analyze a prospective loan from the borrower's perspective. You
will also make and defend an investment and financing recommendation.
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Watch: How Do You Raise The Money?

A wide range of options are available for financing a hotel project. In this
video, Professor deRoos discusses the concept of the capital stack,
including the relative proportions of debt and equity that make for a
successful project. He looks at our three fictional investors, Sophie, John,
and Alexandra, and explores how they might finance their projects.
Video Transcript
What is the proper capital stack? What are the relative proportions of
debt and equity capital that make for a successful project? Here we look
at Sophie, John, and Alex. And each has a different answer to these
questions. There are a wide range of options available for project finance.
Let's start with a classic notion of a real estate capital stack. We saw this
in a previous section as two types of capital, mortgage debt and equity.
Now let's open the stack up to a third type of capital called mezzanine
financing. Hotel real estate investments require large amounts of capital.
So let's start with Sophie. Recall that Sophie works for an insurance
company. Her fundamental driving goal is a desire to put large amounts
of her firm's capital to work as equity. She uses that strategically to boost
equity yield slightly, especially if small amounts of debt, say 20 to 40% of
the capital stack, add little risk to her equity position. Because she is not
capital constrained, she has plenty of funds to put to work, she has no
use for mezzanine funds. The real question that determines how much
equity Sophie contributes is the risk-adjusted return.
Now let's contrast Sophie with John. John works for a real estate
investment fund. Like Sophie, John's fundamental driving goal is to put a
significant amount of equity to work. But unlike Sophie, John wants to
achieve a significantly higher equity yield than Sophie. John uses large
amounts of debt capital to significantly boost the equity yield. His fund is
seen as a low risk borrower, so banks are generally willing to extend high
loan-to-value loans to John. It's not unusual for John to achieve mortgage
debt of 70 to 75% of the required capital, meaning he has to put in 20 to
25% equity into his deals. With less capital investors in each investment,
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John has to do many more investments than Sophie to achieve his

required equity returns.
Lastly, we take to look at Alexandra. Recall that Alexandra works for

hotel developer. She's fundamentally a wealth creator and is usually
severely cash constrained or capital constrained. She is full of creative
ideas, and wonderful sites to be developed or redeveloped, but she is
really short on capital. Alex needs to find capital partners willing to
support her vision of development. Her fundamental driving goal is to use
her limited capital to develop and redevelop capital by working with a
variety of capital partners. She's seen as a relatively risky borrower, so
banks are generally unwilling to extend high loan-to-value loans. In
general, it will be difficult for Alex to borrow more than 65% of the funds
from a traditional first mortgage lender. Alex wants to put in somewhere
between 10 and 15% of the capital stack. Thus, Alexandra has a gap
problem. Let's assume her firm has 15% of the capital needed for their
next hotel as equity, and the first mortgage lender is willing to invest 65%
in its debt. So 65% from debt, 15% from equity, she has a 20% gap
problem. The solution is to use mezzanine funds to bring her borrowed
funds from 65% to 85% of the total capital. While the mezzanine money
is more expensive than a mortgage, it's the capital that gets her deal
done. And it avoids the problem of having to find a partner for the
additional funds. According to real estate folklore, first you do the deal
and then you raise the money. The first money you raise is always equity.
So we will start with equity financing before moving on to that capital.
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Read: Equity Financing: Real Estate Equity Funds
• The fund sponsor raises equity

capital from many different
investors
• The sponsor provides their

expertise and raises debt capital
as needed
• Fund investors contribute equity

in exchange for a percentage of
profits, cash flow, and other
proceeds
Let's begin our look inside possible hotel investment capital stacks by
considering private equity funds. A private equity fund is a collective
investment mechanism where large amounts of equity capital can be
united, usually under the direction of a fund sponsor. The best way to
explain how this works is to take an example.
Illustration of Private Equity Structure
John Dough, our vice president of acquisitions at Black Hall Lodging,

works for a firm that is raising money for a private equity fund focused on
lodging assets. The firm makes proposals to potential equity capital
contributors to gauge their interest in the fund. John's firm proposes to
raise $1 billion for hotel investment. At this stage, Black Hall has no
specific plans to invest in any particular property; however, it does have a
strategy to purchase underperforming properties, and it has a track
record of achieving annual equity returns in excess of 20%. To raise the
$1 billion, John approaches potential investors such as high-net-worth
individuals, sovereign wealth funds, pension funds, endowments, life
insurance companies (in fact, John might approach Sophie at AIGH), and
other real estate investors. Those investors who agree to participate are
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trusting in Black Hall's record of achieved returns. They place their

contribution in a blind pool (they do not know what it is they are buying),
generally handing over control of their money for a three- to seven-year
period. While the fund has the ability to redeem 4% to 5% of the invested
equity each year, investors are mindful of the fact that their investment in
the fund is committed for the holding period.
Once the fund is assembled, John begins to acquire hotel assets. He

adds debt as needed, stretching the equity contribution as far as he can.
It would not be unusual for John to turn his $1 billion in funds into $3 or
$4 billion in real estate assets, using debt capital to supply the majority of
the capital needed for purchases.
Motivations of Each Party

What does each of the partners in the private equity fund provide and
what does each partner achieve?
The fund sponsor, Black Hall, primarily provides expertise. It is John's job
to source and acquire the properties for the fund. Black Hall also provides
seed money and administrative expertise for the fund. In exchange, Black
Hall receives:
Fees. These include acquisition, administrative, and management fees.

