A Beginner’s Guide: The Secret Recipe for a Profitable Hotel Investment
Kristen B. Myers, Vice President of Investments | Raines
Given the strong cash flow generated by hotels, this asset class is highly sought out by active investors. Industry trends year-over-year are up as demand continues to be strong driven by a healthy mix of leisure, transient, and group business while the corporate segment continues to move towards recovery. Hotels have proven their resiliency as an asset class due to the strong recovery compared to previous down cycles. Hotel investment provides the best hedge against inflation and delivers highly favorable yields despite the lending market.
There are signs you can look for when determining whether the asset you’re considering is profitable. Ultimately, the recipe for a profitable hotel investment isn't just intuition; it's grounded in understanding a few critical metrics and some hands-on detective work.
A look at the numbers
The initial move is to understand what to spot and decipher in the financials. There are two critical metrics that every investor should focus on — net operating income (NOI) and gross operating profit (GOP). NOI refers to the total revenue generated by the hotel minus all operating expenses. This metric tells us how much money the hotel is making before taking out the cost of financing. We must then examine the GOP to NOI ratio to determine the hotel's profitability. GOP is the revenue minus only the cost of goods sold, and it tells us about the hotel's profitability after considering the costs of operating the hotel.
The following important metric to consider is the capitalization rate, or cap rate, which is the ratio of a hotel's net operating income to its market value. This rate is critical when acquiring or selling a hotel. Essentially, it measures the rate of return that an investor can expect from their investment. It’s important to note that the cap rate can vary depending on the location and type of hotel, with higher cap rates indicating more risk but also higher potential returns.
Investors should also consider the internal rate of return (IRR) and cash-on-cash return. The former indicates the percentage of the initial investment the investor will receive annually, while the latter shows how much cash the investor will get back annually based on their cash investment. These metrics are especially important for those who want to know how quickly they will recoup their initial investment.
Evaluating the structural elements of the property
Apart from metrics, you’re going to want to get your hands dirty a bit. It's essential to conduct physical inspections when considering investing in an existing asset. This can help you with determining potential issues and avoid any significant surprises down the road, outside of your standard CAPEX reserves.
Some of the important aspects to consider during a physical inspection include:
- Foundation and structural concerns.
- Roof conditions.
- Signs of mold or water damage due to humidity.
- Signs of deferred maintenance, such as broken windows and neglected landscaping.
- Environmental hazards, including considerations for natural disasters.
Leveraging reports and tools to evaluate a worthwhile investment
Another important aspect of investing in a hotel is competitive analysis. Using tools such as feasibility studies and Star Reports, you can assess market size, growth rates, demographics, competitor benchmarking, market segmentation, and demand generators. This analysis can also help you gauge the potential demand for your hotel and the competition you may face.
Once again, you should conduct some boots-on-the-ground investigative work. While you're in town evaluating the asset's structural integrity, get a feel of the community. Do you see any development projects in the works? What do people do on the weekends? Are there any opportunities to collaborate with local breweries or wineries? Think outside the box on this one.
Reviewing the background and expertise of the hotel operator
Finally, the value of an experienced operator cannot be overstated. A competent management company can significantly influence the profitability of a hotel investment. An operator with expertise in benchmarking, identifying improvement areas, and managing operating expenses is essential. It's also beneficial if your manager can scale and share resources to save costs.
Without a doubt, investing in a hotel can be profitable, but it requires careful consideration of several metrics and aspects before deciding. By focusing on metrics like NOI, GOP, cap rate, IRR, and cash-on-cash return, conducting physical inspections, and performing a competitive analysis, it's possible to determine the potential profitability of a hotel. Additionally, having a competent management company can significantly influence the success of the investment.
By following the recipe above, you can increase your chances of success and profitability in any hotel investment.