by 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 buyer’s or the seller’s. 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 doesn’t 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.
Let’s 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 let’s 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. It’s 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 inn’s 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.