What to anchor the exit cap to on a select service hotel when RevPAR growth is really 1.5 percent.

Question

Take a 142 key select service asset in a secondary market. Trailing twelve shows 71.4% occupancy at a 152 ADR, so 108.5 RevPAR. Total revenue 6.1m, GOP 2.45m or 40.2%, base management fee at 3% of gross revenue, FF&E reserve at 4% of total revenue, NOI after reserve about 1.97m. Ask is 24.6m, which is 173k a key and an 8.0% going in yield. The problem is always the exit. The sponsor's model in a case like this uses a 7.75% terminal cap in year five off a stabilized NOI built on 3.5% annual RevPAR growth. Put the submarket at 1.5% at best, because there are two entitled projects coming and the corporate demand base is one employer. At 1.5% growth and an 8.5% exit the deal lands at a low double digit IRR with no promote, and at the sponsor's assumptions it lands at 17%. Same building. So what do people actually anchor the terminal cap to on hotels when the entire spread between a good deal and a bad one sits in that one cell? Trailing transaction comps in a secondary market are thin, and half of them come from a different rate environment.

Rena Expert · Accepted Answer

Anchor it to replacement cost and to the debt market rather than to comps, then treat the cap as an output you test.

At 173k a key you're near or above what a new select-service box costs to deliver in a lot of secondary markets once you include FF&E and soft costs. That matters at exit because your buyer's alternative is building. Two entitled projects in the submarket is the same statement said differently. If those deliver, your 1.5% RevPAR growth is optimistic on occupancy, not on rate, and the exit buyer prices the supply they can see.

The assumption carrying the sponsor's 17% is not the cap rate on its own. It's the 3.5% compounding on top of a 108.5 RevPAR that already reflects a full-strength travel year. Five years of 3.5% is 129 RevPAR with flow-through, and every dollar of that flows to NOI at 55 to 65 percent on a select-service P&L, so the model gets most of its return from a rate assumption. Ask them to show the deal at flat RevPAR for two of the five years. Hotels reprice nightly, so a soft year shows up in full, and one soft year inside a five-year hold is closer to the historical base rate than zero soft years.

Two things your note doesn't address. The 4% FF&E reserve is a reserve, not the actual capital calendar. A hotel that took a PIP at acquisition takes another partial cycle around year six or seven, and if that lands just before your sale the buyer prices the PIP they'll inherit, which is a cap rate adjustment you never see labeled as one. Second, check the incentive fee hurdle in the management agreement and whether the agreement survives a sale. An operator entitled to termination compensation narrows your buyer pool.

tashaford30 · Answer

One question worth asking in the middle of this. Why is the reserve 4% rather than whatever the actual furniture replacement schedule costs? In select service that figure usually comes from the franchise agreement, so confirm whether 4% is a brand requirement or a copied convention.

chriswalton8 · Answer

Quill, that is usually a floor set in the franchise or management agreement, often 3 to 5 percent, and the real spend is lumpy. Sextant, the spread you describe is the reason sponsor IRRs are worth very little on their own. If 3.5% versus 1.5% RevPAR growth moves the number from 11 to 17, the promote is being earned on a growth forecast the LP cannot verify. Does their waterfall have a lookback, or does the GP keep distributions taken in years two and three if year five disappoints?

marcus_hale41 · Answer

Pull the benchmarking report yourself instead of taking the sponsor's excerpt. I want the trailing 36 months of occupancy and ADR index against the competitive set they chose, plus the set they didn't choose. On single-employer markets I also ask for the top ten accounts by room nights and the contract expiration dates. If one corporate account is 18% of occupied rooms, your terminal cap conversation is really a tenant credit conversation wearing different clothes.

dmitri_248 · Answer

On the management agreement, look for the termination on sale clause and what it costs. Some require a multiple of the prior year's fees, some allow termination without a fee after a stated year, some require the buyer to assume the agreement, and a few use a blend of those. Also check whether the operator took key money at signing, because unamortized key money usually comes back to them on early termination, and that lands in the closing statement rather than in NOI.

sonia_alvarez · Answer

An 8.0 percent going-in yield is not what sizes the loan. Hotel lenders typically quote off debt yield, and at a 10.5 percent requirement a 1.97m NOI supports roughly 18.8m, which is 76 percent of a 24.6m ask. Hold the requirement at 11.5 percent and that falls to 17.1m, pushing the equity check up 1.7m and moving the IRR under both growth assumptions. Get the debt yield floor into the term sheet before arguing about the exit cap.

What to anchor the exit cap to on a select service hotel when RevPAR growth is really 1.5 percent.

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