4 HOTEL VALUATIONS 4 - Ryan, LLC

4 VALUATION STRATEGIES November/December 2013 HOTEL VALUATIONS 4 VALUATION STRATEGIES

AN INHOSPITABLE WHY CAN’T WE AGREE

VALUATION STRATEGIES 5HOTEL VALUATIONS November/December 2013 VALUATION STRATEGIES 5

There is no consensus as to how to value hotels, and with many transactions being subject to atypical market

forces, reported sales must be carefully examined and adjusted as needed before being used as comparables.

DEBATE ON HOW TO VALUE A HOTEL?

M I C H A E L A L L E N

for lending, tax, and accounting pur-poses remains a battlefield. Partisansfor the various warring factions andcompeting valuation methodologiesare no closer today to reaching com-mon ground and consensus on how tovalue a hotel than they have been in thelast couple of decades.This article explores ten of the lead-

ing concerns that have contributed tothe confusion and lack of consensusin the valuation of hotels: 1. How is the market driving the con-fusion?

2. Does the “rule of thumb” methodhelp produce credible indicationsof value?

3. Can the entire allocation mess beavoided by addressing values pre-closing?

4. Are real estate investment trusts(REITs) skewing non-realty alloca-tions and thereby inflating hotelsales?

5. Are foreign buyers skewing salescomparables by overpaying?

6. Has Cal i fornia solved theLennhoff/Rushmore debate?

7. Has the Appraisal Institute’s Course833 helped or hurt?

8. Is there a state “legislative fix”?9. The significance of recent andpending judicial decisions.

10. The importance of “raw” vs. “bud-geted” capital expenditures.It is not a secret that there has been

a nasty little war raging within theappraisal industry over how best tovalue “going concern” properties suchas hotels. The current appraisal litera-ture is replete with argument andcounter-arguments from one fac-tion/theory or another.The Appraisal Institute’s Course 833

was supposed to begin the healingprocess and provide guidance, at leastas to how to identify the intangiblesthat need to be considered for adjust-

ment. However, based on personalexperience attending this course, itseems to have merely stiffened theresolve of some to “fight to the death”before compromising or hear inganother point of view. It certainly hassucceeded in removing a lot of civili-ty and professionalism from the dis-cussion. That is tragic and a real missedopportunity to f ind the commonground that is required to produce cer-tainty. Without certainty, opinions ofvalue are meaningless, and only cer-tainty provides a currency that all canuse in valuing such properties forwhatever purpose.

How is the Market Driving the Confusion?It is a busy and interesting time to ownor operate a hotel in the U.S. The lastten years have been a period of eco-

nomic feast or famine. U.S. sale pricesfor hotels have been yo-yoing up anddown, driven by rapidly changingfinancial, investment, regulatory, andlending environments.These sales, in turn, have made valu-

ing hotels under the sales acquisitionscomparison approach almost impos-sible, either as a result of a lack of mar-ket sales or because of deals that are soatypical as to require many adjust-ments, which render any resulting val-ue indications potentially unreliable.In many cases, sales make no economicsense based on actual net operatingincome (NOI). Some acquisit ionsappear to be underwritten on widelyspeculative and overly enthusiasticassumptions as to revenue per availableroom (RevPAR), NOI, and lower cap-italization rates (cap rates). One won-ders what the nature of any suchtransaction “premium” being paid

6 VALUATION STRATEGIES November/December 2013 HOTEL VALUATIONS

Michael Allen is a Principal at Ryan, LLC. He has morethan 30 years of experience in the valuation of complexcommercial real estate with an emphasis in hospitali-ty and lodging properties throughout the U.S. andCanada.

Hotel valuation

might be. Is it a payment to rewardsomething other than the real estateitself, as it existed on the date of theappraisal or assessment?Most hotel insiders seem to regard

and deal with “intangibles” associatedwith their hotels in the same way asJustice Potter Stewart did with pornog-raphy when he famously stated the fol-lowing:

… I shall not today attempt furtherto define the kinds of material Iunderstand to be embraced with-in that shorthand descript ion[“hard-core pornography”]; andperhaps I could never succeed inintelligibly doing so. But I know itwhen I see it, and the motion pictureinvolved in this case is not that.[Emphasis added.]1

This article deals with the statustoday, including the obstacles presented,

of applying a uniform approach to iden-tifying, segregating, and valuing suchintangibles, which most appraisers andassessors know exist when they look atan operating and stabilized hotel.

Management and Amenities as Important DistinguishersPurchasers of hotels and underwritersof such transactions often share a com-mon expectation of increasing valuepost-acquisition through remodeling,upgrading , and refurbishing theacquired property. Management toolsto increase value include rebranding(new flag) and upgrading guest roomsand common areas with new fixtures,furniture, and equipment (FF&E) andincreased amenities. But should thisincreased asset value get attributedsolely to the real estate alone, or mustit be distributed on some basis amongthe other components of value presentat the hotel, including tangible per-sonal property (TPP) and intangibles,including, but not limited to, good-will? If the increased value is a directresult of new and better management,is it appropriate to allocate any of thatnew added value to the real estate thathouses it (other than to the extent thatthe physical building and improve-ments were responsible)?

Financial Crisis and ReboundGone, and apparently already forgot-ten, are the dark days after 9/11 whenhotel va lues in the U.S. plungedovernight and remained depressed forseveral years. After rebounding andreaching a fever pitch in 2007, valuescrashed again with the financial crisislaunched by the failure of LehmanBrothers in late 2008 and the collapseof the house of cards built with mort-gage-backed securities that no oneseemed to understand. Transparencyrelating to underlying hard assets waslacking, with lenders focused primar-ily on the lucrative and multiple feesthat they could earn upfront by trad-ing in these instruments. Unfortunately,like in so many prior financial manip-ulations, when the curtain was pulledback there was no “there, there.”After hotel values plunged again,

financing for acquisition and con-

struction dried up or got very expen-sive. Hotel fundamentals deteriorated,and RevPAR dived, as corporate andvacation travel was cut in the reces-sion. This, in turn, led to loan defaultsfor the overleveraged and foreclosures,and in general created a pretty miser-able time to own or operate a hotel.Of course, those investors and insti-

tutions with money jumped in at thebottom of the market and slowlybought assets cheap through the job-less recovery of the last eight years.Thus, the hotel business slowly recov-ered, fueled in part by cutt ing ofexpenses and room rates. Corporationsadopted a strategy of doing more withless to increase profits, earnings beforeinterest, taxes, and amortization (EBI-TA), and, therefore, stock prices, evenwhile top-line revenues were declin-ing or only growing sluggishly. Com-panies with big travel budgets investedin video conferencing and slashed trav-el and entertainment, thereby furtherhampering the recovery of the hospi-tality industry.

Low Interest Rates Lead the Recovery.

How did hotels dig themselves out ofthis mess and become, yet again, thehot acquisition commodity they aretoday? There were many factors, butprobably none more important thanthe historically low interest rates thatthe Federal Reserve pushed through asa cure to the recession of 2009–2012.Interest rates dropped so low that theywere effectively at or below the rate ofreal inflation. This sounded like freemoney to many investors who had beensitting on the sidelines. Who could turndown free money?

