Term Project

Real Estate Finance

STRUCTURING A HOTEL

TRANSACTION FOR YOUR REAL

ESTATE INVESTMENT VEHICLE

Spring Term 2025

CONTEXT

TO AVOID MISTAKES AND WASTED TIME AND EFFORTS, PLEASE READ AND REVIEW THIS DOCUMENT and FAQ IN DETAIL BEFORE STARTING YOUR WORK.

Over the past decade, the low-interest-rate environment has driven investors away from cash and bonds, making higher-yielding assets like real estate more attractive. However, the post-pandemic capital market has been challenging and volatile. In the U.S., the annual inflation rate peaked at 8.0% in 2022, leading to a rising interest rate environment. This has put pressure on real estate values, as commercial real estate transactions are typically financed with significant amounts of debt. By 2023, the inflation rate began to stabilize, averaging 4.1%. As of February 2025, the year-on-year inflation rate stands at 2.8%. Concurrently, the U.S. economy faces political uncertainty, increased energy prices, geopolitical tensions, and extreme weather events.

Despite these challenges, global tourism is expected to remain a secular growth industry in the long run. At the right purchase price, the current capital market environment may still offer attractive hotel real estate investment opportunities.

The aim of this term project is to analyse and structure a hotel investment opportunity on behalf of your real estate investment vehicle. Your group represents a team of real estate investment analysts, whose primary task is to examine hotel investment opportunities for your real estate investment vehicle. Your firm is well-connected with the industry and regularly receives investment proposals from commercial real estate agents and market intermediaries such as CBRE, Colliers, or Cushman & Wakefield. In most cases, your team can reject proposals as inadequate for your investment vehicle, or too expensive. However, a number of recent opportunities have caught your interest. The chief investment officer has asked your team to investigate one of the investment opportunities in detail. In particular, your team is tasked with:

1) Identifying a suitable hotel investment opportunity for your investment vehicle.

2) Estimating the market value of your chosen hotel.

3) Performing a leveraged (before-tax) investment analysis and recommend an optimal transaction structure.

Your team’s mission is to write up the findings of your investment analysis as a report that will serve as a basis for the investment committee to make a final decision regarding whether or not to acquire the hotel under consideration.

Supporting Materials

This term project handout will refer to the following resources on LMS:

STR Reports:

 Forecast Report

 Profitability Report

 Trend Report

Additional Materials:

 CoStar Market Reports

 CBRE Cap Rate Survey 2024 H2

 News & Research Articles

Once you dive into this term project, you will find an abundance of information at your disposal. One of the key challenges lies in your ability to critically filter and employ only the most relevant data that will effectively inform. your analysis. At the same time, you are strongly encouraged to broaden your research scope by integrating additional relevant information from credible sources to enhance the depth and breadth of your analysis. Expanding your research beyond the provided materials will not only enrich your project but also demonstrate a comprehensive understanding of the subject matter.

To uphold academic integrity and ensure clarity in your report, make sure to properly cite all sources of information, including those listed above and any additional resources you consult, following the APA reference style. Proper citation is essential for enabling readers to verify the information presented and comprehend the foundation of your analysis.

Furthermore, both the written report and accompanying Excel file must be presented in a manner that is easily accessible and understandable to someone who may not be familiar with the intricacies of your project, such as your lecturer or a busy member of an investment committee. This requires careful attention to the organization, clarity, and presentation of your work to ensure it can be efficiently comprehended by readers with limited time.

By adhering to these guidelines and expectations, you will not only fulfill the academic requirements of the project but also produce a professional-quality analysis capable of realistically informing investment decisions in a professional setting.

1.Hotel Choice

When analysing potential investment opportunities, it is essential to consider the characteristics of your investment vehicle. Specifically, what risk-return profile is your investment vehicle targeting? This profile will not only influence whether you invest in core versus opportunistic opportunities but also affect the optimal amount of financial leverage to use when structuring the transaction with equity and debt.

For this term project, your first task is to choose a hotel for your investment vehicle:

 Appendix 1 shows which group has which real estate investment vehicle allocated.

 Appendix 2 shows the list of hotels you may choose.

Several hotels on this list could be suitable choices for your investment vehicle, with no definitive “wrong” options. The primary objective of this initial task is to demonstrate your understanding of your vehicle’s investment background and typical targets. Additionally, this task allows you the flexibility to select which hotel and sub-market you wish to analyse in detail. The aim is not to conduct a systematic or extensive preliminary analysis of all hotels. You should spend only a few hours making this selection. However, you will need to write one or two paragraphs in the executive summary of your report explaining why your chosen hotel is a suitable investment candidate, considering your investment vehicle’s background.

