by Joe Strain, ISHC October 2010
Equity Multiples—the imagined or actual proceeds of a hotel sale compared to the original equity—have long been in play by fund managers, equity ventures, and astute investors. Commonly, the Equity Multiple (EM) was used to compare the equity of a company to its asset value, but in these days where equity funds are heavily invested in real estate and hotels, the Equity Multiple has migrated. Although not yet widely used in real estate circles, with so many hotels already owned by investment funds and with $6 billion raised this year alone for more—the EM’s time is upon us.
Like traditional valuation metrics, the EM is usually stated in before tax terms. However, because the EM compares original cash in—the equity down payment plus the Product Improvement Plan (PIP)—to the net proceeds at sale/reversion, it differs from most other common metrics used to price and value hotels. The EM does not consider, for example, intervening cash flows nor does it fight the unfriendly effects of time like the Internal Rate of Return; neither does the EM focus on room revenues as a multiple of price like the Gross Room (Revenue) Multiplier. And, while the capitalization rate uses current year net operating income (NOI), the EM relies on the NOI from the last year of the holding period only as a component of value and hence, proceeds.
Traditionally, Equity Multiples of 1.5-1.7 were enough to attract investment to hotels. Put a buck in, get up to a buck seventy out. But when financing flowed with little reservation, as it did in 2005-2007, “extreme” leverage replaced equity and cash funding for PIP’s. Equity Multiple targets jumped to 2.0, and higher.
Until the recession hit.
In 2008, when so many new equity fund business plans were written, earning a “double” wasn’t good enough, “triples” became the new target. But, when this non-negotiable target was loaded into the acquisition model, deals stalled. Why? When this risk adjusted EM target was modeled with a RevPar pattern that was accurately negative in the early projection years, flat for the middle projection years, and then, gulp, up 2-5 percent in the later years subject to enough caveats to fill a flash drive, the prospective offer price fell like a movie-meteor. The bid-ask gap widened for those that stuck to their EM target of 3.0. The result: buyers with lower EM targets made the deals. The corollary: hotel transaction activity fell to 7% of 2007 volumes.
By early 2010 RevPar was predicted to fall less than 5% year-over-year, and what were ‘Hail Mary’ assumptions regarding future income patterns suddenly didn’t seem so far flung. But, by mid-2010, the economic outlook became decidedly more mixed: widespread evidence that the economy was recovering was offset by signs the economy was slowing. Yet, against this backdrop, RevPar was forecast to grow at a healthy 4.6% rate, compared to a negative 16.7% for 2009, overpowering concerns over economic turbulence, and the tide of hotel transaction volume swelled. The brighter outlook for RevPar coupled with the rising hotel demand and the low cost and increasing availability of funds conspired to shift hotel investment perspectives to the positive. In the world of Equity Multipliers, the “double” became less risky. “Triples” were increasingly wishful.
At the heart of the difference between targeted and actual results is that the EM requires that initial cash be as low as possible, but others in the deal such as the lender and franchise companies have different and far grander uses in mind for that cash. At the end of the holding period, the differences between targeted and actual EM’s can be traced to a low exit NOI or higher than expected reversion cap rates, or both. While massive initial PIP’s (as a percentage of price) usually lower EM’s due to their high cash outlays, large PIP’s can be EM friendly if the resulting NOI growth is exceptional, such as in hotels that have undergone transformation renovations in best-in-market locations. But, when PIP’s cost well more than what was budgeted, and reversion values flatten or drop, EM’s fall fast, even to 1.0, or less.
Although controlling cash is not a new criterion to making money in the hotel business, it is surprising how sensitive it is to achieving the targeted EM. A half million dollars in new TV’s or for unplanned technology requirements can wither an attractive EM target. Yet, when looking at the data over the last four years for 14 deals (of accepted offers and sales), most EM’s hovered between 1.7 -1.9. Even though some of these were value-add deals fraught with substantial renovation cost overruns, the range of EM’s still didn’t vary much—it was highly consistent. This suggests that built into the EM in this range is an allowance for unplanned expenditures. It is only those deals that were bought, renovated, managed and sold in markets with fast rising NOIs that achieved EM’s well above that range.
Of these 14 deals, the highest EM result was 3.3. It had average NOI growth, low PIP costs (less than 5% of price), and a high debt-to-price ratio of 85%. Those with EM’s of 1.3-1.4 had slow NOI growth or high PIP costs, and small bumps in projected reversion value. The rest—the clear majority—had an average debt-to-price ratio of 61% and spent an average of 22% of price on PIP’s. For all 14 deals, the average EM was 1.8 and the average IRR was 23%.
A final observation
When comparing the EM to the IRR, it became clear that hotel owners do not always sell at the maximum IRR. If so, hotels would have been sold when business plan projections first indicated a flattening of revenues (and NOI), as investments held too long are not friendly to the highest possible IRR. Before the recession, only a few of the big hotel opportunity funds or property owners sold; there was no massive sell-off. On the other hand, the extra holding period brought incremental increases to the EM, inching it closer to the desirous double. Indeed, the EM may be more entrenched in hotel investment decision making than once thought—after all, everyone wants to double their money.
Used over time, the Equity Multiplier can be a critical addition to the decision making tool box. A review of owned hotels might bring sobering clarity to a decision when to sell, when to buy, and what to offer. That double may already be there and if not, holding it may not bring the deal any closer. In any case, it’s a tool that hotel investors, owners and managers will be living with for what looks like a long time to come.
Joe Strain, ISHC, President of Hotel Realty Advisors, has closed over $500 million in hotel transactions, asset managed hotels worth $380 million, and appraised over 400 hotels with a total value in excess of $2 billion.