Acquis i t ions by REITS. Hotelinvestors started looking at replace-ment cost against acquisition pricesand used the cheap money to startbuying again, if they could get it. Manycould not, but REITs found that theyonce again had become the darlingsof Wall Street and could buy verycheap capital to acquire hotels. Accord-ingly, all of the hotel REITs went on abuying splurge that continues today.As is usually the case where availabil-ity of cheap money disproportionate-ly drives investment decisions (ratherthan operating fundamentals), saleswere seen that made no obvious sensebased on existing NOI and cash flow.

VALUATION STRATEGIES 7HOTEL VALUATIONS November/December 2013

Many of these sales were of trophyproperties in U.S. markets where thebarriers to entry or duplication werehistorically very high.The effect on hotel valuation was

that these sales were then in turn usedas comparables to help value otherproperties for loan or assessment pur-poses. Accordingly, there has been acompounding effect when non-REITssuch as foreign investors looking fora safe haven started competing in thisheated marketplace and paying thesesame “inflated” pr ices. Cap ratesbegan to drop again, even though thefundamentals of hotel operationswere still weak. In some cases, futureNOI was used to value hotels, whichcould be very far from actual or his-toric NOI.Lately, interest rates have begun to

rise from their historic lows, and thishas cooled the buying frenzy some-what. Still, there are many unansweredquestions: • What are we to make of all theserecent hotel sales?

• How can we use them at face valueor unadjusted, in valuing other hotelproperties for lending or assessmentpurposes?

• Are these reported sales prices onlyfor the total assets of the business(TAB) and, therefore, serve to mask

and inflate the true value of theunderlying value of the real estate?

• Do these sales require so manyadjustments to get to the underly-ing real estate value, so as to makethem of little use as indicators offair market value under the salescomparison approach to value, invaluing other similar hotel proper-ties?

• Can it be assumed that the nextbuyer will also have access to lowand plentiful financing? If not, willthat push values down again bycausing cap rates to rise to reflectthat additional risk?

• Is a hotel value now dependent onthe buyer’s access to cheap moneyor flight capital from outside of thecountry?

• If a REIT or a foreign investor willnot buy a hotel, who do you sell toand will you get less for your prop-erty?These are all difficult questions for

lenders, appraisers, and assessors toanswer. They are generated from thechoppy data provided by recent sales.

Market in Los Angeles. For instance,consider Los Angeles, where the mar-ket for the second half of 2013 hasbeen resilient and vibrant accordingto a recent Jones Lang LaSalle (JLL)national hotel investment survey.2 In

fact, Los Angeles exhibited the highestratio of buyers to sellers among themarkets surveyed by JLL, and investorexpectations for hotel performance areamong the highest in the Americas,with a positive net balance sentimentof 65.1% for the short term and 75%during the medium term for the city.The medium-term outlook suggeststhat investors feel that Los Angeles stillhas significant hotel performanceupside.JLL adds that there were quite a few

hotel trades in 2011 and 2012, so themarket was taking a breather in thefirst half of 2013. In addition, as sup-ply and demand fundamentalsimproved, many investors decided towait it out to see what would happenbefore deciding to take their assets tomarket. Also, many Beverly Hills luxu-ry hotels that had been stable for yearssimply did not trade at all. And lastly,many owners wanted to take advan-tage of the favorable debt markets andhold onto properties longer in an envi-ronment in which there has been sucha willingness on the part of conduitand balance-sheet lenders to lend again.Expectations for leveraged internal

rates of return (IRR) in Los Angeleshave held steady at 17.2% over the pastsix months, a full percentage pointbelow the Americas’ average, giveninvestors’ positive view of the market.Surveyed cap rates for the market aver-age 7.5%, which is slightly below pre-vious survey periods for the city, andinvestors expect cap rates in the mar-ket to decrease during the next sixmonths as hotel profits increase andmore high-quality assets come to mar-ket. Also, the high number of buyers tosellers is poised to push up asset val-ues and result in more transactions.Some 70% of respondents in the JLLsurvey who are active in the marketare pursuing acquisition opportuni-ties, with private equity investors, own-


EXHIBIT 1Distress Share of Market Shrinking

% Distressed Occupancy50%

Distressed as a % of Total TransactionsDistressed as a % of Volume (Four-Quarter Avg.)PPR54 Occupancy

Sources: CoStar Group, Inc.: STR; PPR As of 13Q1

50%

66%

64%

62%

60%

58%

45%

40%

35%

30%

25%

20%

15%

10%

5%

0%07 08 09 10 11 12 13

56%

1 Justice Potter Stewart, concurring opinion inJacobellis v. Ohio 378 U.S. 184 (1964) (regard-ing possible obscenity in The Lovers).

2 http://www.us.am.joneslanglasal le.com/UnitedStates/ENUS/Pages/Newsitem.aspx?ItemID=25997.

3 Myers, “They May Have Stayed at a Holiday InnExpress Last Night,” http://www.costar.com/News/Article/They-May-Have-Stayed-at-a-Holiday-Inn-Express-Last-Night/150417.

4 http://www.hospitalitynet.org/news/4061815.html.

er/operators, and REITs at the fore-front, in addition to offshore investors.Recent transactions in this market

attest to the growing momentum ofhotel trades. For example, PebblebrookHotel Trust recently purchased the lux-ury Redbury Hotel in Hollywood for$34 million and plans to capitalize onits upside potential. It forecasts thatduring the next 12 months, the hotelwill generate EBITDA of $2.75 millionto $3 million. The REIT netted a total

of $97 million from a preferred equi-ty offering of 400,000 series C shares,which followed public offering of 3.6million series C shares in March 2013.It will use the proceeds for general cor-porate purposes, including possibleacquisitions and investments.

Distressed Properties. According toCoStar, at their height in 2010, morethan 40% of hotel property sales andvolume were distress-related. Now asindicated in Exhibit 1 both metrics are

below 25%, and the pipeline of dis-tressed assets is shrinking too.CoStar finds a changing investment

climate:

For many investors, especiallythose interested in value-add pur-chases, this may be the time to startconsidering assets in secondarymarkets. With distress shrinkingand investors focusing on relative-ly safe assets, in top core marketsprice points often rival mid-2000shighs. And the share of overall vol-ume in these typically fundamen-tal ly superior metros remainsabove the long-term trend.3

As of the first quarter of 2013,CoStar’s Commercial Repeat SalesIndex (CCRSI) found that hotel pric-ing expanded by 12% over the pastyear, exceeding the improvement seenin any other property type. However,pricing outside of the six largest coremarkets has not increased as dramat-ically, and there is generally more occu-pancy upside still to come in manysecondary markets. On the whole, thesemarkets are expected to have two morepercentage points of occupancy gainsbefore los ing steam, double theimprovement of the core market group.But timing is becoming a factor, assome investors are already finding theirway into the nation’s interior.

Current Overall Market OutlookNationally, hotel owners can breathe alittle easier. Their investments are notlikely to be much affected by newhotels coming on the scene to take apiece of the pie. Lodging Econometrics(LE) predicts new hotel openings of739 projects with 82,587 rooms for2015, representing a growth rate fornew supply of 1.6%.4 LE calls thegrowth slow to moderate but steadyand an improvement over 2011’s cycli-cal bottom of 346 projects with 37,193rooms. Despite these increases, theindustry is still far away from the peakfor new openings of 1,341 projects with154,258 rooms set in 2008.