For example, Black Hall may typically receive a fee of 1% to 2% of the
value of the owned assets for asset management.
A percentage of annual profits and losses based on their investment in
the fund.
A “promoted interest” based on achieving and exceeding certain return
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hurdles for the fund investors.

A percentage of the net proceeds from refinancing and net proceeds
from the sale.
A percentage of tax benefits.
What about the fund investors? Obviously, their contribution is cash, paid
either as a lump sum or a staged pay-in. What do they receive?
A percentage of annual profits and losses based on their investment in

the fund.
A preferred cash return. ("Preferred" means that these investors obtain
a return prior to Black Hall obtaining their cash return.)
A percentage of cash flow from operations (after the preferred cash
return).
A percentage of net proceeds from refinancing.
A percentage of net proceeds from sale.
A percentage of tax benefits.
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Read: Equity Financing: Joint-Venture Agreement
• Joint ventures may be attractive to the small developer, who doesn't

have large amounts of capital
• Joint ventures require negotiation of key provisions, including

ownership percentages, roles, funding requirements, and termination
rights
Private equity funds are for the major players in real estate investment,
the "big players" with large amounts of capital for investment. What about
the small developer who does not have the track record or the available
capital, but has a great investment possibility and does not want to go to a
fund? For these developers, a joint venture is often the preferable route.
In this arrangement, the equity portion of the capital stack is assembled

through an agreement between two partners. Usually these consist of a
sponsor or developer, who provides the expertise, and a money partner,
who provides the majority of the equity capital. In the case of an
acquisition, the agreement is usually between a sponsor and a money
partner. In the case of a new property, the agreement is usually between
a developer and a money partner.
Illustration of a Joint Venture
Alexandra, at TarHeel Development, would be a likely candidate for a
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joint-venture agreement. Chronically capital-constrained, she does have

development expertise and a strong sense of the market in the Research
Triangle. A joint venture with a money partner might help Alexandra raise
the equity component of her capital stack. Sophie and AIGH might be a
likely money partner for this joint venture.
Alexandra, via TarHeel, would develop the deal, in exchange for the long-
term fees associated with the project. Sophie agrees to form a joint
venture and contribute a substantial amount of equity capital, conditional
on Alexandra receiving a certificate of occupancy. Alexandra can then
take the joint-venture commitment to the lending community for the
necessary debt capital. She can receive a permanent loan commitment,
again conditional on achieving the certificate of occupancy. Alexandra
can then take the joint-venture agreement commitment and the
permanent loan commitment to construction lenders to secure funding
during the development or acquisition process. Neither Sophie nor the
bank wants to commit money until the hotel can be occupied.
In this particular joint venture, Sophie, as the money partner, would be

the majority owner. Thus, even though Alexandra provides much of the
development expertise, Sophie's money wins her a voice in design,
standards, or any other area where she seeks a measure of input or
control. In many cases, the money partner cedes day-to-day control of
the property to the developer while retaining control over the decision to
refinance or sell the property, major capital expenditures, and approval of
the annual operating budget.
Negotiating the Joint Venture
A successful joint venture requires the negotiation of certain key

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provisions.
The agreement must establish the percentage of ownership for each

partner. Additionally, the partners must agree on what contribution
constitutes the basis for this percentage. It may be made up of cash,
land, other assets, services provided, other value brought to the project,
or some combination of these.
The agreement must specify the roles and voting rights for each partner
during each phase of ownership: development or acquisition, operation,
and disposition.
The agreement must specify the funding requirements. These include
the amounts, the methods and terms of funding, and the fund release
schedule. Provisions for additional funding, including cost overruns and
greater-than-anticipated negative cash flow from operations, must be
specified. The agreement should specify adjustments in the joint-
venture ownership percentages if any partner fails to meet its funding
obligations.
The agreement must specify provisions for termination of any contract
or agreement between the joint venture and any partner, and for
termination of the joint-venture agreement.
A joint-venture agreement may be a sound method for a developer such

as Alexandra to raise the necessary equity capital for an investment. It
can also be a lucrative means for Sophie to put her capital to work
achieving the stable returns she desires.
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Watch: What Do Lenders and Borrowers Want?

