Gary S. DeWeese, MAI
When private-market data
Deriving capitalization rates and other valuation metrics for hotels from the public REIT market
Suppose an investor wanted to know the implicit capitalization rate at which publicly traded hotels are selling in order to apply that rate to a private hotel. Or suppose an analyst or appraiser wanted to use the implicit capitalization rate in the public market to value a private hotel.
How would they go about obtaining this information?
Market participants usually value private commercial real property, including hotels, based on comparable sales, capitalization of net operating income, and a cost approach. However, from time to time, the data necessary to value hotels using these traditional methods are lacking. The lack of information can be due to a dearth of sales in the private market, or because, even when sales occur, some buyers and sellers prefer to not disclose relevant data.
In such circumstances, valuing privately held hotels can still be accomplished. Implicit capitalization rates and other valuation metrics derived from the publicly traded real estate investment trust (REIT) market can be used to determine similar metrics for privately held hotel assets.
In addition, the technique explored here can also be used to supplement traditional valuation metrics or offer an alternative valuation metric even when the private market is active and actual private market transaction data are available.
Obtaining REIT data on publicly held hotels
The public REIT market makes available the source data needed to calculate the alternative valuation metrics as a matter of course. The model’s inputs can be derived from the quarterly (10Q) and annual (10K) U.S. Securities and Exchange Commission (SEC) filings and the “investor supplemental information” that are available on the REIT websites—typically under the “investor relations” tab.
The information is often available in portable document format (PDF). By using the PDF-reader application “search” function, the required data points can be easily found among the sometimes hundreds of pages of information. The information can be input into an Excel model to perform the analysis easily.
Calculating implied capitalization rates
The overall enterprise value of a publicly traded hotel, including its real property assets and other operating departments such as food and beverage, parking, movie rental, and vending, can collectively be labeled Vo. This overall value can be viewed as the sum of the values of two financial components: the value of the enterprise’s equity (Ve) and the amount of outstanding indebtedness (Vm) in the form of mortgages and non-convertible bonds.
The variable Ve represents the stock market equity capitalization—the current stock price multiplied by the number of shares outstanding.
In this way, Vo is represented by the formula:
Vo = Ve + Vm
The net operating income (Io) received by the REIT is similar to reported EBITDA (earnings before interest, taxes, depreciation and amortization). Analysts using this information to value a private hotel may need to deduct a replacement reserve as an additional expense if the overall capitalization rates in the market are based on such a deduction.
Dividing the annualized Io by the sum of Ve and Vm equals the implied overall capitalization rate (Ro) at which the investor is effectively buying the underlying hotel’s assets, as illustrated in the following formula:
Implied Capitalization Rate (Ro) = Io / (Ve + Vm)
The following is a simple example that uses the following hypothetical information:
Annualized Io, adjusted for a replacement reserve = $70,000,000
Number of common and convertible shares outstanding: 10,000,000
Share price: $50
Outstanding indebtedness: $500,000,000
Implied Ro = $70,000,000 / (10,000,000 x $50 + $500,000,000) = .07
Calculating per room gross enterprise value
Likewise, dividing the sum of Ve and Vm by the number of hotel rooms (room keys) in the portfolio will also provide an indication of the gross enterprise value per room, as illustrated in the following formula:
(Ve + Vm) / # rooms = Value per room
Using the same information from the example above, and given 5,000 rooms, implies a value of $200,000 per key.
Calculating stock market price for REIT shares
This analysis can also be reversed by inputting the analyst’s opinion of a certain market Ro or a certain dollar value per room to derive the stock market price at which the REIT shares should be acquired.
The value of REIT-derived metrics for private-hotel valuation
The valuation metrics derived from publicly traded REIT stocks can be used as surrogates to value private real estate for a number of reasons.
Hotel investors, particularly institutional investors, should be indifferent to whether the real estate they are purchasing is being bought privately on “Main Street” or publicly on “Wall Street.” Investment requirements for purchasing property in the private market more or less mirror the same requirements for investing in the public market. Moreover, the publicly traded REIT market often—and sometimes exclusively—represents the only market in which hotels effectively trade on a day-to-day basis.
In addition, because real estate operating fundamentals such as rents, occupancy and expenses affect both private and public markets similarly, the private and public pricing of real estate tends to move, although not perfectly, in the same direction over time.
Informed REIT investors typically also know the Ro or price per room at which they would be implicitly buying the assets of the REIT at a given stock price, because they can alternatively buy similar assets in the private market where they would undoubtedly know these metrics.
However, market participants who use publicly traded hotel REIT information should understand the differences between purchasing real estate in the private market compared to the public market. These differences relate to:
- the relative liquidity of each market;
- the volatility of prices in each market;
- the relative size of the investor pool for each investment; and,
- the different way private investors may or may not finance their investments compared to public investors.
The public market is more liquid and also more volatile in terms of the standard deviation of returns than the private market. Public REIT investors are seldom competitors for the purchase of private real estate, and thus their investment criteria might not directly translate into private market valuation metrics. In addition, public REIT investors do not tend to finance as much of their purchase as do private investors.
Some of these differences—for example, greater liquidity in the public market, but lower volatility in the private market—may offset each other.
Despite the limitations of this methodology, the technique described here can serve as a useful tool for market participants—investors and appraisers alike.
For more information concerning the detailed steps involved in employing publicly traded REIT data to value private real estate, please see The Appraisal Journal, “Deriving Capitalization Rates and Other Valuation Metrics from the REIT Market,” The Appraisal Institute, Fall 2009.
Copyright © 2017-2018 by Hotel Asset Management Magazine. All rights reserved.
About the Author
Mr. Gary S. DeWeese, MAI, has been teaching real estate appraisal classes for more than 20 years, including advanced courses related to highest and best use and market analysis, and the income, sales and cost approaches. DeWeese has an MBA from the University of California, Berkeley, and is the former head of the real estate investment group for the UC pension and endowment funds. He is the founding principal of Real Estate Strategic Solutions, LLC, a real estate consulting firm.