Where Are We in the Development

Pipeline? At mid-year 2013, the totalconstruction pipeline stood at 2,822projects with 350,151 rooms, a 4%increase for projects year over year(YoY). Projects under construction have


Rushmore and hiscamp historicallyfavor and want toprotect lenders.

been on the rise for eight quarters. At646 projects, they are up 23% YoY, whilerooms at 81,531 are up 22% YoY. Pro-jects expected to start in the next 12months are up 36% at 1,116 projects.Rooms at 128,861 are up 38% and havebeen trending upwards for four quarters.However, projects in early planning

are down 23%. Early planning cur-rently stands at 1,060 projects with139,759 rooms. LE says this indicatesthat fewer luxury and upper upscaleresort and city center projects areentering the pipeline. While growth inthe pipeline is sluggish by historic stan-dards, LE believes that there is no realcatalyst for development on the hori-zon. Due to the severity of the “GreatRecession,” compared to other lodg-ing real estate cycles, this one appearsdestined to be prolonged for a mini-mum of two extra years. Overall, devel-opment is likely to continue “sailingagainst the wind” into the second halfof the decade.5

Why Are Going-ConcernProperties a Valuation Problem?Going-concern properties are usuallydefined as real property that serves asa platform for a particular business,the value of which is the aggregate offour components: • Land.• Improvements to land.• Tangible personal property.• Intangibles.Accordingly, using the value of the

going concern (aka business enterprisevalue) or to use the newly approvedAppraisal Institute (AI) terminology,the total assets of the business (TAB)to represent the real estate-only value ofthe property is always going to be thewrong answer for both lending andassessment purposes.Often, these properties are designed

and improved for a very particularbusiness purposes. In doing so, theproperty loses much of its generic realestate value and takes on a more sub-jective and perhaps increased value,but to a much smaller potential pool ofusers, buyers, and tenants. That, inturn, can affect its market value andgenerate different types of values,including investment value, market val-ue for assessment purposes, and fair

market value under the Uniform Stan-dards of Professional Appraisal Prac-tice (USPAP).6As Steven Rushmore put it so apt-

ly back in 1984:

… Appraisers soon learn that lodg-ing facilities are more than land,bricks, and mortar; they are retail-oriented, labor-intensive business-es necessitating a high level ofmanagerial expertise. In additionhostelries require a significantinvestment in personal property(furniture, fixtures, and equip-ment) that has a relatively shortuseful life and is subject to rapiddepreciation and obsolescence. Allthese unusual characteristics mustbe handled in a proper mannerduring the hotel valuation processin order to derive a supportableestimate of market value.7

Status of the ValuationMethodology DebateAn objective analysis of the differencebetween the so called Rushmore andLennhoff approaches always leads tothe conclusion that they agree morethan they disagree on the basic valu-ation methodology. Both of thesecamps rely primarily on an incomeapproach to value hotels. They bothapply a residual technique to arrive atan annual, stabilized NOI of the TAB,which they then adjust until they getto an estimate of annual NOI of thereal estate only that is then capital-ized into a value estimate of the realestate using a “loaded” capitalizationrate (i.e., base cap rate plus applicablelocal tax rate because property taxesare usually not expensed prior toarriving at the NOI of the real estate).


Much more isneeded to get

everyone singingfrom the same page

of sheet music.

The Rushmore and Lennhof fschools both start with the assump-tion that 100% of the NOI of the TABcannot be allocated to just the realestate, or else the significant invest-ment in tangible personal property(TPP) and intangibles that are pre-sent in all operating hotels is notrewarded. They also seem to agreethat the TAB NOI needs to be adjust-ed to get down to the NOI of the realestate and then capitalize that into avalue indication of the real estatealone, using a real estate-specific caprate. However, they disagree on whatbelow-the-line adjustments should bemade (e.g., whether to deduct thedepreciated value of the TPP afterhaving already taken a return on andof it or if startup costs should be con-sidered and adjusted for).Exhibit 2 illustrates the main dif-

ferences between the Rushmore andLennhoff camps:8Lennhoff himself often makes the

point that there is more that he andRushmore agree on than they disagreeon. But they do disagree. Furthermore,it appears that the engine of their dis-pute is the purpose of the intendedvaluation. Rushmore and his camp his-torically favor and want to protectlenders. That is the basic profile of theirclients, and their work product is typ-ically appraisals for lending. Accord-ingly, they are very sensitive to anymethodology that would dilute the val-ue of the underlying real estate “hardassets” (even in USPAP appraisals)because that could affect the amountand size of the loan that could be made

by the lender to the hotel or its buyer.Lennhoff, on the other hand, has beenassociated more with hotel operatorsand their need to reduce operatingexpenses, particularly property taxes.The key differences are Lennhoff ’s

promotion of a business start-up costdeduction, and his deduction for areturn on FF&E. They both adjust forresidual intangibles. Any way you lookat it, both methods are complicatedand require numerous potentially sub-jective adjustments, which if doneimproperly, would skew the resultingreal estate value indication significantly.With all these complicated valua-

tion formulas, the question becomeswhether, as the French proverb goes, weare …“noyez le poisson,” or are wedrowning the fish?”9 Is there a simplerand more universa l ly acceptablemethod to value hotels? Do we need 70pages of USPAP complying analysisand valuation to tell us how much topay for, lend, or assess the real estatethat houses a hotel?

Does Rushmore’s Rule of Thumb

Method Produce Credible Value Indica-

tions? Rushmore has asserted as farback as 2003 that the hotel industrymay have a rule of thumb that providesa rough approximation of a hotel’s val-ue based on its room rate.10 This ruleof thumb suggests that the value of ahotel can be estimated by multiplyingthe hotel’s average room rate (ADR) by1,000. The result is presumably theTAB value of the hotel on a per roombasis. If a 100-key hotel has an averageroom rate of $300, its value per key is$300,000 (300 x $ 1,000); thus, the


EXHIBIT 2Rushmore and Lennhoff Methods Compared

Main differences in Rushmore / Lennhoff methodsRushmore

TAB Net Income less:

Business ComponentManagement Fee

Adjust for Residual Intangibles

Personal Property ComponentReserve for ReplacementValue of FF&E in place

Lennhoff

TAB Net Income less:

Business ComponentManagement Fee

Adjust for Residual IntangiblesBusiness Start-Up Costs

Personal Property ComponentReserve for ReplacementValue of FF&E in place

Return on FF&E

5 “Report: New hotel supply still growing at slug-gish pace,” Hotel Management (8/14/2013),http://www.hotelmanagement.net/industry-fundamentals/report-new-hotel-supply-still-growing-at-s luggish-pace-21718?utm_source=&utm_medium=newsletter&utm_campaign=_12311969&utm_content=21718&spMailingID=17809364&spUserID=Mjg4NjQwNjExODcS1&spJobID=222153702&spReportId=MjIyMTUzNzAyS0.

6 The USPAP are the generally accepted stan-dards for professional appraisal practice in NorthAmerica. They contain standards for all types ofappraisal services including real estate, personalproperty, business, and mass appraisal. TheFinancial Institutions Reform, Recovery andEnforcement Act of 1989 (FIRREA) recognizesUSPAP as the generally accepted appraisal stan-dards and requires USPAP compliance for statecertified appraisers. State appraiser certificationand licensing boards; federal, state, and localagencies; appraisal services; and appraisal tradeassociations require compliance with USPAP.http://www.appraisalfoundation.org/s_appraisal/index.asp.