In addition to equity capital, all investors need some debt capital to
finance their hotel real estate investment. In this video, Professor deRoos
reviews the debt portion of the capital stack, which involves two primary
players: lenders and borrowers. Each party has different goals but
Professor deRoos discusses how they can find common ground and
negotiate the best set of terms for their individual needs.
Video Transcript
What do lenders and borrowers want? Let's start with the lenders, and
how they evaluate a prospective mortgage loan using their lender's
underwriting criteria. Lenders use two fundamental criteria to size loans.
These two criteria, the debt-coverage ratio, and the loan-to-value ratio,
are the primary means lenders use to evaluate and to size a loan.
First, lenders want assurance that their loan is safely paid. Thus, they are
very interested in the amount that the net operating income, the NOI,
exceeds the annual debt service. The metric used to measure this factor
is called the debt-coverage ratio, known in the business as a DCR, or
DSCR for debt-service-coverage ratio. The DCR is defined as net
operating income, or NOI, divided by the annual debt service. Think
about this for a moment, a minimum debt coverage ratio of 1.5 means
there must be at least $1.50 of cash flow for every $1 of annual debt
service. What lenders do is specify the minimum debt-coverage ratio they
will tolerate for different property types and for different risk levels.
The second fundamental underwriting criteria is called the loan-to-value

ratio, or LTV. This metric is used because lenders will want to be able to
sell the property for at least the amount of the loan should the borrower
default. The loan-to-value ratio is defined as the loan amount divided by
the market or appraised value of the property. Lenders specified the
maximum loan-to-value ratio they are willing to tolerate for different
property types and for different risk levels. In addition to underwriting,
lenders want to obtain a proper risk-adjusted yield on every loan. They
want the interest rate on hotel loans to have a premium relative to the
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other property types because of the additional risks to hotels over the
business cycle.
Finally, lenders want borrowers to have little or no ability to prepay the

loan before the end of the loan term. They want borrowers to take the
interest rate risk and the term risk over the agreed upon loan term. So
this gives you a feel for what lenders want.
Let's now take a look at what borrowers want. First and foremost,
borrowers want a big loan as a means to increase their equity returns.
They will negotiate very hard with lenders over debt-coverage ratios and
loan-to-value ratios to increase the size of their loans.
Secondly, they want a low interest rate, a so-called low-cost loan. Note
that maximizing the loan amount and minimizing the interest rate are
definitely in tension. If the lender allows the loan to get bigger, they want
to charge a higher interest rate due to that increased risk. So if a
borrower truly wants a low interest rate, they generally have to be
satisfied with a smaller loan.
The third thing that borrowers want is the maximum flexibility to prepay
the loan or to refinance the property within the loan term. Note that this is
in tension with one of the lender's desires, which is little or no ability for
borrowers to prepay. Fourth thing the borrowers want is mechanisms that
structure payments based on a property's ability to pay. One of the most
important manifestations of this is that new properties or newly acquired
properties need a few years for the NOI to grow and then stabilize. In
these cases, borrowers would like payments to be lower in the earlier
years of a mortgage.
Finally, borrowers want limited recourse in case they default. Generally,

this is structured as a so-called non-recourse loan in which the lender's
only recourse is their ability to foreclose on the property and sell it in the
event of a default. Recourse means the lender has the ability to go after
other borrower assets in default. The broadest form of recourse is a
personal guarantee, meaning the borrower pledges all of their personal
wealth toward the repayment of the loan. Borrowers are extremely
reluctant to do this. So recourse is generally negotiated by limiting the
ability of lenders to take other assets in the event of a default.
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So, we can clearly see that there is some common ground between the
borrower's desires and the lender's desires. And we can also see that
there are things in tension. Borrowers and lenders need to be nimble and
have very clear objectives as they are negotiating their loans to obtain
the best set of loan terms. This is not an impossible task. Lenders and
borrowers come to terms every day. But borrowers that don't have their
eye on the ball, or borrowers that are not very clear about their
objectives, tend to get sub-optimal loans.
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Ask the Expert: The Importance of Relationships in

Lending
Lending for real estate, particularly hotels, is intimately tied to economic

conditions at the time loans are originated. During economic downturns,
the credit markets exhibit what is known as a “liquidity crisis,” the
tendency of lenders to halt lending until economic conditions improve. In
this video, Mark Wolman discusses his experience with lenders
immediately after the great recession of the late 2000’s and his current
experience during a period of economic expansion.
Mark Wolman is a Principal and Director of Waterford Group, a leading

