Finance concepts and applications

Finance

Faus wants to sell the hotel and vacant lot. He has plans to sell the other assets associated with the Arts Property and Hotel, but must determine fair value for the hotel, the vacant lot and the adjacent apartments. The hotel value should derive from two things -- its book value and the present value of future cash flows. The current value of a hotel can be estimated using comparable. Barcelona is a hot property in the European hotel market, but the benefits of that might be offset by the increased intensity of competition. One of the drawbacks to the sale of the hotel is that it is currently under a very long-term operating contract to a company called Real Cortez. Unless the terms of that contract can be renegotiated, that contract will put downward pressure on the value of the hotel.

Faus must now determine his strategy with respect to selling the hotel. He first needs to know the value of the hotel, so he can set an appropriate price. Key to selling the hotel will be to renegotiate some of the terms of the hotel management agreement with Real Cortez, as that firm has the hotel management contract until 2018, with a five-year extension option. At this point, the troubled history of the hotel is not relevant. The purchase price for Faus and his group is relevant, as is the present value of the hotel and the present value of the hotel's future cash flows. This case will analyze these questions in order to come to some recommendations about the course of action Faus should take.

2. There are several components to the value of the hotel. With 455 rooms at 76% occupancy, the Arts Hotel is a comparable property to other five-star hotels in the city. The average daily room rate is €315, which is between 50-100% higher than the rates at comparable properties. This could mean stronger free cash flow from the rooms, or it could be a weakness whereby the ADRR must come down in the face of increased competition, much of it from newer properties.

The capitalization rates for hotels in Europe are among the lowest in the world, which makes Europe a good destination for bargain-hunters in the hotel business. The estimated capitalization rate is 8% for European hotels. As the Barcelona market is hot at present and showing growth, a higher cap rate might be acceptable. However, the cumbersome management contract works against increasing the cap rate, as does the influx of new competition. Leveraged IRR rates are stable at 16.7% on acquisitions in Europe. The market in the Americas is not a good corollary for the European market, so the growth in IRRs there can be discounted.

The current hotel value in Barcelona is just over €200,000 per room, which implies a value of just €91 million for this property. Given that it has the highest ADRR of any property in the city, and still maintains strong occupancy, the value of the Arts Hotel should be significantly higher. The sale to Faus' group was at €626,374 per room, showing that averages cannot be effectively used to calculate the value of the Arts Hotel.

The cap rate is applied to cash flow before debt, but after reserves for furniture, fixtures and equipment, and after reserves for operating fees. The gross operating profit -- which does not appear to include any non-cash items -- is estimated to be €35.289 million for 2002. When the reserves for management fees are subtracted, the cash before debt is €26,613. Using the 2002 values and the 8% cap rate, the value of the hotel would be €332.67 million. However, the ideal would be to consider the five-year forecast of cash flows. For the next four years, the cash flow is expected to decrease as prices are held stable and the impacts of competition and the 9/11 terrorist attacks reduce the occupancy rate. The discount rate used to calculate the net present value of the next five years' cash flows should be based on the weighted-average cost of capital. The capital structure is 85% debt (at 6%), with 8% equity and 7% T-bills. The T-bill rate is very low (estimated 1%) and the cost of equity can be roughly estimated as a 7% premium on the T-Bill rate (so 8%). This gives a WACC of:

(.85)(6) + (.08)(8) + (.07)(1) = 5.81%

The NPV calculation is as follows:

Year

1

2

3

4

5

26613

24113

22673

21286

24728

PV

25151.69

21537.63

19139.42

16981.94

18644.7

NPV

101455.4

average

20291.07

d

0.0581

This calculation indicates that the average present value of the future cash flows is lower than the current level of cash flows at €20.291 million per year. Using the 8% cap rate, this gives a hotel value of just €253.64. That the purchase last year came at an average cost per room substantially higher than any other major hotel deal in Europe supports the idea that the hotel might not be worth as much as Faus paid for it.

This leads to the conclusion that while the hotel can be loosely valued between €250-335 million, it is likely at the low end of that figure. Faus will already sell other parts of the property for €85.13 million. These figures do not include the vacant lot nor the apartments.

To calculate the value of the vacant land, it is assumed that a hotel will be built there. This 220 room hotel would have a total development cost of €52.805 million, which at €119,091 per bedroom is a lower price than either what was paid for the Arts Club or what the average value of a hotel room in Barcelona is. Selling the other assets will free up cash to develop this property, however, but this cost must come from equity as debt service is not expected to be available for this project until it has operating cash flows in 2006. Based on the average value of hotel rooms in Barcelona, the hotel developed would be worth anywhere from €44 million (average value x 220 rooms) and €300,000 per room, a discount from recent deals but appropriate for a non-branded hotel, a total of €66 million. At the higher end, developing this property could be profitable for Faus. The major risk is that delays could occur in the development of this property due to the high number of properties currently being developed in Barcelona, and that real estate prices could be suppressed as the result of this development glut. Selling the land for its value of €19.070 would generate capital quickly and absolve Faus of the risks associated with becoming just another five-star construction project in Barcelona. In addition, developing this property as a hotel runs the risk of cannibalizing business from the Arts Hotel, lowering that hotel's value.

3. The incentives need to be better aligned. If the current management agreement can be altered, the percentage of gross operating profit and base management fee should be negotiated downward. At 2%, the base management fee is higher than the industry average of 1.8%. More important is the incentive fee, which at 10% is significantly higher than the industry average of 6.9%. The agreement should have been signed to terminate on sale, but that has not taken place. The main issue for Faus is leverage -- he wants to renegotiate these terms but needs some quid pro quo to offer Real Cortez, who are under no obligation to renegotiate. His primary leverage appears to be the vacant land. If he turns that into a hotel, this will hurt the Arts Hotel and by extension Real Cortez. For Faus, it is just cannibalization but for Real Cortez it is a loss. In addition, Real Cortez' management contract for the apartments is coming up. Also, sale of the property to an unknown entity also represents a threat to Real Cortez. Faus could argue that he can look after Cortez' interests or give them a seat at the table during the sale, in exchange for their cooperation on the management agreement. So there is some room for bargaining. In particular, if offering a €19 million parcel of land for concessions that increase the NPV of the Arts Hotel by more than €19, then that is an avenue that Faus should pursue. While it is unlikely that Real Cortez would respond favorably to this aggressive application of leverage, something dramatic is needed to bring Real Cortez to the table.