7 Rushmore and Rubin, “The Valuation of Hotelsand Motels for Assessment Purposes,” TheAppraisal Journal (April 1984).

8 Presentation by Suzanne Melkin, HVS, atAppraisal Institute Fall Conference 2010.

total value of the hotel’s real estatewould be $30,000,000 ($300,000 x100). Other multipliers can be appliedto adjust the indicated value. Thedrawback with this approach (at leastthe 1,000 x ADR x number of keys for-mula) is that it does not calculate forthe underlying real estate value. It justtells you how much to pay for the TABof the hotel.Rushmore asserts that while many

factors go into estimating a hotel’s val-ue, over the years this rule of thumbhas been surprisingly accurate, andmany hotel industry insiders swear byit as a gut check when reviewing hotelvalues produced by traditional valua-tion approaches. In most instances,the difference can be attributed to fac-tors such an abnormally low or highoccupancy, highly efficient or ineffi-cient management, or unusual sourcesof other revenue. Such differencesoften will skew the appraised valueand make the rule of thumb approachinaccurate.According to Rushmore, this rule

of thumb is also helpful in evaluatingthe initial feasibility of a proposed

hotel. Instead of comparing the resultsto market value, the rule of thumb canbe used to determine whether the totalproject costs are in line and also howmuch can be paid to acquire the land.It is worth noting that some of the

assessing jurisdictions in New YorkCity have adopted a version of thismethod to value their hotels for prop-erty tax assessment purposes. Al-though, they typically take off 20% +/-and only use a multiplier of 800+/-rather than the default 1,000, presum-ably to adjust for TPP and intangiblespresent in the TAB value that thismethod produces.

Testing the Method. In an effort tosee how this method works in the realworld, it was applied to the assess-ments issued in 2013 for selectedhotels in the Mid-Atlantic region.Hotels were selected in Washington,D.C., Northern Virginia, and Balti-more, and then classified by their type(as defined by the Penn State Index ofU.S. Hotel values).11

The metro Washington, D.C. areais one of the top hotel markets in thecountry, and hotels there have sold for

high prices per key in recent years.Exhibits 3 and 4 show pro formaassessments based on the rule ofthumb approach as compared to theactual assessor-proposed assessmentsissued in 2013. Exhibit 3 uses a for-mula of 1,000 x ADR x number of keysto get to the equivalent assessed value.This was then compared to the pro-posed assessed value, and the differ-ence shown as a percentage.Significantly, although the rule of

thumb approach on average producesan overall set of values equal to 90% ofthose produced by the local assessorsusing the income approach, the indi-vidual variances swung dramaticallyfrom 71% to 127%. When compared tothe appealed target value, the overalldifference is 74%, and the range widensfrom 45% to 119% as illustrated inExhibit 4. This is an important indi-


EXHIBIT 3Assessor vs. Rule of Thumb Assessments Comparison

Hotel TypeProposed

Assessed Value AverageDaily Rate Rooms Multiplier

Rule of Thumb Value

PAV as % of RoT

Washington, D.C.Upper Midscale $12,677,960 $130 100 1,000 $13,000,000 103%

Luxury $69,239,610 $425 144 1,000 $61,200,000 88%

Upscale $67,557,300 $180 265 1,000 $47,700,000 71%

Boutique Hotel Nat Flag $20,402,500 $180 140 1,000 $25,200,000 124%

Non Flag Limited Service $30,312,640 $150 230 1,000 $34,500,000 114%

Non Flag Limited Service $66,279,550 $160 340 1,000 $54,400,000 82%

Upper Upscale $224,267,210 $210 807 1,000 $169,470,000 76%

North VirginiaNational Flag Upscale $74,748,500 $175 319 1,000 $55,825,000 75%

Upper Upscale $52,882,600 $185 241 1,000 $44,585,000 84%

Upper Upscale $9,063,500 $190 45 1,000 $8,550,000 94%

Upper Upscale $51,424,760 $165 396 1,000 $65,340,000 127%

BaltimoreUpper Upscale $102,809,000 $195 622 1,000 $121,290,000 118%

Value Totals $781,665,130 $701,060,000 90%

9 http://www.linternaute.com/expression/langue-francaise/450/noyer-le-poisson/.

10 Rushmore’s October 2003 Hotels Monthly,http:/www.hvs.com/article/594/hotel-valuation-thumb-rule/.

11 Penn State Index of U.S. Hotel Values, http://hhd.psu.edu/shm/Hotel-Values/index.html.

cation because assessment appeal tar-get va lues ref lec t what owners/operators believe the real estate fortheir hotels to be worth, althoughalways somewhat understated becausedeveloped to be used in an assessmentappeal setting.Perhaps of even more relevance is a

comparison of these rule of thumb val-ues as compared to the post-appealdecisions because that reflects howassessors have changed their originalvalues once they have the most recenthotel operating data. Based on deci-sions received to date, the overall per-centage of the rule of thumb value tothe post appeal values rose to 84%,with a range of 75% to 128%.If a multiplier of 800 were used

instead of 1,000 to reflect a 20% non-realty component in the TAB values ofthese hotels, the results are as follows:Overall Rule of Thumb Value toOriginal Proposed Assessed Value

(PAV): 133%Target Values: 93%First-Level Decisions: 127%On the basis of a statistical average

that is pretty impressive, the problem

is that the swing in ranges remainslarge:Overall Rule of Thumb Value toOriginal PAV: 93% to 172%Target Values: 56% to 148%First-Level Decisions: 93% to 160%Based on this limited and selective

data and analysis, any support for therule of thumb method to determine thereal estate-only value of a hotel is weak,so it is not likely to be the panacea thatmany thought it might. Therefore, onceagain, we are left with two competing,complex valuation methodologies thateach produces similar TAB values forhotels and vastly different real estate-only value indications.

Can the Allocation Mess be Avoided by Addressing Pre-Closing Values?Inherent in all definitions of fair mar-ket value, market value, and fair valueis the concept that they must each rep-resent the value of what typical buyersand sellers of the subject propertywould pay for it on a given day and inan arm’s-length transaction, without

undue influence and after reasonableexposure to the market.So, what happens when the buyer

and seller not only segregate the indi-vidual components of value in theirclosing documents but memorializetheir allocation of those values in theirpurchase and sale agreement (PSA), onthe HUD1 closing documents, and inthe recordation, and on deeds and billsof sale used to officially transfer thetitle to all of the components of thesubject property? What appraiser orassessor is not going to give that weight?Obviously, such al locat ions, i f

signed off by the buyer and seller, willcarry great weight if formally memo-rialized in the closing documentsbecause that typically creates a pre-sumption that said allocations repre-sent market value as of that date.Would these agreements and theirmemorialization not trump intellec-tual disagreements about which intan-gibles to segregate and what theirrespective values are? Certainly forassessment purposes, which alwaysestablishes values post-closing, thiswould be helpful and usually dispos-itive for re-assessment purposes, ifreasonable and supported by a third-party valuation. For lending purpos-es, the allocations would have to be inthe PSA or its addenda to be consid-ered and probably has less relevancein that connect ion. Post-clos ingreconstructed allocations are of coursepossible, but they typically are givenless weight than those that are incor-porated contemporaneously into theclosing process or in the PSA and arenegotiated pre-closing.The most notable advantages of pre-

closing buyer-seller allocations would be: • Reducing transfer and recordingtaxes due at closing.

