How to Know if the Price of an Inn is Right?

This article will appear in the next PAII Newsletter for Aspiring Innkeepers.

Of all the questions that we are asked during our Innkeeping Seminars and in our consulting practice, the most important, and most frequent, one is "How can I know if the price for an inn is the right one?"

First, some general background. Most aspiring innkeepers have previous experience in buying real estate, mostly for their own residence. They understand the concept of comparative market analysis (CMA) in which they, or a real estate professional, compare what they want in a home to many, many houses on the market or recently sold. The problem is that inn businesses are really unique combinations of assets, and there may be very few true comparables from which to get price data with respect to recent sales in a given area. An inn is a very different bundle of assets than a house. It is a combination of real estate (i.e., land, buildings and, most importantly, location), furniture, fixtures and equipment (because most inns are sold on a turnkey basis), and, most of all, the financial capabilities of the inn and its good will. Financial capabilities include both the historic cash flow of the inn after expenses, but more importantly, the projected cash flow from operations in the near term. What you are really buying when you purchase an inn is not what it did in the past, but for better or worse, what will it generate in terms of cash flow in the next few years after the purchase. Good will, on the other hand, is a bit more amorphous, and may include some specific assets like the website, URL, phone numbers, guest list, etc., but also its name and the general reputation of the inn to the public.

Financial Analysis: In determining what to pay for your "ideal" inn, the first and most important analysis that has to be done is to review what the historic cash flow of the inn has been, and to compare that data to other similar inns. If you have expressed serious interest in purchasing an inn on the market, you need to see the financial history of the inn for at least the last three years, including occupancy records, detailed profit and loss statements, and in some cases, tax returns for that period. (You may have to sign a confidentiality agreement to get access to this information.)

Once you have the data, you need to develop a reference point for the expenses of the inn to determine which ones will continue in the future and which ones reflect one time occurrences (like specific renovations or maintenance expenses). Some expenses are attributable to lifestyle or personal choices of the current owners (e.g., if they pay for an expensive car through the inn or have decreased their active participation in day-to-day activities, and more staff is hired to cover for them). PAII’s Industry Study of Operations and Finance is an invaluable source of financial data which can be used to compare the financial income and expenses from a given inn to industry-wide data which is broken down by several different categories (e.g., by region, size, average daily rate, location, etc.) By comparing each individual expense account in an inn's financial data against the appropriate industry averages contained in the PAII study, an aspiring innkeeper can identify those areas of expenses as either personal in nature to the owners of the inn or as unexpected and therefore need further explanation. Once this comparison is done, you can then project what this inn might produce in revenue under your management, and more importantly, what the Net Cash Flow (NCF) would be in future years. For purposes of this article, NCF would be the net income of the inn after all expenses but before interest, taxes, depreciation, amortization, and owner compensation (thus an "EBITDA" calculation).

Rules of Thumb: Most aspiring innkeepers who have been out in the market looking at inns have already heard about the so-called "Rules of Thumb" that industry professionals use to track and compare inn sales. These include, specifically, both Price per Guest Room and Gross Revenue Multiplier (GRM). At each PAII Convention (you should absolutely be going to these if you are really serious about becoming an innkeeper) there is a seminar given by inn brokers, inn consultants, and appraisers from around the country called "Valuations From the Four Corners" which details the inns sold during the last year by region, showing the sales price, price per room, gross annual revenue, GRM, and revenue per room. These seminars will be invaluable to you in determining the correct price to pay for an inn.
Here is a look at some Rules of Thumb: Price per Guest Room simply divides the sale price of an inn by the number of guest rooms. This very simple number tells an aspiring innkeeper very little about the nature of the business of the inn. It is only one of many variables that affect price, and likely the least precise and most unreliable of all of the measures of success. In the 2006 PAII Industry Study, the average national price per room was $125,242. Regional data was also available, and varied widely depending on location. Our own Oates & Bredfeldt data for mostly Northeastern U.S. inn sales showed average Price per Room of $126,498 for bed and breakfast inns.