hospitality company specializing in the development, ownership and
management of hotel, gaming and venue projects. He has more than 30
years of experience in land development, residential and commercial
construction, hospitality development and operations, as well as asset
management. In his role with Waterford, Mark has been integrally
involved in the development and supervision of projects totaling more
than $3 billion. Waterford has successfully owned and/or operated more
than 80 hotels and convention centers, from small to large, as well as
independent to virtually all major national brands. Notable projects
include the world-renowned Mohegan Sun; the Front Street District, a
$775 million mixed-use development in Hartford, CT; as well as,
numerous Marriott, Hilton, and Starwood branded hotels throughout the
United States.
How have lending practices changed for your organization

over the years?
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Video Transcript
So, lending is a very big part of the cycle. Real estate, and specifically
hotels, live in a very cyclical environment. And in our business, probably
a couple years ago, you couldn't really get bank financing. So, it was
more a conduit market that was out there for funding projects. And new
construction is virtually impossible without getting major guarantees and
low loan-to-value or loan-to-cost loans. As this market that we are in now
in the last two or three years that has really recovered, smaller banks and
banks have reentered the market and it all comes down to relationships.
So, we've found out that the smaller banks and the regional banks are
open to finance hotels again, and even giving a lot better terms then the
Wall Street or conduit markets. And that's encouraging in some ways
because you can get projects off the ground and not have to be as
dependent on somebody that you don't even meet because it's in some
kind of conduit-lending process. Whereas the local banks, you have a
banker that trusts you. You have a relationship you can develop and
there's much longer-term value to you and to the bank. So, we've seen
that evolve and we've really encouraged in a recent number of years that
business is back and we're able to do some deals.
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Read: Project Presentation for Lenders
• Borrowers and lenders are business partners
• Loan application is the borrower's business case
The lender and borrower each have their own objectives when entering
the mortgage loan process. How does the borrower present their case to
the lender to increase the likelihood that they obtain a loan that meets
their objectives?
Lender Requirements
The borrower knows what the lender is considering when it reviews a

loan application. First, the lender applies underwriting criteria to help
originate safe loans (applying the DCR and the LTV). Second, the lender
would like to earn a proper risk-adjusted rate of return on the loan. Third,
the lender has a set of portfolio targets in order to balance their loan
portfolio. The lender wants a certain amount of real estate in the
portfolio, and within real estate, they want a certain amount allocated to
lodging. Lastly, the lender must evaluate whether or not they are
interested in owning a hotel if the borrower should default. For some
lenders, this last criterion prevents them from considering loans for hotels
investments. They simply have no interest in owning a hotel via a default.
Structuring the Loan Application
Borrowers need to put together a loan application that addresses these
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matters. The borrower should anticipate putting together a high-quality

and visually appealing loan application package. The package is
designed to convince the lender of the benefits of this project, to “sell” the
entire investment to the lender. The borrower also hopes to achieve
some influence over the underwriting of the loan. The loan application is
the borrower’s opportunity to share their vision of the project with the
lender. A great loan application package includes:
Documented market analysis and operating projections. In a perfect

world, these would be prepared by a third-party consultant. In many
cases the lender accepts these from the borrowers when they have a
good relationship and the borrowers have a demonstrated record of
delivering on their promises. The lender knows that they have the ability
to order a third-party consulting report should the need arise.
Documented turn-key cost. This should explain what the turn-key costs
are to build the property if it is new, or what the total costs are of an
acquisition and renovation/repositioning.
A developer package. This includes a wealth of information about the
developer or borrower and their background. It includes:
Objectives for ownership
How the borrower's equity is structured
Who the borrower's partners are, if they have any
Who the borrower's major principals are, with background on each
Details of any partner commitments between the borrower and third
parties, including copies of partnership agreements
Background on financial assets and completed projects for the
borrower in the past; a history or vita
The borrower's net worth, in detail
Evidence that an operator has agreed to operate the project if a third-
party operator is needed. Ideally, this would include a copy of the
management contract, a copy of the franchise agreement, or a copy of
the lease.
Architectural renderings for a new project or glossy photos for an
acquisition. This is a key element of selling the project to the lender.
Show the lenders a great set of images to help them envision the
property and commit to the project.
Evidence that the borrower has searched land use and title issues. This
may entail evidence that the borrower can obtain legal title to the land,
evidence that the property can be used for the intended purposes
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(zoning and planning approvals), and evidence that all necessary

economic and environmental impact studies have been successfully
completed.
Finally, the borrower is well advised to prepare a forecast of the
lender's cash flows. What is the lender likely to achieve by providing the
debt capital for this project? For a straightforward, fixed-rate loan, this
might not be necessary. But for a participating loan, or a loan with
conversion features, it is advisable to help the lender understand what
the returns will look like.
Throughout this process, it is very important that the borrower treat the
lender as a business partner. Lenders have seen many applications. If
they spot any “puff,” any dubious numbers, they will likely treat the entire
application with suspicion. By treating the lender as a business partner
you can convince them that you will treat them fairly and honestly. This
goes a long way towards helping the borrower obtain a loan that meets
their objectives.
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Watch: Sizing the Mortgage