2.Market Valuation

2.1 Cash Flows

This task involves estimating the market value of your chosen hotel as of June 1st, 2025, using a 10- year discounted cash flow (DCF) analysis.

The first step in the market valuation is to provide an overview of your hotel and its location. Describe the facilities, size, and scale of the hotel, the strength of the brand, and the micro-location. Analyse supply and demand in the local hotel market by considering the strength of the local economy and the area’s attractiveness to tourists. The STR trend report will be helpful in understanding the evolution of occupancy, supply, and demand in the market. This preliminary analysis will serve as a basis for estimating expected future cash flows and the property discount rate in the market valuation. You are encouraged to create graphics or tables (e.g., a map showing the micro-location of the hotel and its major competitors). Overall, the description of the hotel and its location should not exceed one page of text (excluding graphics or tables).

The next step is to estimate the future cash flows of your hotel for the next ten years. Determine the average daily rate (ADR) of your hotel using current room price information available online. If the hotel has multiple room categories, calculate a weighted average ADR that reflects the number of rooms in each category. Additionally, consider seasonal variations in room prices to ensure your ADR is representative of the entire year. If you cannot find room rates for the whole year, use data from the STR Trend Report to extrapolate the missing figures.

Note that hotel prices per room shown on the internet represent the so-called "rack rate." According to industry insiders, the ADR received by the hotels tends to be ~ 15% lower than the rack rate. Therefore, adjust your online prices downward accordingly.

Another important factor to consider when estimating the ADR for your hotel is the value-added tax (VAT). In many countries, the room rate advertised online includes VAT, which is a tax paid by the guest to the government. However, this tax is not a revenue stream for the hotel and should be excluded from the calculation of the ADR. Therefore, it is important to divide the rack rate by (1+VAT rate) to obtain the pre-tax room rate, which is used to estimate the hotel's future cash flows.

To calculate the ADR growth rate (for the stabilised phase), utilise the four-factor formula introduced in the lecture. This involves considering the historical ADR growth in the market, the depreciation rate, and both past and anticipated future inflation rates. Should your analysis determine that the market is currently undergoing a transition phase, it's crucial to model the ADR explicitly for the duration of this phase. The ADR growth rate derived from the four-factor formula should then be applied starting from the first-year post-stabilisation.

Use the STR Trend Report to calculate the historical ADR growth rate in the market based on CAGR. Hint: Ideally, use a historical data period as long as possible to cover several market cycles.

To estimate the depreciation rate, you should ideally use a simple linear regression model to determine a submarket-specific rate. The STR Profitability Report for your hotel’s scale includes an MS Excel sheet called “Participation Report,” which can serve as a starting point for building a relevant comp set. Gather data on the current ADR (sourced online) and the age of hotels from your selected comp set. Ensure your final depreciation rate estimate is realistic, which may involve eliminating outliers (e.g., an old hotel with a very high ADR due to its location). Your estimate may become more accurate as you increase the sample size by including relevant hotels not listed in the STR participation report. Ultimately, you may still choose to adjust your estimate manually. In the lecture, we discussed that the depreciation rate typically ranges from -0.5% to -1.5% per year. If your regression estimate is 0% (or even positive), consider it an indication that the depreciation rate in this market is likely at the lower end of the range (-0.5%).

Use online resources to find the historical inflation rate for the same period.

Develop a realistic estimate for the future inflation rate. In the lecture, we typically represented the future inflation rate as a single figure, resulting in one future ADR growth rate. However, given the current high inflationary environment, you might consider forecasting the inflation rate explicitly for each of the next 10 years, or at least until it stabilizes. Consequently, the ADR growth rate would vary for each year or phase

Hint: Always carefully consider whether your inputs and estimations are realistic. Consistently sense-check inputs and results, as this applies to all aspects of your analysis. Avoid inputting your result from the four-factor formula into the DCF if you find the estimate unrealistic. Use your analytical judgment to determine if adjustments are necessary. Such adjustments may be warranted based on insights gained from analysing future supply and demand.