• Reducing other ad va loremtaxes/fees due only on real estateand payable at closing.

• Avoiding the reporting of inflatedreal estate values to the government.

• Influencing local real propertyassessors as to the value of realestate property acquired.

• Mitigating future real property tax-ation if based on “chasing” salesprices.

• Resetting tangible personal prop-erty asset values to fair market.


EXHIBIT 4Rule of Thumb Values Compared to Owner’s Values

Hotel NameRule of Thumb(RoT) Value Target Value

TV as % of RoT

Washington, D.C.Upper Midscale $13,104,000 $9,960,000 76%Luxury $61,920,000 $47,040,000 76%Upscale $49,025,000 $51,500,100 105%Boutique Hotel Nat Flag $25,060,000 $16,030,000 64%Non Flag Limited Service $35,190,000 $22,004,200 63%Non Flag Limited Service $53,380,000 $55,400,000 104%Upper Upscale $169,470,000 $88,048,000 52%North VirginiaNational Flag Upscale $56,118,480 $48,985,000 87%Upper Upscale $44,585,000 $52,882,600 119%Upper Upscale $8,550,000 $3,819,000 45%Upper Upscale $64,944,000 $45,924,000 71%BaltimoreUpper Upscale $121,290,000 $79,072,500 65%Value Totals $702,636,480 $520,665,400 74%

• Permitting more accurate personalproperty tax rendition reportingand taxation.

• Permitting the appeal of “current”real and personal property assess-ments issued pre-closing.

• Permitting the recovery of certainoverpaid taxes post-closing.Accordingly, if the buyer and sell-

er agree as part of their purchase salesagreement to these allocations, it is agood indication of the market valueof these assets, at least for tax pur-poses and perhaps for lending pur-poses as well.

Assets Sale vs. Sale of Stock or Con-

trolling Interest. It should be noted thatsome jurisdictions such as Californiadeem the sale of a majority or con-trolling stake in the stock of a corpo-ration (or other owning entity) to bea constructive sale of the underlyingreal property owned by that entity.Therefore, even if no new deeds arerecorded, assessors will try to decon-struct the transaction to get to indi-vidual real estate values to set new baseyear values or for the next re-assess-ment cycle. In bulk sale transactionslike this, or of the assets themselves,allocation of individual TAB values ofeach of their components of value arevery useful, particularly if done pre-closing and memorialized at closing.

Cost Segregation and Identifying

Depreciable Intangibles. Once the TABhas been allocated, there are furtherbenefits to look at on how each of theindividual buckets of assets can befurther valued and classified. Cost seg-regation is an analysis and valuationprimarily for income tax purposes ofthe improvement value of the TAB(i.e. , bui ldings, f ixtures, and siteimprovements combined). It is pri-marily undertaken to help establishthe correct classification and depre-ciation schedule for the building, etc.,so not all are classified as 39 yearassets, if portions should be depreci-ated quicker than that.Intangibles usually can be qualified

into those that are depreciable andthose that are not depreciable at allsuch as goodwill. The exact processfor doing this is outside the scope ofthis article, but there are five categoriesof intangibles that the Financia lAccounting Standards Board (FASB)

recognizes as depreciable at about halfthe useful life of real estate.12

Reporting. Post-closing, new buyersshould be careful to report, on gov-ernment quest ionnaires and anyrequired income and expense surveys,the same allocations of the TAB asreported and used at closing for trans-fer tax purposes. The same is true forthe reset value of TPP as reflected onthe bill of sale used and recorded atclosing. The new values should bereported on the next TPP renditionfiled for those assets.

Are REITs Inflating Hotel Sales?Since their establishment in 1960,REITs have not had to pay corporatetaxes on income as long as at least 90%of their taxable income is paid as div-idends. The tax savings from thisexemption has been a main sellingpoint. Industry officials and analystsnote that the first REITs were estab-lished to give individuals an easy wayto invest in income-producing realestate, and it is unlikely that they willlose their tax exemption any time soon.They point out that REIT dividendsare taxed at a higher rate than othercorporate dividends, 39.6% vs. 20%.One of the key drivers of the increase

in hotel prices is the active and aggres-sive participation by REITs. In fact, agrowing number of commercial realestate owners are actually convertingto the REIT format in order to get thedual advantages of beneficial tax treat-ment and greater availability to capitalmarkets. From a valuation point of view,REITS are a source of distortion in themarket place. First, they can overpayfor assets because they have access tocheaper capital than “typical” investors.This has periodically led to a compres-sion of cap rates used to underwriteREIT transactions. They in effect donot need as great a return on invest-ment because their initial cost of capi-tal is so much lower. This means thatREIT sales often need adjustment beforebeing used as sales comparables for oth-er properties, and in particular, adjust-ments to their reported transaction caprates which need to be carefully exam-ined and adjusted upward to reflectmore market typical costs of capitaland returns on such investments. Cap


rate compression was one of the mainreasons commercial real estate got sooverheated in the last boom and whythe market fell so low when it correct-ed after 2008.REIT sales are also routinely con-

sidered to be suspect because they aresubject to draconian rules as to howmuch non-realty value they can assignto a going concern property. No morethan 15% of revenues can be allocat-ed to non-real estate assets or 25% ofthe overall asset values, although theseare portfolio-wide restrictions. As apractical matter, CFOs of publicallytraded REITs have been very conserv-ative in assigning much value to TPPor intangibles, especially in hotels.Because they could lose their REIT sta-tus if they violate these rules, they tendto err heavily on the side of caution.This, in turn, can lead to reported REIThotel sale data that is misleadingbecause too much of the TAB has beenassigned to the real estate and notenough to the non-realty assets.Thus, with many hotel sales in

recent years having been done byREITs, sales comparables based onthose transactions are usually distort-ed for all of the reasons stated aboveand, therefore, need to be carefully ver-ified with the participants, investigat-ed, and adjusted as needed beforebeing used, including cap rates derivedtherefrom. These under-adjusted hotelsales also have a damaging effect onthe accuracy of ad valorem real prop-erty assessments. If the reported realestate component is overstated, asses-sors who rely primarily on that unad-justed data for mass appraisal purposes(as many do) will produce inflatedassessed values, and that always resultsin over-taxation.

Are Foreign Buyers Skewing Comparables?Foreign investors, like REITS, are alsodisrupting the organized and rationaloperation of the hotel real estate mar-

ket in the U.S. because of their specialinvestment criteria. With many Euro-pean countries suffering from stagnanteconomies, high interest rates, andongoing fiscal crises, sophisticated for-eign investors and their advisors havebeen looking to diversify their invest-ment portfolios. They are attracted tothe U.S.13 The problem is that, likeREITs, foreign investors can afford tooverpay for real property because theyare gambling on their home currencyfalling further by the time they cashout their investment in a stronger, dol-lar-based real estate investment. This,coupled with historic low interest ratesat or near the rate of real inflation,means that even if a hotel’s currentNOI remains constant overt the holdperiod, the foreign investor can stillrealize a healthy return. This leads tocurrency premiums being paid thatdistort the market and, like REITs,requires careful analysis of sales andadjustment before any unit of com-parison can be arrived at.In today’s market, foreign capital

and high-net worth investors are com-peting directly with the opportuni-ty/hedge funds, pension fund advisors,and big institutions for a finite poolof assets. Hotels have been high up ontheir shopping lists. But are they buy-ing just real estate or a currency playor long-term preservation of their cap-ital? Are these “premiums” all intangi-bles that need to be backed out of thesales price for valuation and assess-ment purposes?