You've just read about the importance of the borrower's presentation to
the lender. A critical part of this presentation includes the expected future
results from operations, including revenues and expenses, and net
operating income (NOI). In this video, Professor deRoos shows how the
future results influence the lender's underwriting criteria, which determine
the size of a mortgage. He provides examples of how changes in key
variables act to constrain the size of the mortgage. You can download the
mortgage sizing worksheet on the following page.
Video Transcript
An important piece of the borrower's presentation to the lender involves

the borrower's presentation of the expected future results from
operations. While the borrower may present past history, it's the pro
forma estimates of future revenues and expense that are most important.
Looking at the pro forma, it is the bottom line, the net operating income,
that's the most important number. The borrower and the lender enter into
a negotiation over the numbers used to size the mortgage loan. As an
example, we will consider the Hannah Hotel in San Francisco. Here, the
borrower has presented a three-year pro forma with cash flows drawing
from $3.26 million in the first year to $4.03 million in the third year of
operation as the hotel occupancy and rate improve over time. The lender
responds by reviewing this information and producing a column called the
lender's underwriting.
In this example, the lender says I am very comfortable using the

borrower's year three numbers with two important exceptions. The first is
in lieu of a 77% occupancy that the borrowers prepared, the lender is
only willing to underwrite an occupancy of 75%. The second adjustment
that the lender does is to add a franchise fee of $443,000 a year because
the lender feels if they foreclosed on the property, they would have to
have the property franchised in order to operate it. These two
adjustments reduce the NOI from the 4.3 or 4.03 million presented by the
borrower to 3.6 million used by the lender. As we'll see, this has
significant impact on the size of the loan the lender is willing to provide.
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Now, let's take a look at the lender's preliminary or base case loan. So,
Hannah Hotel base case, the lender uses an interest rate of 5.5%, an
amortization term of 20 years, monthly payments, and a loan-to-value
ratio, maximum 62% of the value of the property, the appraised value of
the property. The lender hires an appraiser, paid for by the borrower. The
appraiser goes to the market and provides a market value appraisal of
$50 million. 62% of 52, no sorry, 62% of $50 million is a $31 million loan
via the loan-to-value ratio. Next, the lender imposes a debt-coverage
ratio of 1.5. What this means is that cash flow needs to be $1.50 for
every $1 used for debt service. So 1.5 divided into NOI used for
underwriting of 3.6 million results in an annual debt service of 2.4 million
and results in a loan that's sized at $29.2 million.
At this point, the lender steps back and says, I've got two loans that are
sized. One using the loan-to-value ratio of 31 million. One using the debt-
coverage ratio of 29.2. The lender will always originate the smaller of the
two, in this case, the $29.2 million loan. To note the impact of the
underwriting, in this case, if the lender was willing to use the $4 million,
not the $3.6 million, NOI, this would have resulted in a $32 million loan.
However, at this point, the lender would have fallen back to the $31
million used for the loan-to-value ratio, but in either case this shows the
impact of underwriting on loan sizing.
Finally, for the base case let's take a look at the projected debt-coverage
ratios. First year that operating income as we've shown 3.26 million,
annual debt service of 4.2 million, results in the debt coverage ratio of
1.35. Similarly, the calculations are done each year and we see that this
loan quickly grows into a debt-coverage ratio 1.5, 1.67, ending in 1.79, a
very safe loan for this lender. The borrower asks if there might be a way
to increase the loan size by looking at optional loan terms, they're highly
distressed at this point that the loan is only sizing at $29.2 million. The
lender responds with an optional set of loan terms, which look like this.
The optional case is a 25-year amortization with a 5.7% loan. So the
lender's willing to have a longer amortization term at a higher interest
rate. Same loan-to-value ratio. Same debt-coverage ratio. Same
appraised value. Same NOI used for underwriting. What's different in this
case is the loan size via the loan-to-value ratio remains at 31 million, but
the loan size via the debt-coverage ratio is at 32.1 million. In this case the
lender says, okay, I'd be willing to originate a $31 million loan. This is
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quite a bit larger than the earlier loan, it's $1.78 million larger, or about
6.2%. In general, borrowers would take the larger loan proceeds, even
though this is a slightly more expensive loan. What this means is the
borrower needs to provide $1.78 million less of equity capital and replace
it with $1.7 million of the bank's capital, which costs 5.7%. In almost
every case, the borrower would say yes because this increases the
borrower's return to equity. You will have an opportunity to model this in a
case study that concludes this course. We hope that you enjoy taking a
look at this.
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Tool: Mortgage Worksheet
• Use the helpful Mortgage

