Interview – Investment and returns a deeper understanding

Morning, Steve. My name is Emma Dyson, and I’m a consultant in the hotel sector. So I’ve been working with Glion and yourself on this course. And I think there’s a couple of aspects of the course that we can delve into in a little bit more detail, just to get the best of your expert knowledge on this topic and so the students understand more clearly. Let’s think a little bit more about the types of investment. So I understand from the course so far that there’s two types of investment, so debt and equity. Can you tell me a little bit more about those? So shall we start with equity, and what’s involved and what that investor would expect as a return.

So the equity investor puts in the equity capital, which is probably 65% to 75% of the total investment in the property. And what the equity investor gets out of their investment is that each year they own the hotel, they get periodic cash flow. And that cash flow is cash flow after payment of debt service. And so they get this period of cash flow throughout the holding period. And in valuation, we typically assume the holding period is 10 years. And then upon the end of the 10th year, we assume that there’s a sale. And then every time that you own a hotel, eventually you’re going to sell it.

So when you sell the hotel, you get the proceeds from the sale, but then you have to pay off the mortgage. So if you take the proceeds from the sale, pay off the mortgage, you have what’s called the equity dividend. And that is what the investor gets. So they get the periodic cash flow, plus the equity dividend. And to value that, you discount that back to the present value. And that’s how our valuation model works. Excellent. And what about the debt aspect? What would that investor expect in hotels? So the debt part comes from usually some type of lender. It could be a bank. It could be an insurance company. It could be a real estate investment trust.

So they put in the debt capital. And their position is pretty safe, because of the fact that they get paid first before the return on equity. And what they get out of the transaction is what we called interest rate. So they would get interest rate. They would get the loan paid off periodically during the course of the loan. And then when the property’s sale, they get paid off the total principal of the loan. So the interest rate is what return they get on the investment. OK. I understand from what you’re saying that the equity investment is much riskier. So would the investor expect a higher return than the mortgage lender? Absolutely.

So if you look at today’s market rates in various parts of the world, let’s assume that the interest rate on a hotel mortgage would be 8%. In that case, the equity investor would probably want a greater return, an annual rate of return of somewhere between 15% to 20%. So you can see the difference, but that’s really the cause of the difference in the risk factor of this type of investment. That’s significantly higher, isn’t it? How do we factor that into the model and the calculations itself? That’s the equity yield portion that we put into our model. And as we saw in our model, it ranges between 15% to 20%.

So that’s the IRR, Internal Rate of Return to the equity investor. And we discount all those periodic cash flows each year, plus the residual at the end of the 10th year back to the present value at the equity yield rate. So tell me a little more about the weighted average cost of capital, which is the approach you use in the HVS model. The weighted average cost of capital is that we assume that there is a significant amount of debt, as I said 60% to 75%. And then the rest made up of equity.

So if you take the percentage amount of debt times the interest rate plus the percentages amount of equity times the equity yield rate, add them up together, that’s the weighted cost of capital. And we find this is much better to use than using an overall discount rate like a lot of other appraisers, because we can really focus in on coming up exactly what the mortgage interest rate is. Thanks very much for that insight, Steve. That’ll be really helpful for us to understand the valuation model going forwards.