Cash Equivalency AdjustmentsOne technique that should be con-sidered in adjusting hotel sales madeby both REITs and foreign investors,before they are used or relied on invaluing hotels in the general market,is the cash equivalency analysis. Whilethe details of how this is done areoutside the scope of this article, basi-cally adjustments are made to theunderwriting assumptions, borrow-ing terms, and overall financing avail-able to REITs and foreign buyers toequalize them with correspondingfinancing and capital costs availableto “typical” U.S. buyers. For examplefor foreign investors, the differenceis the currency and financing advan-


12 http:/www.fasb.org/facts/.13 The Association of Foreign Investors in Real

Estate came out with its “emerging market”survey in January 2013, which found that of thetop five global cities for investment preferredby their members, four are in the U.S. This isthe first time this has occurred since the ques-tion was first asked in 2001.

tage, and that premium is then backedout to get to an adjusted sales priceand/or cap rate that can be used tohelp value typical U.S. transactions.However, absent insider informationabout such individual transactions,it is hard to do such adjustments witha high degree of confidence that theyare appropriate. The need to be ableto do so is growing however, as thevolume of foreign investments accel-erates.

Has California Solved theLennhoff/Rushmore Debate?As previously discussed, the Rushmoremethodology stipulates removal ofboth the management and franchisefees in the valuation of a hotel in orderto address and back out all of the non-realty components of the TAB, but thatprobably fails to completely removethem. As Eliot Johnson, Senior Man-ager of Property Tax for Marriott Inter-national Inc., has pointed out:

…Compensation to the hotel man-ager is intended to satisfy a debt foroperating the business enterpriseand should not be recognized as ameans of extracting all of the asso-ciated returns ent it led to theinvestor as it pertains to com-mencing a business operation. Anadditional function must be per-formed to appropriately removethis intangible asset from the TotalAssets of the Business Enterpriseand derive the income attributableto the real property solely.141

He goes on to assert that whenderiving opinions of value for hotels inCalifornia, there is substantial regula-tory and statutory guidance as towhich of the Rushmore or Lennhoffadjustments should be made. In par-t icular, he points to Sect ion 502,“Advanced Appraisal,” of the CaliforniaAssessors’ Handbook as a guide.15 In fact,the Assessors’ Handbook, while not stat-ing it explicitly, appears to agree thatMr. Rushmore’s methodology does notfully address the removal of the busi-ness enterprise from the going-con-cern income stream. This publicationis given great weight in many otherjurisdictions, particularly in the West-ern states. The Handbook states interalia the following:

Income derived from rental ofproperties is preferred to incomederived from their operation sinceincome derived from operation isthe more likely to be influenced bymanagerial skills and may arise inpart from nontaxable property orother sources. When income fromoperating a property is used, suf-ficient income shall be excluded toprovide a return on working cap-ital and other non-taxable operat-ing assets and to compensateunpaid or underpaid management.

In California, the property taxtreatment of intangible assets andrights is governed by two funda-mental principles. The first of theseis that intangible assets and rightsare not subject to taxation.

The value of intangible assets andrights relating to the going con-cern value of a business using tax-able property shall not enhance orbe reflected in the value of the tax-able property.

If the principle of unit valuationis used to value properties that areoperated as a unit and the unitincludes intangible assets andrights, then the fair market value ofthe taxable property containedwithin the unit shall be determinedby removing from the value of theunit the fair market value of theintangible assets and rights con-tained within the unit.

Goodwill, going concern, right todo business, franchises, customerlists, trademarks, trade names,work force in-place, vendor rela-tionships, brand recognition, cus-tomer loyalty, the cumulative effectof prior year’s advertising and mar-keting, patents, copyrights, andlicenses.

…the appraiser must determinewhether addit ional income isattributable to real property, per-sonal property or … intangibleassets …. An appraiser has toensure that the final value indica-


It may be necessaryto adjust pricespaid by REITs andforeign investors.

tor does not include any nontax-able value … the appraiser mustidentify the intangible assets andrights in order to safeguard theirexclusion … the value of nontax-able property within the unit mustbe removed….

Investors demand both a return oftheir investment (a recapture ofthe investment) and a return ontheir investment (a yield on theinvestment).

The value of intangible assets andrights cannot be removed by mere-ly deducting the related expensesfrom the income stream to be cap-italized. Allowing a deduction forthe associated expense does notallow for a return on the capitalexpenditure. For example, allow-ing the deduction of wages to askilled work force does not removethe value of the work force in placefrom the income indicator, becausethe wages paid does not necessar-ily represent a return of and on thework force in place, and furtherbears no relationship to the costsassociated with locating, inter-viewing, training, and otherwiseacquiring the work force.

When estimating the income to becapitalized, income and expensesare estimated on a market, or eco-nomic, basis . Market income,which is generally income fromproperty rental, is based on marketrent, which is the rent that a prop-erty would command, assumingprudent management, if placed forrent on the market as of theappraisal date. It is the rental rateprevailing in the market for com-parable properties, in contrast tocontract rent, which is the actualrental income of a property asspecified by terms of a lease. Mar-ket expenses reflect the level ofoperating expenses that a prudentbuyer would expect to pay assum-ing prudent management.

Given all of the above guidelines, itis difficult to understand why certaintaxing jurisdictions in California, orat least their local equalization boardscharged with adjudicat ing flawedassessments, have not wholeheartedlyembraced the Lennhoff approach tovaluing hotels. In fact, they have not.Their reluctance is probably driven bythe potential negative fiscal affect offully implementing these guidelinesand the tax refunds that they wouldgenerate.

Glendale Litigation. This fear in turnmay be why the Los Angeles CountyBoard of Equalization (BOE) has tak-en the unprecedented step of hearinghotel assessment appeals only if peti-tioners first certify that they will notraise the issue of “intangibles” in theirappeal presentations. If the petitionersinsist on doing so, and most will, thenthe case is placed in a semi-permanentlimbo to await the ultimate conclusionof the case of EHP Glendale Hilton, LLCv. County of Los Angeles.16 The centralissue in the case, which is on appeal,was that the taxpayer filed an assess-ment appeal and argued “that theassessment impermissibly captured thevalue of nontaxable intangible assets.”