Worksheet tool to analyze
different mortgage parameters
and how they affect the size of
the mortgage.
You just saw Professor deRoos use this Excel-based tool to show how
changes in the mortgage interest rate, amortization term, payments per
year, mortgage constant, LTV ratio, debt coverage ratio, appraised value,
or cash flows from operations change the mortgage loan size via the LTV
or the DCR. Now you can download the tool and use it for your own
projects.
You can enter a new value for any of the blue cells to see the adjusted
loan sizes. Remember, the lender generally originates the smaller of the
two loans that result from applying the LTV and DCR underwriting
methods.
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Read: The Lender's Response: Term Sheet
After borrowers make their presentation to the lender and the lender
applies their underwriting criteria, the parties work through the negotiation
process and then come to an agreement over the terms of a mortgage.
The Term Sheet is a document that summarizes these terms and
documents what each party agreed to.
In the sample Term sheet below for the fictional Hungerford Hotel, hover
over an item and if it is highlighted in yellow, click to learn more. You can
download this sample Term sheet on the following page.
Property Description: A 200-room Hungerford Hotel

to be built in Grandville, NC. The 8-story hotel will
open in 18 months. The property will be built using a
General
poured concrete and stucco facade. Amenities will
Information
include a restaurant, indoor pool, fitness facility,
business center, and 2,000 square feet of meeting
space.
Quote Date: Address: xxxxxxxxxxxxxxxxxxx

3/20/20xx
City/State: xxxxxxxxxxxxxxx
Quoted by: Phone:
xxxxx Fax: xxxxx
Loan Terms Hungerford Hotel- Preliminary Terms

Borrower Single-purpose entity required
The borrower is listed here as a single-person entity. This means the
borrower must be a legally separate entity from any and all other assets
owned by the borrower. If the lenders need to foreclose, they can cleanly
foreclose on this asset, without having to carve it out from the borrower's
other assets.
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Loan amount $27,000,000

4.75%; based on 275bp spread over a 10-year
Interest rate treasury, adjusted at closing unless borrower
exercises the rate lock option.
The loan interest rate is based on a 275-basis-point spread over a 10-
year treasury. In other words, the interest rate is 2.75% greater than a
10-year treasury. The 10-year treasury is used due to the 10-year term
on the loan. Borrowers negotiate the interest rate through a negotiation
over the spread, not the rate itself.
75% Loan-to-Cost ratio based on the client's cost

Required LTV estimate of $36,000,000
Required DCR Cash Flow from operations in year 2 must be at least

1.50 times annual debt service
Both the required loan-to-value ratio and loan-to-cost ratio are (slightly)
negotiable. Note that in this case the loan is based on a loan-to-cost
ratio, not a loan-to-value ratio. Either ratio can be negotiated. Also note
that the debt-coverage ratio here is based on year 2, before the property
has stabilized. The year for the DCF is also negotiable.
Interest calculation Actual/360

Interest is based on the actual number of days since the previous
payment, based on an assumed 360 day (not 365 day) year.
Term 10 years
The borrower must pay any remaining mortgage balance due at the end
of the 10th year of the mortgage; making this a "balloon" mortgage.
Amoritization 25 years
Loan payments are calculated assuming the loan principal will be
returned over 25 years.
Yes, with standard 'bad boy' carve-out liability
Non-recourse
provided by entity acceptable to Lender.
The loan is nonrecourse, meaning that the only recourse the lender has
is to foreclose the property. The standard carve-outs here are fraud,
misrepresentation, gross negligence and declaring bankruptcy during
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foreclosure. In those cases, the lender reserves the right to seek redress
from the borrower personally.
Defeasance allowed with loan prepayable at par for
last 30 days of the loan term. (Yield Maintenance
Prepayment option: The transaction is open at the greater of 1%
or yield maintenance throughout the loan term with
last 12 months open at par. Add 5 basis points)
Prepayment is costly for this loan. The lender outlines two prepayment
management devices, defeasance and yield maintenance, which both
act to deter prepayment.
Lock-out period None
The borrower is not contractually prohibited from prepaying the loan at
any time. Lenders often ask for a lock-out period of the first 12 to 24
months of the loan.
Yes, upon execution of Loan Application, Forward
Rate Lock
Rate Lock Agreement, and deposit of a 1% Rate
Available
Lock Deposit.
Required
Tax & Insurance
Escrow Required. Annual FF&E Escrow in the amount of 5%
of Total Gross Revenues. Escrow account shall be
FF&E Escrow
interest bearing to borrower.
Two escrows are established with this loan, a tax and insurance escrow
and an FF&E escrow. For both, funds are placed into an account under
the lender's control. The borrower does not have the right to disperse
these funds without notifying the lender. "Tax and insurance" refers to
property taxes and property insurance. The lender requires that the
borrower put money into an account to pay these on annual basis. The
FF&E escrow is for capital improvements to the property. The borrower
can disperse these funds according to a capital improvements plan
approved by the lender.
Springing Established at closing, Borrower shall retain

