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Business value

Most of the existing body of literature on hotel valuation has been offered by Stephen Rushmore of Hospitality Valuation Services. The American Institute of Real Estate Appraisers published two monographs authored by Rushmore: The Valuation of Hotels and Motels, in 1978, and Hotels, Motels, and Restaurants: Valuations and Market Studies, in 1983. Rushmore’s work has considered the element of “business value” in a hotel enterprise and offers two methods for removing this element from the real property valuation.

He suggests that one way to quantify the business value is to consider a hypothetical rental based on comparable market lease terms and provisions to yield the value of the real estate encumbered by the lease (Rushmore 2003, 105). This value can then be subtracted from the “enterprise” value, as determined by a discounted cash flow analysis, to quantify the business value.

Alternatively, Rushmore suggests that the management fee, or cost of professional management, could represent a “fair estimate of the income attributed to the business” (Rushmore 2003, 105) and that by deducting the management fee from the income stream, the business value would be removed from the valuation. More recently, much attention has been focused on the treatment of business value in a hotel valuation, especially in determining ad valorem real estate taxes. Rushmore and Rubin (2004) again describe the business value adjustment; however, they also include the deduction of a franchise fee for chain-operated hotels.

The most appropriate theory for today’s environment is based on the premise that by employing a professional management agent to take over the day-to-day operation of the hotel–thereby allowing the owner to maintain only a passive interest–the income attributed to the business has been taken by the managing agent in the form of a management fee. Deducting a management fee from the stabilized net income thereby removes a portion of the business component from the income stream. An additional business value deduction must also be made if the property benefits from a chain affiliation.

This is accomplished by either increasing the management fee expense or by adding a separate franchise fee deduction. (Rushmore and Rubin 2004, 281) No support for this so-called “theory” is offered other than the authors’ suggestion that the management fee could be thought of as income to the business. Nelson, Messer, and Allen address hotel enterprise valuation and refute the theory offered by Rushmore that a capitalized management fee is indicative of the value of the business. They state, “While this sounds simple and sensible, it is actually the same as saying that a hotel has no business value” (Nelson, Messer, and Allen 2004, 164).

They further offer that the management fee is a normal cost of operating an enterprise and represents the return on the management company’s expertise and talents, but not on the owner’s investment in the business. The method Nelson, Messer, and Allen suggest for isolating the business value is modeled after a segregated cost approach and stems from the logic that any entrepreneur would only undertake an enterprise knowing all costs involved. This would require estimating the cost of organization, working capital, inventories, liquor licenses, franchise fees, and so on.

Fisher and Kinnard (2000) expound on the business enterprise value component of “operating properties,” mentioning that the appraisal literature recognizes hotels as having business value and quoting Rushmore as follows: The business component of a hotel’s income stream accounts for the fact that a lodging facility is a labor-intensive, retail-type activity that depends upon customer acceptance and highly specialized management skills, in contrast to an apartment or office building where tenants sign leases for one or more years, a hotel experiences a complete turnover of patronage every two to four days….

Another facet of business value is the benefits that accrue from an association with a recognized hotel company through either a franchise or management contract affiliation. Chain hotels generally out-perform independents and the added value created by increased profits is exclusively business-related. The article by Fisher and Kinnard deals more specifically with the issue of business value in a shopping center; however, the shopping center use of real estate is distinct from a hotel use in that the owner receives essentially a fixed income stream from long-term leases.

Today, hotels are typically operated under a management contract whereby the investor receives the residual of the business income. Rubin offers an analogy to explain the basis for the Rushmore and Rubin theory offered in 1984: In valuing the fee simple interest . . . ownership in a retail mall via the income capitalization approach, appraisers and assessors alike know that the revenue streams to the mall’s ownership take the form of rental payments made by the tenants in the mall.

The rental payable by any particular tenant is typically not equal to the tenant’s income but, rather, to only a part of the tenant’s income. Let’s assume, for example, that the operator of a cigar store leases retail space from the mall’s ownership at an annual rental of 10% of gross revenues. Let’s further assume that this particular tenant can drop 20% to the bottom line before rent. In this particular case, the tenant’s rental payment would equal half of his bottom line; the remaining half (10%) goes directly into his pocket as business income.

For the purposes of calculating rental revenue to the owners of the mall, it makes sense that only the portion of the tenant’s bottom line that is payable in rent is considered…. What many assessors fail to recognize is that for hotels, the equivalent of a tenant is a management company. (Rubin 2001, 6) This idea that the management company can be thought of as a tenant seems contradictory to Rushmore’s comparison of a hotel investment to an apartment building where apartment tenants sign long-term leases and the hotel’s patronage (or “tenants”) turns over every three or four days.

Lesser and Rubin (1993) repeat the theory that deducting management and franchise fees removes the business value component from the income stream to be capitalized such that the resulting valuation does not include business value. Hennessey (2003) posits that this procedure is flawed: “The income attributable to business value clearly is not equivalent to the amount of management fees. To a property owner, the cost of management is just another expense, like utilities. ” However, he offers no plausible alternative to the problem of measuring the business value.