What Is An Inn Worth? How Lenders Look at Value
Doug Carleton of Business Lenders, LLC
How much an
inn is worth is always a popular topic in the bed & breakfast
industry. To an innkeeper who has invested capital, a number (maybe
a lot) of years and, most of all, a tremendous amount of emotional
and physical energy, the inn has one value. To a buyer an inn
will probably have a different value, and it is not going to be
the same for every buyer. A buyer looking for a business who does
not need to count on the income from the inn to support them may
be willing to pay one price. A buyer looking at an inn purely
as a business venture (albeit a very attractive business with
interesting clientele) that has to be the sole source of income
may have another value.
And there may
be a third party interested in a value. If the buyer needs to get
a mortgage, a lender is going to establish a value for the inn,
and it may be different from either the buyers or the sellers.
How a lender arrives at a value for loan purposes is something that
can be helpful for both sellers and buyers to understand.
In our industry, there is a segment of inns that contain between
one and four rooms. They operate like other inns, but because of
their size generally are not considered commercial properties. This
has a bearing on how lenders will value them and determine how much
they are willing to loan. Properties of up to four rooms will usually
be viewed by lenders as residential properties, which simplifies
the valuation and loan process considerably. In residential lending,
the normal process for a lender to establish a value is to have
an appraisal done, against which the lender will usually lend a
certain percentage, say 75% or 80% of the appraised value. The buyer
of such an inn qualifies for the loan based on their personal income
available to pay the loan, just like a house purchase. In this situation,
the lender generally doesnt care how much income the inn earns
because it will not usually be enough to support a mortgage. The
lender looks purely to the borrower and their income.
Once an inn gets to five rooms and above, it is probably going to
become a commercial property for mortgage purposes, and the process
of determining how much loan to make becomes much more complex.
Now the income from the inn available to service the mortgage becomes
the critical factor, both in terms of valuing the inn and in terms
of how much a buyer can borrow.
Lets look first at a commercial mortgage. One of the most
important determinants of how much someone can borrow on a mortgage
is governed largely by what the debt-coverage ratio will be. The
debt-coverage ratio is the ratio between the amount of cash available
from the inn to make mortgage payments and the payments themselves.
The way to determine the debt-coverage ratio is, first, to determine
the net operating income (NOI) of the inn. This is simply the gross
income minus operating expenses. The operating expenses are all
the expenses, both fixed and variable, that are required to run
the inn on a day-to-day basis. The NOI is what is left to pay the
debt service, with whatever is left over going to the innkeeper.
To use a simple example, if the NOI is $1,000, and the amount of
annual debt service is $700, the debt-coverage ratio is 1.43 ($1,000
divided by $700). If a lender has a requirement that their debt
service needs to be covered at least 1.25 times, divide the $1,000
by 1.25, and it gives you $800 available to make mortgage payments.
Then, by applying an interest rate and a term, you can determine
how much loan a property will support. In the above example, if
the loan terms were 7½% for 25 years, the $800 would support
a loan of $9,021.
The most important thing to a lender is to feel assured that their
loan is going to be paid back. And it is the NOI that is going to
be used to make the loan payments. A lender is not going to care
how much someone says a property is worth if it does not generate
enough cash to pay the mortgage.
Now lets go back to the NOI and its relationship to value.
If an inn is considered a commercial property, a commercial appraisal
will be required as part of the loan approval process. In commercial
appraising, value is established using a combination of three approaches
the income capitalization approach, the cost approach and
the sales comparison approach. In the income capitalization approach,
the net operating income (NOI) is converted into a value by means
of the capitalization process. To illustrate the capitalization
process in the simplest possible way, suppose you are going to buy
an investment and you have a rule that you want to earn at least
10% on your invested capital. That 10% is your capitalization rate,
which you will use as a means of determining value. If you are offered
an investment that has a cash flow (NOI) of $1,000, you would be
willing to pay $10,000 for that investment because it would give
you a 10% return, or $1,000 a year. Therefore, to you, the value
of that investment is $10,000. If an inn has an NOI of $70,000 and
the appraiser is using a 10% capitalization rate, the indicated
value under the income capitalization approach is $700,000.
In the bed & breakfast industry, the cost approach is the least
accurate except in cases of a new construction project, in which
case the value established by the cost approach will be the actual
cost to build it. For existing inns, the cost approach becomes less
reliable or useless. For example, to apply the cost approach in
an appraisal of a 1790 brick Federal-style inn would be a waste
of time because it would cost a fortune to reproduce faithfully,
and would be highly unlikely to be sold as a business at that price.
The sales comparison approach can be more useful, but it has its
own built-in set of limitations. The farther apart geographically
the sales comparables that an appraiser can find, the less relevant
they become. Its one thing to compare a 56-room Sleep Inn
in one state with a 56-room Sleep Inn in an adjacent state because
the physical facilities are identical and the room rates are similar
because it is a franchise. But to compare a seven-room inn in the
mountains of one state with a seven-room inn near the seacoast in
an adjacent state, or even the same state, becomes more difficult.
Also, the buildings themselves may be dramatically different.
There are two other frequently used valuation techniques in the
bed & breakfast industry that are variations of the sales comparison
approach. One is the sale price per guestroom. This is simply the
sale price divided by the number of rooms. This is a commonly used
method in the hotel/motel industry where there are a relatively
large number of sales of properties that are essentially the same.
Because of this, it is much easier to draw a value conclusion for
a hotel or motel property because an appraiser may find ten sales
of a comparable market segment property (such as a particular flag
motel). But in the bed & breakfast industry, because properties
are almost universally so dissimilar, this method leads to a very
imprecise measure of value.
The other method used in the industry is the Gross Revenue Multiplier
(GRM). This method simply takes the sale price of a property and
divides it by the gross revenue of the inn. So, for example, an
inn that had gross revenues of $100,000 and sold for $500,000 would
have a GRM of 5. The GRM is closely akin to the sale price per room,
and suffers from the same limitations.
Establishing a fair and accurate value for an inn is important for
anyone either already owning an inn or contemplating a purchase,
especially if a mortgage is going to be required by a buyer once
an inn is sold. Fortunately, for smaller inns, those of less than
five rooms, the process can be relatively simple because the value
is usually going to be based on the inns value as a single-family
residence, and residential appraisals are very straightforward and
simple compared to a commercial appraisal. For larger inns that
must be valued as commercial properties, there are several different
ways to come up with values. But as a starting point, establishing
a value as though you were a commercial lender is the most realistic
place to start. Apply a capitalization rate of between 9 and 11%
to the NOI of the inn, and you will have a very good starting point.
Many other factors may ultimately come into play in determining
the final value, but a value based on cash available to make loan
payments is usually the most accurate and widely used method in
the hospitality industry.