Lockbox/Collection complete control over the Site Account unless an
Account event of default occurs in accordance with the terms
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Account of the loan.
A springing lockbox or collection account is established with this loan. If

the borrower defaults on this loan, all funds generated from the property
go into a bank account controlled by the lender. This provision helps
lenders control their interest in the property when a property is in default.
It ensures that the borrower cannot "empty the till."
Lender's Outside
Required
Counsel
Lender will not use the bank's counsel to close this loan.
Initial transfer fee shall be 1% of the remaining
balance. Subsequent transfers are not allowed. In
Transfer Fee
the event of a recapitalization of the borrowing entity,
the fee shall be $25,000.
This loan can be transferred or can be assumed by a third party, subject
to a 1% transfer fee. Subsequent transfer is not allowed, meaning that
this loan can only be transferred once. In the event of a recapitalization,
where the borrower brings partners into the borrowing entity, the lender
charges $25,000. This fee helps the lender with the attorney's fees
necessary to rewrite the loan documents for the new ownership entity.
Third Party
Reports
Physical Condition Required at Borrower's expense at the completion of
Report construction.
Generally from a civil engineer.
Environmental Required at Borrower's expense at the completion of
Assessment construction.
Generally from an environmental engineer.
Seismic Study Not required
Generally from a structural engineer.
Required at Borrower's expense at the completion of
Appraisal
construction.
Generally from an appraiser chosen from a list supplied by the lender.
Background and
Required at Borrower's expense
Credit Reports
Due Diligence Fee $10,000
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Deposits Application Deposit: $ 25,000

To insure that the borrower is serious about obtaining funds. Refunded
at closing.
*Preliminary quote subject to Lender due diligence and confirmation of

information received. 1.) The management agreement shall be
reasonably satisfactory to lender and subordinate to the Mortgage Loan.
2.) The Franchise/License Agreement shall be reasonably satisfactory to
Lender, together with a Comfort Letter acceptable to Lender.
Cornell University
Tool: The Hungerford Term Sheet
• Use this sample term sheet when

you negotiate mortgage loans.
The term sheet results from a negotiation between a borrower and a

lender over the terms of a mortgage. It answers a simple question for
both parties: what did we agree to? Use this sample term sheet from the
fictional Hungerford Hotel project as a guide when you negotiate
mortgage loans for your own hotel real estate projects.
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Mortgage Sizing
Adjust the size and structure of a mortgage based on changes in key
variables in this required evaluation. Download the Mortgage Size
worksheet that you will need to complete this evaluation.

score.
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Case Study of the Hungerford Hotel

For the final course project, you will analyze a prospective investment
around the fictional Hungerford Hotel, estimating the returns to the
relevant partners and determining if the investment is financially feasible.
To complete this quiz:
1. Download the following documents, which describe your assignment

and give you tools you will need.
Description: Download and read the Hungerford case study.

Pro Forma: See the description of the case for an explanation.
The Excel workbook: The workbook has a series of tabbed worksheets.
Keep this useful worksheet to use later for your own hotel investment
projects.
2. Answer the questions in the Excel workbook by entering the proper

information in the blue cells in each worksheet.
3. When you have completed the workbook, answer the questions

below about the results of your work in the workbook

score.
Hint: If you are unable to calculate the correct answers after several
attempts, you can click here and here to see the completed
spreadsheets.
Cornell University
Loan Recommendation
Instructions:
You are required to participate in all discussions in this course.
Discussion topic:
You have completed your analysis of the financial feasibility of the

proposed Hungerford Hotel. Now let's consider which of the two loans
offers the best terms for TarHeel. If THD does proceed with the
Hungerford project, which financing option—the base case or the optional
case—would you recommend the firm choose? Why?
You should characterize the additional risks that THD is taking under the
optional case financing scenario, and then make a recommendation.
You should also respond to the recommendation of at least one of your
classmates.
To participate in this discussion:
Click Reply to post a comment or reply to another comment. Please

consider that this is a professional forum; courtesy and professional
language and tone are expected. Before posting, please review
eCornell's policy regarding plagiarism (the presentation of someone
else's work as your own without source credit).
Cornell University
Tool: Financial Analysis of Investments Action Plan
• Use the Financial Analysis of

Hotel Investments Action Plan to
guide your efforts on the job.
This course explained how to make informed decisions about the relative
attractiveness of hotel investments. It demonstrated how to
estimate returns, make valuation estimates, and structure deals that meet
the needs of owners, operators, and lenders.
This action plan provides a valuable opportunity for you to consider how
you can apply your new skills to challenges in your own career. What
different investment approaches can you take? How can you analyze and
evaluate investment projects from different perspectives? The action plan
on this page follows traditional "SMART" methodology to help you identify
steps to take on the job that are specific, measurable, action-oriented,
realistic, and time-based. You may choose to use it now as a tool for
yourself, as a means of demonstrating to your manager or to peers how
this course will influence your efforts on the job, or you may choose to
save it and use it to guide your future work.
Cornell University
Module Three Wrap-up: Structuring the Deal:

Current Equity and Debt Financing Structures
After investors have determined that a hotel real estate project offers
sufficient returns, then they look to finance the project using both debt
and equity financing. Finding appropriate equity partners and negotiating
the best terms with lenders are both critical to the success of any real
estate investment.
In this module, you explored the different options for financing hotel real
estate projects and connected them to the different types of owners. You
examined the mortgage-sizing process and performed a forecast of the
size of a loan for a given project using the lender's underwriting criteria.
You analyzed a prospective mortgage from the borrower's perspective.
Finally, you analyzed a hotel real estate investment opportunity and
provided investment and financing recommendations.
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Read: Thank You and Farewell
Jan deRoos
Associate Professor and
HVS Professor of Hotel Finance and Real Estate
School of Hotel Administration
Cornell University
Congratulations on completing Financial Analysis of Hotel
Investments. A primary goal in any hotel investment is to create
value. By now, you should have a better understanding of the role
played by the three dominant actors in the hotel investment
community: the owner, the hotel operator, and the lender. In order for
any of these actors to truly achieve their objectives, they need to
understand the motivations and incentives of the other actors.
Participants who have the insight to anticipate the needs of others
generally find success by creating an environment in which everyone
creates value for themselves, while recognizing the needs of others.
This doesn't mean giving up returns; it means crafting deals that allow
all parties to get to yes.
I hope you found this to be a stimulating and informative introduction
to the financial analysis of hotel investments. I hope the material
covered here has met your expectations and prepared you to better
meet the needs of your organization.
From all of us at Cornell University and eCornell, thank you for
participating in this course.
Sincerely,
Jan deRoos
Cornell University
Additional Resources
The Center for Hospitality Research provides focused whitepapers and

reports based on cutting-edge research.

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SHA611: Financial Analysis of Hotel Investments

SHA611: Financial Analysis of

Explore the varied motivations of owners, operators, and lenders in

Investing in hotel real estate is a complicated and

In this course, Professor deRoos demonstrates several analytical tools

Professor Jan A. deRoos, on the faculty of the School

operators and lenders. Based on my real world and academic

Module 1: The Hotel Owner-Operator-Lender Partnership

Module 2: Evaluating the Deal: How Owners, Operators,

1. Module Two Introduction: Evaluating the Deal: How Owners,

7. Tool: Operator and Lender Project Metrics

Module 3: Structuring the Deal: Current Equity and Debt

1. Module Three Introduction: Structuring the Deal: Current Equity and

Module 1: The Hotel Owner-

Back to Table of Contents

Module One Introduction: The Hotel Owner-

In this module, you will determine the interests and

Back to Table of Contents

Watch: Putting Together Hotel Real Estate

Let's take the example of an owner working with a third party

Consider the operator, or manager of the hotel. The operator is interested

Back to Table of Contents

Read: Lodging Investment Participants and

• Owners contribute the equity

• Lenders provide the capital

• Operators provide the brand and the managerial expertise

Hotel real estate investments involve a range of different participants. In

Owners contribute equity to a hotel investment. This equity is in the form

Entrepreneurs: usually individual owners or small firms

Owners-in-foreclosure: lenders who have been forced to take

Lenders provide the majority of the capital needed to finance a real

The senior mortgage capital provided by commercial lenders is often

The third major participant in most hotel real estate transactions is

In addition to the three major participants, a number of

Consultants or appraisers perform the market analysis of the proposed

Finally, Governments often play a substantial role in hotel real estate

Putting together a successful hotel real estate transaction involves a

Back to Table of Contents

Read: The Partnership: Owner, Operator, and

• Owners are primarily interested in returns

• Branded operators' primary interest is in market presence and

• Lenders need to achieve an adequate overall risk-adjusted return

Most hotel real estate projects involve a three-way partnership among

One of the primary interests of an owner is returns. These can come in

owning a competitive hotel. They want a quality hotel

Additionally, owners are interested in influence over the management

flexibility necessary to sell or refinance when they so choose. Owners

To achieve their objectives, operators are also interested in operating a

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Tool: Hotel Investment Participants

• Use this summary of hotel

Hotel real estate investments include a number of primary and secondary

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Watch: Different Owners Have Different Reasons

Different owners have different reasons for investing. It seems

one of the most remarkable characteristics of real estate, is that it is a

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Watch: Different Ownership Structures

First, we have a real estate owner with a branded operator. In this

A second structure, similar, is a real estate owner with an independent

A third structure, is a real estate owner with a leased hotel. In this

A fourth structure, would be a hotel owner operating the hotel

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