Has Course 833 Helped or Hurt?The Appraisal Inst itute’s recentlylaunched Course 833 was taughtnationally in the last year. It does notpurport to tell how to allocate differ-ent values present in a going concernproperty, but it does lay out a roadmap as to how to identify which itemsmight need adjustment.The course’s official name is “Fun-

damentals of Separating Real Prop-erty, Personal Property, and IntangibleBusiness Assets.” Its purpose is to pro-vide the theoretical and analyticalframework for separating the tangibleand intangible assets of real estate-centric businesses. It is intended toprovide an overview of business val-uation procedures and clarification ofreal estate and business valuation ter-minology, so participants can becomefamiliar with the terminology rele-vant to separating asset values. Fur-thermore, the purpose of the class isto include the “… review [of] the legalfoundations for property rights, be

introduced to the methodologies, andbecome aware of the controversial andunresolved issues in this field.”17 [Empha-sis added.]Amazingly, there is even a specific

disclaimer on the Appraisal Institutewebsite that states:

Note. Fundamentals of SeparatingReal Property, Personal Property,and Intangible Business Assetscontains diverse opinions regard-ing appraisal theory and applica-tions. Neither this course nor theAppraisal Institute advocates a par-ticular theory or method. Rather,each appraiser must come to hisor her own conclusion based onthe property type, local marketcustoms, and scope of work.18

So much for taking a leadership rolein resolving this dispute, and findingcommon ground and setting an indus-try standard for valuing going concernproperties. Course 833 does have a lotof useful new terminology and providesa useful framework to identify intan-gibles, but it does not go the last mileand actually tell how to value them.On completion of Course 833, stu-

dents should be able to: • Recognize operating properties asdistinct from pure space properties.

• Recognize when the scope of workrequires the separation of variouskinds of assets to produce a credi-ble appraisal.

• Understand the concepts, termi-nologies, and economic principlesthat underlie the asset claims to therevenue stream.

• Understand the terminology rele-vant to separating asset values andthe roots of that terminology inaccounting, business valuation, andvaluation for financial reporting.

• Understand the complexity of valu-ing a proper ty as it relates toappraisal problems, separating assetvalues, and valuation for financialreporting.

• Understand the legal foundationsfor property rights.

• Identify when there is a need towork with a professional in anoth-er field, such as when conductingbusiness or tangible personal prop-erty valuations.

• Recognize the methodology.(Continued on page 42)


14 Presentation at IPT Property Tax Symposium,Monterey CA, 11/9/2011.

15 California State Board of Equalization,(December 1998), http://www.boe.ca.gov/prop-taxes/pdf/ah502.pdf.

16 193 Cal. App. 4th 262 (2011). Readers areencouraged to see the summary at http://www.winston.com/sitefiles/publications/article4_ehp.html. In addition the amicus briefdiscussion provides a good outline of theissues: http://www.boe.ca.gov/meetings/pdf/042513_M1_Amicus_Brief_EHP_Glendale.pdf.

17 http://www.appraisalinstitute.org/education/course_descrb/Default.aspx?prgrm_nbr=833&key_type=C.

18 http://www.appraisalinstitute.org/education/course

(Continued from page 17) • Objectively articulate the variousissues that are considered contro-versial and unresolved.

• Understand the parallels betweenthe business valuation methodolo-gies and real property valuations.Much more is needed to get every-

one reading and singing from the samepage of sheet music.

Small Business Administration. Oneof the interesting and unexpected by-products of Course 833 is that thosewho have successfully completed it andits exam are placed on a l is t ofapproved Small Business Administra-tion (SBA) appraisers, who alone cando these types of intangible allocationsfor the SBA.

The Legislative FixOne way to mitigate the problem ofallocating values to non-realty compo-nents of a going concern property is tolegislate when and how it must be done.This was attempted a few years ago inGeorgia, to address the situation ofassessors not making any attempt toadjust for non-realty items in their hotelassessments. Furthermore, assessors inthe state took the position that they didnot have to make such adjustments.Starting in 2011, real property tax

assessors in Georgia are now for thefirst time required to adjust for intan-gible value embedded within goingconcern properties such as hotels. Arevision to the Georgia Code wasenacted which provides as follows:

(B.2) In determining the fair mar-ket value of real property, the taxassessor shall not include the val-ue of any intangible assets used bya business, wherever located,including patents, trademarks,trade names, customer agreements,and merchandising agreements.19

Unfortunately, this provision asadopted was watered down from theone originally proposed, which had amuch longer laundry list of mandato-ry items that had to be considered andadjusted for if found to be present. Theeffort to establish mandatory adjust-

ments for assessors to follow is nowbeing pursued in several other states.As long as the state legislation is con-sistent in terms of what needs to beadjusted, this is a useful tool, at least forassessment purposes in making surethat only the pure real estate value isused for ad valorem property taxation.

New Cases and PendingDecisionsIn recent years, there have been sever-al major battles in the courts overwhich of the competing Lennhoff orRushmore approaches is better for thevaluation of a hotel. Initially, Lennhoffhad some successes with judges, most-ly because the Appraisal Institute’sCourse 800 was deemed to back hisposition, and there appeared to be

some consensus among appraisers as tohow intangibles should be adjusted for.However, as a result of effor ts toexpand these theories to other types ofproperties such as regional malls, orjust bungled litigation, coupled withthe Appraisal Institute’s withdrawal ofCourse 800 for re-tooling, the Lennhoffapproach was rejected in severalprominent cases in favor of the Rush-more approach.As a result, today most assessing

jurisdictions assert that they use theRushmore approach, although basedon their application of what they thinkthat means, Mr. Rushmore might behard-pressed to recognize either hisprocess or methodology. It is, of course,ironic that the jurisdictions that nowpurport to embrace Rushmore’s theo-ry and practice are the same ones who


Hotel Valuations

rejected it so vehemently when he firstpromulgated it back in the 1970s and1980s.In addition to the ongoing appeal of

the Glendale case in California men-tioned earlier, there is another land-mark judicia l case pending inWashington, D.C.20 Because Washing-ton is a hotel town with a significantamount of its overall budgetary rev-enues generated directly or indirectlyfrom taxes levied on hotels, vendors,employees, or guests, any potentialchange in how hotels are assessed forproperty tax purposes is significant.In this case, Ashford Hospitality filed

a judicial assessment appeal in Wash-ington, D.C. Superior Court in Sep-tember 2009 for the 2009 tax year,alleging that its assessment was inflat-ed because of numerous errors com-mitted by the assigned assessor. After

mediation and prolonged discovery, atrial was held on this case in the sum-mer of 2011. It is noteworthy that onlyone or two trials on assessment issuesare held in Washington, D.C. annually,and that decisions thereon can takemany years to be rendered. Some saythat this delay is intentional to encour-age taxpayers to settle disputes at thetwo prior levels of mandatory mediationthat must be completed before trial.This case is the first hotel trial in

Washington, D.C. in more than 20years. The plaintiff engaged DavidLennhoff as the appraiser and expertwitness. He prepared and delivered afull-blown valuation of the hotel basedon all of his theories and beliefs. TheWashington, D.C. Office of Tax andRevenue (OTR) responded by sayingthat it uses the Rushmore approach,and that its proposed assessment com-plied fully with that approach.Interestingly, the OTR did not com-

mission an independent appraisal orengage a licensed state-certified generalappraiser knowledgeable in hotel val-uations to support its position and rep-resent them at trial. Although the OTRassessor designated to be the expertwitness was the author of its valuationreport, he was unlicensed, had onlyrecently moved to Washington, D.C.from California, and had no appraisaldesignations or special hotel training.Nonetheless, the judge allowed him totestify and opine as an “expert witness”on behalf of OTR, and he bravely didbattle with Lennhoff.To most courtroom observers, the

outcome should be obvious, and thejudge should rule in favor of the plain-tiff despite the assessor enjoying a pre-sumption of correctness and the highburden that this places on the plaintiff.Whether the judge elects to find forthe plaintiff on narrow grounds, or justdecides the case without opiningbroadly on the Lennhoff/Rushmorecontroversy, remains to be seen. A rul-ing for plaintiff will probably result in

an application to the D.C. Court ofAppeals to hear the case on furtherappeal and a request to clarify theseissues once and for all. The Court ofAppeals may of course decline to do soeven if asked. This is a case to watchand one of the few pending in a majorjurisdiction that could advance andperhaps clarify the Lennhoff/Rush-more debate.

