This is the second part of Understanding Hotel Feasibility Studies articles. When we look at the total cost calculations you need to look at from the cost of land to development, construction, FF&E, inventories and all other expenses required to start a hotel on day zero.
Most industry experts use per room basis calculations for these calculations. Therefore, it is important to identify proposed facilities in terms of number, mix, and type of guest rooms and recreational amenities as well as style and size.
I have listed basic assumptions and guidelines with industry standard estimates below;
Cost Elements of a Project
(3) Interest during construction
(4) Furniture, fixtures, and equipment
(5) Operating equipment
(7) Pre-opening expenses
(8) Working capital
(9) Franchising Fees
Let’s look at each of these areas in details;
(1) Cost of Land
Depends on whether the land is actually purchased or owned
Cost of land typically weighed based on the number of rooms in the hotel. Can range from $500 per room to as high as $30,000 or $40,000
Taxes during construction and costs of clearing the land factored into the overall cost.
(2) Cost of Construction
Largest cost element in any hotel project
If franchised, have to adhere to franchisor specs
$60,000 per-room cost of construction is considered sufficient (Prevailing market scenario without interest).
a) Fixed-price contract: Cost more controlled, difficult to get because of the inflation prevalent both in labour and in construction materials, this is not often feasible.
b) Cost-plus contract: Contractor’s profits are a percentage of the costs. Maximum ceiling on cost can be written into the contract.
(3) Costs Pertaining to Furniture, Fixtures, and Equipment (FF&E)
Either developer buys from one-stop shop supplier or spreads out across several suppliers.
Front of house and back-of-the-house equipment.
Air-conditioning or heating is considered to be part of the construction cost.
$12,000 per room for furniture, fixtures, and equipment is considered acceptable (Of course depends on brand)
(4) Operating Equipment
Linen, silver, china, glassware, and, in some instances, uniforms.
Backup inventories must be acquired
$8,000 per room is reasonably acceptable.
Inventories can be broken down into the following categories:
3. Cleaning supplies
4. Paper supplies
5. Guest supplies
7. Engineering supplies
Excessive inventories can tie up capital and create additional interest costs. $6,000 per room for operating inventories should be considered satisfactory.
(6) Pre-opening Expenses
Prior to the opening of a hotel, expenses incurred for pre-opening payroll, training costs, advertising, and sales expenses and travel.
To be factored into the overall budget
Depends on the pre-opening philosophies of the operator.
$3,000 per room is considered optimum
(7) Working Capital
Funds required to meet early payrolls and operating expenses (unpredictable time period)
Determines cash flow health of the firm
Should amount to at least $2,000 per room.
(8) Franchising Fees: If the project is a franchise, total cost and fee structure to be clear.
I have shared a detailed article on Financial Calculations and ratios, however, I would like to touch base on a couple of key calculations for guiding purposes. If you need any further information you can either visit my previous articles on www.hospitalitycode.com/blog or you can contact me directly on firstname.lastname@example.org.
The second step is to project the hotel’s operating revenue and expenses based on the previously estimated occupancy and room rate. This results in an estimate of annual net operating income. Most consultants use a five- to 10-year projection period, so this process needs to be repeated for each year.
The last step is to convert the projected NOI into an estimate of value using a weighted cost of capital discounted cash flow procedure. The end result is an estimate of economic value that can be compared to the total project cost.
Some companies will substitute a net present value calculation or determine the internal rate of return (IRR) for the last step. However, I prefer using the economic value approach because you end up comparing “apples with apples” — i.e. cost with value.
As you can see, this process of determining economic value requires local market knowledge, hotel financial expertise and experience with valuation methodology. Luckily for architects and hotel developers, there are two simple rules of thumbs that will provide a rough approximation as to whether a project is economically feasible.
To be able to make it easier and give a guidance, I will use a sample project and apply key calculations accordingly.
A proposed hotel is being considered on a parcel of land that can be acquired for 5,000,000. Zoning permits the development of 200 rooms.
Based on local market conditions, the proposed hotel should achieve a stabilized occupancy of 75.0% and an average room rate of 150.00
Using these inputs, the Economic Land Value would be calculated as follows:
(1) Net Operating Income: Operating income is the profit realized from a business' own operations.
(2) Interest Carry Ratio %:
This ratio gives you an idea of the maximum interest rate that a loan's cash flow could carry. This example shows a 13% interest rate. The cash flow is great for this example.
(3) Debt Service Coverage Ratio %:
The higher the debt service coverage, the less risky the loan. Typical debt service coverage requirements range from 1.1 to 1.25. A 1.52 ratio reflects a good investment.