To estimate a realistic current occupancy rate, start with the market-level occupancy rate provided in the STR Reports. Carefully assess whether your hotel’s occupancy rate might differ from the market average. For instance, hotel-specific occupancy rates may need to reflect the unique characteristics of the hotel’s submarket, micro-location, or other peculiarities. Ensure you account for any cycles and seasonality appropriately. When you forecast changes in the occupancy rate, be cautious not to end up with unrealistically high or low estimates for the final year.

To estimate other segment revenues (e.g., F&B and Spa), use the benchmarks provided in the STR Profitability Report. In a real-world scenario, you would have access to the hotel’s historical revenues and expenses. For this term project, we will use the STR benchmarks as an approximation. Keep in mind that the figures in the STR Profitability Report represent the market average.

State your assumptions for other revenue and cost items. Explain your choice of starting year values (e.g., as a percentage of revenue or in absolute terms) and their growth over time (e.g., in line with the expected inflation rate). The challenge is to make the market valuation as specific to your hotel as possible. While market averages can often serve as reasonable proxies, your hotel may differ from the market average in many cases. Customize the market valuation as much as possible. For instance, eliminate revenue and cost items for “F&B” if your hotel does not have a restaurant or bar. Clearly state the reasons for any upward or downward adjustments. If you find no reason to deviate from the STR benchmarks, mention this as well, providing a brief explanation.

Critically analyse whether the reserve for capital replacement in the STR Profitability Report sufficiently approximates all actual future Capex requirements. Adjust it if necessary. Addtionally, evaluate if franchise, management, and incentive fees are appropriate for your hotel.

Use the direct-capitalisation approach to estimate the expected sales price at the end of the 10th year. Start with the proxies provided in the lecture slides for estimating buyer and seller transaction costs, but also consider finding country-, sector-, or even city-specific proxies that are more realistic for the particular circumstances.

Avoid being misled by data artifacts. For instance, if you estimate an extremely high or low depreciation rate, interpret it as an indication that the depreciation rate in this market is at the upper or lower end of a reasonable range, as discussed in the lecture. When encountering conflicting data from different sources, use your discretion to select the most realistic option and explain your choice.

2.2 Property Discount Rate

Discount the expected future cash flows using a property discount rate that appropriately reflects the hotel's risk profile. Refer to market reports (such as the one mentioned below) and apply the cap rate approach taught in the REF lecture to estimate the property discount rate.

Finding current market hotel cap rates can be complex, depending on your market. You are encouraged to seek out the best available information, with CoStar reports being particularly useful. Consider making further property-specific adjustments to account for factors such as micro-location, competitive situation, and other hotel-specific risks (e.g., building-related issues). Aim to account for these differences to the best of your knowledge and justify your reasoning.

Consider whether current cap rates are in equilibrium or unusually high (low) due to the hotel market being in a crisis (boom). If you suspect this is the case, a complementary estimate of an appropriate property discount rate based on the risk-premium approach may be helpful. Ensure that your estimated cap rate and forecasted future growth rate are realistic. Emphasise making strong arguments to support your rationale.

When estimating the growth component in the cap rate approach, you may use your result from the ADR growth rate analysis based on the 4-factor-formula.

Finish your market valuation by stating the rounded market value of your hotel (rounded to full 100,000 $.)

The following investment analysis requires a specific assumption for the purchase price. While the market value estimates the expected sales price under normal conditions, the actual transaction price is always the result of negotiations between the buyer and seller. For instance, a seller under financial distress may sell under time pressure, negatively impacting the sales price. Conversely, a buyer may identify defects in the building’s physical structure. A skillful negotiator can leverage such shortcomings to secure a lower purchase price than would otherwise be justified.

For the investment analysis in the next step, assume that after a long, strenuous, but successful negotiation process, your investment vehicle (the buyer) has agreed with the seller on a transaction price 10% lower than your estimated market value. This discount was possible because the previous owner had excessive financial leverage and was forced to sell to improve liquidity and avoid bankruptcy.

Overall, the market valuation section of your term project should not exceed four pages, excluding tables and figures.

3.Investment Analysis

3.1 Setting

The primary objective of the term project is to assess whether the potential hotel acquisition target meets the risk-return requirements of your investment vehicle. This entails ensuring that the hotel has the potential to at least match, and ideally exceed, the minimum total return target after accounting for financial leverage. Additionally, the hotel should align with the risk tolerance of the typical investors in your investment vehicle.

