Hotel and Hospitality Cap Rates Explained
Cap rate is defined as the annual, non-levered return of an investment property. It’s calculated by taking the NOI of a property and dividing by the current property value. Hotels generally offer the highest cap rates of any asset class, with cap rates typically varying from 7.5% to 10.5% depending on asset type and market conditions.
According to appraisal firm Marhsall Stevens, the average cap rate for hotels over the last few years has varied between 9.1-9.5%. CBRE’s Q1 2019 North American Cap Rate Survey indicated that urban hotels had an average cap rate of 8.01%, and suburban hotels had an average cap rate of 9.55%.
In general, there is no one good cap rate for a hotel investment. A good cap for a hotel varies based on asset quality, asset location, and industry metrics, such as RevPar (revenue per available room) and ADR (average daily rate).
Hotel Cap Rates in 2020 Increased Substantially
Hotel cap rates have increased significantly since 2019, though there has been a certain degree of cap rate instability. Data from Marshall Stevens indicated that hotel cap rates from Q1 2021 averaged 10.5%. This increase in hotel cap rates can be attributed to a decrease in hotel values due to the COVID-19 pandemic, combined with NOI increases due to stronger consumer demand after the lifting of lockdowns in many states.
For comparison, CBRE data suggests that average U.S. multifamily cap rates during the period between Q2 2019 and Q3 2021 fluctuated between 6.82- 6.28%, far less than the average cap rates for hotels. Likewise, average cap rates for office and retail properties remained significantly lower than cap rates for hospitality assets. For those looking for more granular data, CBRE’s 2021 cap rate survey breaks down hotels both by region and by type.
Hotel Cap Rates, Risk, and Property Valuations
Cap rates are generally correlated with risk, with higher cap rates indicating riskier properties.
However, this is not always the case for hotels. During the last two years, hotel cap rates were highest for budget hotels, which experienced both steadier property values and higher occupancy rates than their more luxurious counterparts. In general, economy and mid-range hotel assets located near state boarders, particularly budget extended-stay hotels, saw much lower valuations decreases than did luxury properties.
This is likely due to the needs for transportation industry workers and construction crews, as well as other middle-income essential workers who travel for business.
Since budget hotels have seen higher cap rates than luxury hotels combined with less decreases in property values, budget hotels may be an exception to positive correlation between investment risk and cap rate seen in other asset classes.
Factors and Metrics That Impact Hotel NOI
A wide scope of factors influence the NOI of hotel properties, including average incomes, employment levels, consumer sentiment, and overall consumer perceptions of the economy. Hotel NOI can be derived from several sub-metrics utilized in the hotel industry. These include:
Occupancy/Vacancy Rates: Hotel occupancy varies based on the factors mentioned above, as well as many other additional inputs. Occupancy and vacancy rates also vary due to local and regional factors. For example, a lack of high-end business travel due to COVID-19 negatively impacted hotels utilized by upscale business travelers. however, an increase in low-budget family vacations positively impacted budget hotels located in low-cost vacation destinations.
Average Daily Rate (ADR): Average daily rate has decreased since March 2020, due to decreased demand. Average daily rate, multiplied by the number of available rooms and the occupancy percentage of a hotel is a good way to estimate a hotel’s NOI over a specific period.
Revenue Per Available Room (RevPar): Revenue per available room (RevPar) decreased over all hotel segments in the aftermath of the COVID-19 pandemic. Lower RevPar naturally means a lower NOI. However, if hotel valuations decrease relatively faster than hotel NOI, cap rates will still increase.
Hotel Cap Rates Are Just One Measure of Hotel Property Profitability
Cap rates are only one way to measure the profitability of a hotel asset. Since cap rates do not factor in leverage, and most hotels carry a significant amount of debt, cash-on-cash return and overall project IRR may be better ways of determining the profitability of a hospitality asset. The more debt a hotel carries, the more likely it is to generate a higher cash-on-cash return and IRR, though this will not impact its cap rate in any way.
The measures mentioned in the section above, such as ADR, RevPar, and occupancy are good measures of the stability and profitability of the hotel market as a whole. In general, cash-on-cash return, cap rates, and project IRR are good ways to compare similar hotel assets, while industry measures like ADR and RevPar can help investors determine when (or whether) to invest in hotels in the first place.