January 2009 Status Report on the Boutique Lodging Industry in California
by
G. Michael Yovino-Young, MAI, ASA
Berkeley, California
The recent 2009 CABBI Conference was the only one I have missed since the predecessor organizations were formed in 1983. Ironically, this year the hospitality industry is facing the worst economic decline in more than sixty years, and owners and operators of smaller lodging properties need to know the realities of their industry in the context of a severe recessionary economy.
As an appraiser and real estate economist, I have monitored the lodging industry and markets for more than 30 years. This is my report on the situation facing the bed and breakfast industry in the Spring of 2009.
The realities of the changing economy were first evident in mid- 2007 and the recession was fully underway by early 2008, even if an inept and clueless administration in Washington, D.C. refused to acknowledge the inevitable until well into the third quarter.
Over the past 15 months, the negative effects have increasingly been felt in the commercial real estate markets, but none more acutely than in the hospitality industry. PKF has calculated that the large hotel market has already experienced a decline in market values of 34.2% to date compared to 2007 and they expect this trend to continue into 2010.
In the Northern California market, occupancy ratios, after six years of steady increases even through 2008, have declined so far in 2009 by 10%. Occupancies are expected to decline further through 2009. At the same time, average daily rates (ADR) industry wide, which reached close to $200. in 2008, have declined in the first two months of 2009, with best estimates in late February at $175. or lower, e.g., a drop of 13%. Additional reductions in ADR indices are expected.
What does all this doom and gloom in the large scale hospitality market portend for the boutique lodging market, specially the smaller scale properties that characterize the bed&breakfast segment of this marketplace?
Traditionally, as I have reported in prior recessionary periods, the most recent being 2000-2003, the boutique lodging market generally does not experience the same level of decline in revenue or value compared to the large hotel market. This does not mean that smaller lodging properties are immune to economic realities but they tend to be less impacted by the contractions in convention and business-travel based tourism.
The smaller lodging operation typically has a stronger and more predictable market demand from local and regionally based tourism. Even if true for this current recession, there are still significant changes in the characteristics of the market that will impact the smaller lodging property and business in revenue generation, occupancy ratios, profit levels, and ultimately, the market value of these business assets.
Perhaps most telling is the virtual halt to “effective” demand for smaller inns. I have not been able to confirm a sale of an inn since early 2008. There are close to twice the number of inns on the market currently and over the past six months. Unfortunately, many of these inns are still listed for prices that reflect peak revenue periods in 2006 and 2007, in some cases, extending into mid-2008. In contrast, the annual revenue data I have recently reviewed clearly demonstrates a negative trend, with declines of 10% to as much as 20% (compared to end of year 2007 data).
Coupled with the decline in revenues, the capitalized value of net profits has also declined with the increases currently observed for capitalization rates throughout all of the investment real estate markets. By way of illustration, the following is an example taken from a recent appraisal of a seven room B&B in northern California. Note that some amounts are rounded and/or adjusted to reflect minor changes in lodging revenue statistics.
| 2007 | 2008 | 2009 (projected) | Chg since 2007 | 2008 | |
|---|---|---|---|---|---|
| ADR | $230 | $230 | $220 | -09% | 09% |
| Occupancy Ratios | 64% | 62% | 58% | ||
| Gross Revenues | $376,000 | $364,000 | $326,000 | -13% | 09% |
| Net Profit after Stabilized Expenses | $159,000 | $150,000 | $135,000 | -20% | 15% |
| Capitalized @ | 6% | 6.5% | 7.25% | ||
| Capitalized Value | $2,650,000 | $2,300,000 | $1,865,000 | -29% | 19% |
These declining revenues and resulting declining market values in this real world example are dramatic and unfortunately may be even greater than predicted if revenues projected for 2009 prove to be optimistic.
You will note that one of the more significant changes since 2007 is the 21% increase in the capitalization rate from 6% to 7.25%. Most economists and lodging researchers project increases in cap rates for hospitality properties of at least 150 basis points over the very low rates experienced in 2006 and 2007. Based on my observations in recent weeks, I would not be surprised if the cap rate continues to increase to a range of 8%, depending on the changing costs of borrowed capital, e.g., mortgage rates. As an aside, I used a 7.25% in early January 2009; as of late February, the cap rate has increased to about 7.5%, thereby reducing the 2009 value indicator further to about $1,800,000.
However, observe that even if the cap rate remained constant at 6%, a decline in net profits of 14% would result in a significant decline in market value, e.g.
2009 projection of net profit at $135,000., capitalized at 6% = market value of $2,250,000.
an 8.5% decline in market value since 2007.