The investment analysis aims to determine whether the investment is financially advantageous and to propose a transaction structure that best aligns with your investment vehicle’s risk-return preferences. Consider the following minimum total return targets for the different investment vehicles. Simultaneously, ensure that the maximum loan-to-value (LTV) ratios are not exceeded to maintain controlled investment risk:

For more information on the three investment vehicles, refer to the lecture slides "Real Estate as an Asset Class" and the short article "The Major Real Estate Investment Vehicles" on LMS.

This part of the term project aims to structure the investment transaction using an optimal mix of equity and debt financing. Examine the following three alternative transaction structures with respect to the LTV ratio:

Assume that the mortgage loan is an interest-only loan, fully repaid by the end of the final year of your investment analysis. For the interest rate assumption, which depends on the LTV ratio, refer to the instructions provided below.

3.2 Mortgage Loan Interest Rates as a Function of LTV

When evaluating the optimal financial structure, consider the increased risk associated with higher financial leverage. As detailed in the lecture “The Effect of Leverage on Risk & Return,” both the expected return and risk for the equity investor rise with an increasing LTV ratio. Additionally, the interest rate on mortgage loans tends to increase with the LTV ratio, reflecting the heightened risk for the bank as financial leverage escalates. Therefore, as part of the investment analysis, it is essential to determine the cost of debt—or the mortgage interest rate for hotel loans—across various LTV scenarios.

The HVS Report on hotel interest rates, published on May 30, 2024, provided estimates for a range of potential hotel interest rates in the coming years as follows:

Given the uncertainties surrounding borrowing costs for hotel investments, and for the purposes of this project, refer to the table below for the borrowing rate to use in your hotel analysis.

3.3 Leveraged Investment Analysis Before Taxes

The final step is to conduct the leveraged investment analysis before taxes. Calculate the leveraged cash flows for the three LTV scenarios (see above) depending on your investment vehicle. Afterwards, analyse the following three measures for each LTV scenario:

 Internal rate of return (IRR)

 Modified internal rate of return (M-IRR)

 Net present value (NPV)

Which investment decision tool prefers which LTV scenario? Explain any potential differences in the rankings and come up with a final recommendation.

The last paragraph of the investment analysis should conclude with a summary of the investment case. Provide a recommendation regarding whether or not to pursue the transaction and the optimal transaction structure. Overall, the investment analysis part of your case study should not exceed three pages (excluding figures and tables).

4.Deliverables

4.1 Professionally Formatted Report (PDF)

The report must contain the following sections:

1. Executive Summary (about 1 page): A concise summary of the context, your findings, and your recommendation.

o Brief explanation of why you chose the hotel and how it matches your investment vehicle.

o Market value estimate from the DCF approach.

o Optimal LTV structure and the corresponding interest rate.

o A brief explanation of the final recommendation for the deal structure.

2. Market Valuation (about 3-4 pages): How did you develop your assumptions regarding growth rates, cash flows, cap rates, discount rates, capital reserves, etc.?

3. Investment Analysis (about 2-3 pages): Interpret the financial analysis results. Explain your recommended deal structure. Why did you choose this specific loan scenario, and how does it fit into the investment strategy?

Requirements: Strictly within seven pages of text, i.e., excluding tables, figures, and the cover page. The more concise your report, the better. APA referencing is mandatory in the report but not in MS Excel. The report must be formatted in Times New Roman, with line spacing 1.5, a font size of 11, and standard top and bottom margins (circa 1 inch). Any violations of these rules result in a penalty.

4.2 Financial Model (MS Excel)

The Excel file must contain the following tabs in the given sequence. Additional analyses could be added in the latter tabs:

1. Introduction: A short description of the MS Excel file. A layperson reviewing the file should be able to comprehend the nature of the contents included in the file. 100-150 words are ideal.

2. Preliminary Analysis: This part may contain the analysis of the cap rate and growth rate. The sheet may also include tables on other statistics such as ADRs, pipeline reports, occupancy ratios, or measures to assess the risk of the market. No extensive explanation is needed.

3. Assumptions: All assumptions and sources used in the DCF valuation method must be specified. The remaining tabs must use cell-referencing in calling these assumptions. The absence of cell-referencing may affect your grading if we cannot efficiently check your calculations.

4. Market Valuation: A complete DCF analysis. The final value should be provided in an easy-to-spot, specially formatted cell.

5. Investment Valuation: This sheet should contain the leveraged cash flows for three different LTV scenarios, as well as the calculation of the IRR, M-IRR, and NPV for all three scenarios. You can opt to show the different LTV scenarios in separate tabs. 10