Valuation strategies for the new normal

Green Street Advisors’ August 6 Commercial Property Price Index (CPPI) showed that hotel sector values declined 25% from pre-COVID-19 levels. While few events could equal the severity of that nosedive, the pandemic may have to take a backseat to the Florida Fifth District Court of Appeal in terms of its long-term impact on how much hotel real estate assets are worth.

On June 19, the appellate court challenged the underpinnings of one of the industry’s most widely accepted valuation approaches when it ruled that Stephen Rushmore’s valuation methodology “violates Florida law because it does not remove the nontaxable, intangible business value from the assessment.”

Contributed by Mary Scoviak

Although the court issued a revised opinion in the case of Rick Singh, As Property Appraiser (“Appraiser”) vs. Walt Disney Parks and Resorts US, Inc., et al. (“Disney”) on August 7 concluding that it was Orange County (Florida) property appraiser Rick Singh’s incorrect application of the approach, not technically the methodology itself, that violated state law, this ruling could build some major distance in the already wide bid-ask gap on hotels.

It’s not the first time the Rushmore Approach has come under fire. The California Court of Appeal ruled in 2014 that, in using this method, the San Mateo County Assessor illegally assessed the intangible assets of the Ritz-Carlton, Half Moon Bay, California. Despite the high profiles of the California and Florida rulings, this methodology has withstood most court tests and been adopted by thousands of hotel appraisers worldwide.

But that was all in the pre-COVID-19 past. The question now is what it means for prospective buyers who already see prices as unpalatably high and willing/unwilling sellers who won’t go to market with fire sale pricing.

Getty Images
Getty Images

At issue is what constitutes the actual value for hotel real estate. On one side is Rushmore, who founded Hospitality Valuation Services (later renamed HVS), Westbury, New York, in 1980, and served as its CEO and president until his retirement last year. He essentially reset the parameters for determining hotel values with a 1978 monograph and a 1983 appraisal textbook on hotel and motel valuation. His methodology shook up general valuation processes by separating out income attributable to business (intangible assets) and income attributable to personal property from the hotel’s entire income stream.

The Rushmore Approach addresses the tangible personal property component by deducting a reserve for replacement along with the actual value of the personal property in place. So, that means starting with net income and, in terms of the business component, subtracting the franchise/management fee and adjustment for residential intangibles as well as, on the personal property component, subtracting the reserve on replacement and return on personal property of the value of the FF&E in place.

On the other is David Lennhoff, principal, Lennhoff Real Estate Consulting, Washington, D.C., and editor of “A Business Enterprise Value Anthology.” As applied to appraisals of just the real estate component, not the total assets of the hotel, his Business Enterprise Approach (BEA) starts with the value of the total assets of the business, then subtracts the market value of the tangible personal property; market value of the cash equivalents; market value of “the skilled and assembled workforce;” market value of the name/flag/reputation and market value of any residual intangible assets to determine the real value property as a residual.

This approach also amortizes business start-up costs, unlike the Rushmore method, which contends that hotels, by the very nature of their short-term tenancy, are constantly expending money on sales and marketing and assembling its workforce (a nod to high turnover.)

More than a war of words, these contrasting methodologies lead to vastly different valuations for hotel real estate. One of the first major tests for these two methods, the 2003 property tax appeal regarding the Marriott Hotel in Saddle Brook, New Jersey, filed in the Tax Court of New Jersey, illustrates the impact that could ensue if more states follow Florida in rejecting the Rushmore method.

For the purposes of the Marriott case, the Rushmore method would have valued the real property component as US$75,000 per room or 60% of the total property value while Lennhoff’s approach would have put it at US$45,000 per room or 36% of the total property value. After a two-year deliberation, the Tax Court of New Jersey accepted Rushmore’s estimated market value.

Fast-forward to 2020, it’s no wonder tax-paying Florida hotel owners see the state appellate court’s decision as a major source of good news, especially with coronavirus still fueling cash burn. Prospective buyers also have a reason to celebrate on the pricing side but may find it hard to obtain financing.

The decision also opens larger questions on whether the BEA metrics would garner adequate insurance coverage or leave hotel loans under water. It can’t make sellers very happy, particularly as they see the end of bank forbearance nearing and, if they’re worried about making deferral payments, whether they’ll be forced to sell as highly deflated prices.

“The big picture which really scares hotel appraisers is that the small group pushing the BEA is very powerful in the Appraisal Institute and, if they get their way, they will mandate that ALL hotel appraisals utilize this approach, said Rushmore. “This will result in values that are 20% to 50% lower which means the hotel mortgage market will totally collapse. It would be a disaster. Very few hotel owners and operators understand the ramifications; they only want the property taxes reduced.”

Lennhoff sees it differently. He also stresses that the Florida case is about appraisals of the real estate component for tax purposes, not for buying or selling hotel assets. “The valuation of hotel real property in the current circumstances is challenging,” he said. The first step is determining the highest and best use of that property. If continued operation as a hotel doesn’t meet that criterion, “the appraisal becomes a land valuation,” he added.

If it does, the appraiser must do three things: determine when the market expects the property to return to stabilized operation, what that stabilized operation will look like in terms of ADR and occupancy and what the risk is of those two events occurring as planned. Once that has been uncovered, the appraiser calculates the net income to the hotel real estate by beginning with total revenue to the total assets and deducting expenses to total assets then return on and of FF&E and business intangibles. That net income is then discounted to a present value using a discount rate that reflects the risk identified as a part of the first three steps shown above.

“The thing is, market value assumes a sale. So, it isn’t really a matter of whether the seller wants to sell. Again, if there is no business value now and no real prospects for recovery, then the highest and best use is probably a tear down. If it is more a matter of waiting until market returns, then price/value today would be discounted present worth of right to property at stabilized value once it has recovered,” Lennhoff said.