(4) Economic Land Value:
It is the easiest way to test the cost of the land to determine whether it exceeds a supportable economic land value. The following formula calculates economic land value:
(5) Economic Value:
This is a very simple way to approximate a hotel’s total economic value. The formula is as follows:
(6) Land Cost Vs Economic Value %:
This link percentage gives you a reference to whether the project is feasible or not. This relationship should be no more than 15% to 20%. In other parts of the world where labour cost is low, this percentage relationship can be higher.
Using these hotel feasibility rules of thumb combined with a professionally prepared study will ensure the architect and developer are not creating a project that has no economic viability. As with any rule of thumb, there are numerous exceptions that need to be factored into the evaluation. Before abandoning a project because the rules don’t produce the desired results, it is a good time to call in a professional consultant to prepare a more in-depth analysis to either verify or dispute the conclusions produced by the rules of thumb.
Development Cost basis Feasibility Analysis
While performing market studies its crucial identify forecast, average rate, projected revenues and expenses for proposed hotels to determine their feasibility. It is important to recognise development costs which are critical to the investment decisions.
So far, we have examined the traditional approach which requires market supply and demand conditions on the proposed hotel facilities.
The economic value is calculated and compared to the construction cost or the cash-on-cash returns are analysed. While this process is thorough and informative, it is time-consuming and expensive. To move ahead with a development, we often have three questions that need to be addressed:
Is there a demand for a new hotel in this market?
What is the appropriate brand, size, facilities, and amenities for a new hotel?
Is it feasible?
In analysing the potential feasibility of a proposed hotel, the process is somewhat of a chicken/egg dilemma. Will the market support a new hotel? Will the hotel generate an acceptable return on investment?
In order to answer these questions, a market study that analyses supply and demand and provides only rate and occupancy information may not tell the developer enough for him or her to make a thoughtful decision, but it is a good place to start. Even if the rate and occupancy estimates are expanded into a forecast of occupancy and rate, the income potential is only one part of the equation.
Analysing the return on investment for a new hotel is fundamentally no different than for any other business decision.
In determining the success of many types of hotel properties, the construction cost of the project is probably the most critical determinant of hotel feasibility. The cost is a fixed known component of the analysis, while revenue performance is variable subject to the dynamics of the particular marketplace. In order to set up a framework with which to evaluate the potential success of a proposed hotel, we recommend that developers work their analysis backwards when appropriate.
As an example, a 3.0-acre site is available for £28.7 per square foot for a total of £5,000,000 or £25,000 per room. Let’s run a basic analysis to set up the realistic range of acceptable room revenue performance that would determine the project feasible. Previously we look into the market to determine if the area can support the hotel, this time we will go other way around and try to find the RevPAR per day to see if we can estimate project feasibility.
When a new hotel project starts, we look at the site and a suitable land to build on. This is determined based on the market in the particular location. For the sake of this scenario, hotel development cost projected around 15% of the total budget of £166.667 per room. Just a reminder that this is a rounded figure, the land cost can be more or less depending on the particular market and site.
From this point on we will assume that financing is available for 65% of the construction cost, an equity contribution of £58,333 per room (or 35% of the construction cost) required.
To make calculations more efficient we will project to open a limited-service hotel which in general require a 12% equity dividend return. As a result, the 65% financed (or £108,333 per room) would be subject to a 9.0% mortgage constant. Therefore, the necessary income to provide these returns would be £16,750 per room.
The £16,750 per room income represents a 10.05% return on the total project cost. STR provides a range of reports based on the operating statement of more than 5,800 US hotels which allows you to select custom HOST reports. According to this report, limited-service hotels net operating income per room (£16,750) is 40% of gross revenue and that rooms revenue also represents 90% of gross revenue.
Daily room revenues translate to a RevPAR of £103.25 which is a combination of occupancy and average rate (RevPAR = Occ% x ADR). I have listed potential rates and occupancy that could help you to reach required RevPAR.
Based on these figures now we can start a market study to evaluate whether any of these combinations work and identify whether the proposed hotel be able to achieve a rate and occupancy in its market that supports the construction costs?
There is no one approach to find the answers and therefore, when we do the feasibility analysis we have to look into which would make more sense and save money, time and efforts to make evaluations more effective. In this example case, if you see that you have no chance to achieve the required rate and occupancy levels in the current market, this will save a lot of market study analysis.
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I regularly upload easy to use spreadsheets for guidance and free to use basis. You can also find above calculations in an excel spreadsheet. please visit hospitalitycode.com/resource-hub to download.
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