Future Capital ExpendituresMost people would not buy a housewith a leaking swimming pool. Typi-cally, they would either insist that theseller fix it before the closing or get acredit against the purchase price forthe full cost to cure the problem. Invaluing hotels, essentially the sameproblem can be presented. Sometimes,there are large items of deferred main-tenance or other obsolescence that thenormal repair and maintenancereserves of the hotel cannot fund oraddress. Older hotels may today haveoutdated plumbing; energy inefficientwindows; or inadequate air condi-tioning, heating, or elevators. Fur-thermore, some proper t ies bui ltpre-1979 have asbestos issues that maybe currently encapsulated and han-dled, but any future repair or remod-eling would require complete andexpensive remediation. Similarly, aroof, once its warranty has expiredand depending on its condition andconstruction, can be a never-endingbattle, particularly if multiple roof sur-faces have been applied as temporarysolutions.These are all big-ticket items, and

the next buyer of the property is notgoing to pay full price for a hotel withthese un-remediated problems becauseto do so would jeopardize the buyer’sfuture stabilized ROI. After all, com-mercial real estate investors are buyingfuture cash flow from all revenuesources, especially in hotels. Anythingthat would dilute that income streamwould also diminish the present valuethat the next buyer will pay for thehotel as a going concern property.Leaky roofs or no hot water do notsustain or enhance future RevPARassumptions very well.In arriving at a value indication that

as of a certain date mirrors what the


19 3 Georgia Code Ann. § 48-5-2(3)(B).20 CHH Capital Hotel Partners LP (Ashford

Hospitality), D.C. Sup. Ct. 2009 CVT 00945,filed 9/24/2009. Because the Washington, D.C.court system consists of only the SuperiorCourt and Court of Appeals, Superior Courtdecisions there may have significantly moreweight than decisions from first-level triers offact in other jurisdictions.

next typical, prudent, and knowledge-able next buyer would pay for the sub-jec t proper ty in an arm’s- lengthtransaction after exposure to the mar-ket, any unresolved large future capi-tal expenditure(s) (CapX) should betaken into account and adjusted for inthe valuation process.Sometimes, adjustments for such

items are addressed as increases to theselected base cap rate in order to reflectadditional risk, particularly if theamount or extent of the future hit can-not be quantified. The selection of theadditional risk component to the caprate can be very subjective, and it isusually hard to load a cap rate for suchfuture risk and make it credible andmarket-supported, especially in mar-kets where all comparable hotels to thesubject property have similar issues,and there is no verified data that sug-gests that this was a consideration oradjustment in recent similar sales.Accordingly, hotel valuers may look

at the owner’s/seller’s CapX budget toquantify the likely costs to cure need-ed to preserve assumptions of futurecash flow. The problem is that in mostorganizations, there are several CapXrequests and estimates floating around.The easiest to obtain is of course theone that has been scrutinized, accept-ed, and funded for budgetary purpos-es. These amounts are funded over afinite period of time and will be spentbecause these items are crucia l ,although not always spent in the cur-rent calendar or fiscal year.Unfortunately, these amounts are

usually just a fraction of the original-ly requested CapX funds made by thelocal manager/engineer. Managementwill typically trim these requests, evenif fully documented and justified, tothe amount that can be effectivelyfunded out of cash flow. Apart fromemergency repairs, the total requiredinvestment to cure adverse conditionsand obsolescence is only ever partial-ly accepted and then only funded overthe longest period of time possible.So, is the raw or unbudgeted CapX

a better number to use as a below-the-line adjustment for valuation purposes?Certainly, if coupled with a timeline tolikely expenditure so that it can be dis-counted back to a present value, thisamount would represent a better reflec-

tion of the likely cost to fix the entire“swimming pool” and more fully miti-gate future risk and loss of anticipatedNOI to the buyer. Overall, it is proba-bly a best practice to request both thefinally accepted budgeted CapX, as wellas the raw CapX request. If they varydramatically, that is a sign that addi-tional work is needed to get to the fairmarket value of the subject property.

ConclusionThe following observations can bemade: • There is still no consensus as to howto value the real estate componentof a stabilized and operating hotelin the U.S. Which approach to takeseems to depend on whether thevaluation is primarily for lendingpurposes or to assist in the mitiga-tion of property taxes.

• Many recent hotel sales are basedon very speculative assumptions asto future demand and performancein terms of ADR and RevPAR.REITs and foreign investors appearto be overpaying for hotel assets byvirtue of their superior buying orfinancing power. Accordingly, theirreported transactions do not nec-essarily meet the definition of fairmarket value or fair value. That dis-tinction may be acceptable for lend-ing purposes, as long as USPA iscomplied with in terms of the scopeand limitation of the appraisal, butit may not meet the applicable legalstandards for assessment purpos-es. Therefore, great care must betaken in extracting indications ofvalue or cap rates from such saleswithout first making all indicatedadjustments.

• The hotel market appears to be frag-menting into a multi-tiered marketdriven by different underwritingassumptions and anticipated returnrates and holding periods. Again,any hotel sales produced from sucha choppy market must be carefullyexamined, verified, and adjusted asneeded, before used as a compara-ble or to extract a cap rate, to estab-lish the value of another hotel inthe same market.

• In the case of REITs and foreigninvestors who are using “cheap”

investment funds or are motivatedby potential currency arbitrage ora need to move assets to a “safe har-bor,” thereby reducing their ROIexpectations and increasing theprices they will pay for “trophyassets,” a cash equivalency adjust-ment may be needed to adjust thoseprices to typical market compara-ble sales.

• If an oversupply of certain types ofhotels in a particular market devel-ops, but this is not reflected in localsales prices, adjustments may alsobe warranted. If this is coupled withaccelerated replacement of FF&E orremodeling to try and differentiatea hotel in that market, or to justifyincreased RevPAR, future NOIassumptions need to be closely con-sidered, together with any deferred“raw” CapX. Increased pr icesrequire increased investment yields.This can be accomplished by a com-bination of increased revenue anddecreased expenditures. The nextbuyer is going to discount the futuresales price by the cost to cure suchdeferred raw CapX.

• Overall, hotel sales prices are backto 2005/2006 levels and thereforethose established at the height ofthe last market spike pre LehmanBrothers crash. That in turn repre-sented the height of the value cyclefor the last couple of decades. So itis hard to say where values go fromhere, particularly since it is likelythat interest rates for new financ-ing, coupled with property-specif-ic income and expense data, willdetermine hotel values, rather thantheir being based on any homoge-nized value.

• The appropriate valuation method-ology and assumptions to be usedfor hotels and their underlying realestate is still very confused and sub-ject ive. Unfor tunately, no realprospect exists for any unity or uni-formity on this subject anytimesoon.

• For the foreseeable future, U.S. hotelvalues are likely to be determined bythe answer to the question, “Whatdo you need the valuation for?” It istoo bad that we cannot find a com-mon ground, so we can all just getalong. �


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