Another Rule of Thumb is the Gross Revenue Multiplier (GRM) which is a calculation of an inn's ability to produce revenue as a factor of its value. Oates & Bredfeldt data (mostly from the Northeast) for the period 2002-2006 showed a GRM of about 4.47 times. Surprisingly, data presented by Michael Yovino-Young, a very knowledgeable appraiser from California, showed GRM approaching, and in some cases exceeding, six times earnings. The most important thing to ask about all of the data behind a GRM is what does the gross income from any business tell you about its profitability and future earnings? This is an interesting statistic to look at or keep in the back of your mind, but it is no substitute for a detailed review of the financial history of an inn.

Capitalization of Income: This approach to valuation is at the heart of most financial analysis of businesses as going concerns, and is one of the three methods used in every real estate appraisal. It basically takes the historic cash flow from the business and projects what it is likely to do over the near term future. This develops a net cash flow (NCF) for the future as a stream of income. The concept is that the value of a business is the present value of the net income that it will generate over the foreseeable future. The present value is represented by a mathematical computation based on a capitalization rate or "Cap Rate" that is a reflection of the relative risk of investing money in that type of business. Thus, the formula is to divide the NCF by the Cap Rate to find the value. By way of example, if the NCF of a business were $500,000 and the Cap Rate were 10%, under a capitalization of income method, the value of the business would be $5,000,000. The lower the Cap Rate, the higher the value. Historically, Cap Rates for inns have ranged from 9% to 11%, but there have been recent data, particularly from California, that seems to indicate that underlying real estate value can impact the Cap Rate by lowering it, and thus creating higher values. The one thing that this approach does not provide is to determine what is the correct Cap Rate for a given area or particular inn. This is a subjective conclusion that must be made based the relative risk of the investment and the present cost of capital. Thus, you would need to look at not only the consistency of the historic NCF of the inn, but also current interest rates on commercial financing, and comparable investment returns on similar businesses. While the ranges help, determining where you fall within such a range is more difficult, and in some cases may require professional assistance.

Debt Coverage Test: This is another way of looking at price and value. This methodology looks at the historic or projected NCF of a business and determines how much of that NCF is necessary each year to pay the debt service on a normal commercial mortgage on the property and how much above the debt service is available for uncertain future events or owner compensation. Most commercial mortgages are offered at a loan/value ratio of 75% (i.e., the borrower is investing 25% equity) with debt service calculated on a 20 year amortization with usually a fixed rate of interest for the first 5 years of the loan. Using the NCF projected from the inn, an aspiring innkeeper can then determine what the annual debt service on the loan would be and to what extent the NCF exceeds that debt service. The ratio is usually given as a percentage with the formula equal to the NCF/Debt Service. Thus, if the NCF was $130,000 and the annual debt service on the loan was $100,000, the Debt Service Coverage Ratio would be $130,000/$100,000 or 1.3 times. Most financial institutions when underwriting a commercial loan will be looking for at least 1.20 to 1.25 times coverage, meaning that there is a cushion in the NCF equal to at least 20% to 25% of the debt service available for unforeseen events or return to the owners. In looking at the Debt Coverage of an inn, you can therefore determine whether the inn "cash flows" or has sufficient earnings to pay a normal mortgage, and if there is excess cash flow, what kind of return does it provide an owner based on the amount of money invested in the inn business (i.e., the down payment, closing costs, renovations, and working capital invested in the inn). This is a method of making sure that you are investing in a sound business that will succeed over the future.

Conclusion: While all of this seems daunting to many aspiring innkeepers, it is very important to understand that an inn is a business that needs to be carefully analyzed before any price negotiation or offer is made. For those who feel uncomfortable doing this type of financial analysis themselves, there are inn professionals (i.e., consultants, brokers, accountants, and appraisers) who can provide fee-based assistance to aspiring innkeepers in reviewing, analyzing, and comparing this financial data in order to come up with the right price to pay for an inn.