Put this in another perspective: even if net profit somehow remained at 2007 levels, the change in cap rates in the 2009 market would result in this drop in market value for the inn:
Net Profit $159,000., capitalized at 7.25%, results in a value indicator of $2,200,000., a decline in market value of $450,000.
Many inn owners are enamored with the price per guest unit index commonly used in the marketing and sales trades for hospitality properties. I also monitor this index very closely and note that in the above example:
the market value per guest unit index changes are:
in 2007: $378,500.
in 2008: $328,500.
in 2009: $266,500.*
*ironically, this index is nearly identical to the market value for this same inn in 2004, when net revenues were about 15% less than in 2009.
The realities of these calculations for the boutique lodging market are hard to accept and many of the owners of inns currently on the market have yet to face these changes in the value of their lodging assets. My counsel is to not attempt to sell an inn during this recessionary period unless it is an absolute necessity. Wait out the time it will take to start a recovery, predicted to be not before mid 2010 at the earliest.
If you have to refinance, there are lenders making loans on inns, but the requirements are much more onerous and the inns’ track record must be strong and net profits clearly demonstrated as adequate to service the loan. Lenders commonly use a “debt service ratio” index, which is the amount of net profit over and above the annual cost of principle and interest on the mortgage debt. Whereas a DSR of 1.15 to 1.25 was common in prior years, e.g,, net profit was from 115% to 125% of the debt service costs, today, the DRS is more likely to be 1.3 to 1.4.
Current interest rates quoted by institutional lenders are from 6.7% to 8.5%, often with 1% to 1.5% added in “points” (a percentage paid up front based on the loan amount). Terms range from 5 year fixed with adjustable rates thereafter, to 10 year fixed. I have not heard of any longer terms than ten years but there may be some lenders making such loans. Expect vigorous scrutiny of your financial records and operating history. The appraisal will be very attentive to this information since there are so few (if any) sales happening to develop a credible market comparison approach to the appraised value.
Many inns that I have appraised have debt to value ratios of between 55% and 65%. Based on 2008 values, this means the equity investment will be between 35% and 45%. In the example presented here, based on a current value of $1,865,000., the equity component will be from $650,000. to $840,000. The existing debt may therefore still be covered by the drastically lower 2009 value estimate and there is equity to protect in this investment.
The example presented in this paper illustrates a dire change in the market value of a high quality, luxury class, well located seven unit inn. It is not atypical of what has happened to the lodging market since the peak in 2007.
Will the lodging market ever recover to its peak years in 2006-2007? And when will lodging properties regain their high market values that existed during that time? I am asked these questions often and can only suggest that stability in the real estate market will return eventually, but it may be years before revenues and market values regain their all time highs experienced just two years ago.
To some degree, the lodging market was influenced by the “bubble” in the larger housing markets which were a force in keeping mortgage rates low and mortgage credit plentiful for all types of real estate investment. These conditions may never return, but certainly, the banking industry and mortgage lending industry will eventually recover and regain their influence on a stabilized and predictable real estate investment market.
Currently, research is underway to show the year by year changes in market values for the smaller inn and lodging property in California. This study will be completed in the coming months and will be published in the CABBI newsletter. In the meantime, inn owners need to accept the realities of the current recession and its impact on the market value of their business assets. Most can expect a decline in market value since the peak period in late 2007 ranging from 10% to a probable 20%, all other things being equal. This will be true even if revenues and net profits remain at high levels; the increasing capitalization rates dictated by market conditions will capitalize to lower market values.
Over a period of nearly 30 years, there have been only a few periods of short duration where the boutique inn might have lost value, and such losses were comparatively small and usually recaptured in robust recovery periods. Those declines and recoveries were in times where annual appreciation rates for investment properties like b&bs were predictably consistent with the changes in inflation and financial growth in the general economy.
The difference today is that the changes in market values since the late 1990s have reflected what Greenspan famously called “irrational exuberance” with annual appreciation rates exceeding 15% and some at 20%. In the example provided earlier in this paper, the market value for this typical luxury b&b increased by 42% in just three years (2004-2007), while revenues rose a much more sustainable 18% during this same time frame. The “disconnect” between revenues and market values/prices for b&bs was never more evident than in these past five years, and all it took was a meltdown of the economy and especially the real estate markets to destroy the gains in values recently experienced.
I am sorry to be the bearer of such bad news, but the bed and breakfast inn industry needs a reality check to help owners and innkeepers plan their financial futures and business operations to minimize the negative impacts of this recessionary economy.
G.Michael Yovino-Young, MAI, ASA, is the President of Yovino-Young, Inc. in Berkeley, California. He has appraised more than 450 bed and breakfast inns, boutique and country lodging properties throughout the western states, as well as appraising many larger, nationally branded resorts, hotels and motels. He was a contributor to the creation of the Industry Study now published bi-annually by PAII.
