Hotel Vertu: Financing the Venture in the Boutique Hotel Industry – Case Solution

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Hotel Vertu: Financing the Venture in the Boutique Hotel Industry Case Answers

1.0 Introduction – Hotel Vertu

Hotel Vertu is an upcoming 4-star boutique hotel business whose birth is credited to Yvonne D’Arcy and Elisabeth Whiting, two recent graduates from prestigious universities who have had rich work experiences thus far.

The former Peach Tree office building will be renovated with the help of experienced architects, and the building was praised for its excellent and convenient layout. The hotel will be in a vibrant historic district in Savannah, Georgia, with other booming tourism areas around it.

2.0 Hotel Vertu Opportunity Analysis

2.1 The Boutique Hotel Industry

One of the factors that encouraged the creation of Hotel Vertu is the performance of the hotel industry. From Appendix 1, the hotel industry in the United States experienced a CAGR of 5.08% from 2001 to 2008. And from 2009 to 2015, it gained an even better CAGR of 7.29% (Statista, 2015).

The latter CAGR exceeds the U.S. GDP CAGR of 4.75% during the same period (Statista, 2015), whereby a growing economy is also a positive sign for the hotel industry since it is cyclical.

Boutique hotels are expected to grow in market share as they have competitive advantages in capital expenditure requirements and pricing against large hotel brands. This scenario leads to better profit margins as it targets an increasing number of younger audience that demands a non-typical and unique experience (Mangla, 2015).

This trend has encouraged large hotel brands to acquire and/or develop their own boutique hotels as the lower cost but relatively close room rates promote a better return on investments as compared to traditional hotel business models (Reuters, 2015). Examples are IHG’s acquisition of Kimpton and Hyatt’s launch of Andaz.

The competition in the boutique hotel industry intensifies as hotels focus on their ability to offer the best unique experience to customers at the lowest cost.

2.2 Hotel Vertu Valuation

The cost to purchase Peach Tree is $20 million, while the renovation cost and additional expenses are $7.8 million and $10.1 million, respectively, bringing the total cost to $37.9 million. From Appendix 2, the forecasted cash flow from 2017 to 2020 involved a significant jump in revenue from 2015 to 2017 (65.3%) and increased departmental and operating expenses as a percentage of revenue. This is to be expected as the rooms and restaurants saw considerable upgrades in quality and design and required more cash to maintain them.

Consequently, the gross profit and operating profit margins are expected to underperform that of Peach Tree. The improvement, however, comes from the reduction in fixed expenses by removing management and franchising fees, which helps Hotel Vertu to outperform the old building in terms of net operating income (NOI) margin from 2018 onwards.

Using the given forecasted NOIs, the NPV of Hotel Vertu stands at approximately $13.2 million. The input for the discount rate is the expected market return of the property market of 9% (Re) (American Properties, 2015). The interest rate on loan obtained is 5% (Rd), the debt-to-total capital is (24607 / 37857 = 0.65), the E/V is 0.35, and the tax rate which is the sum of Georgia’s state tax and property tax of 5.02% (SmartAsset, 2015) Discount = the terminal value obtained using the cap rate multiple methods by multiplying Hotel Vertu’s year 2020 NOI with (1 / assumed cap rate at the sale).

The RevPAR, the product of the occupancy rate and room rate and a metric that shows the economic performance of a property, shows an increasing trend from 2017 to 2020, higher than the historical RevPAR of Peach Tree as well. This is largely due to the 10% average annual increase in the average room rate. A positive NPV and increasing RevPAR show that Hotel Vertu is an attractive opportunity.

3.0 Deal Structure Analysis

3.1 Deal Structure Performance

Factors that influence the decision-making of the deal structure of Hotel Vertu are the internal rate of return (IRR) and payback period (P.P.) for the investors and D’Arcy and Whiting (principals). Scenario A involves the investors receiving 80% of the cash after debt payment each year until Hotel Vertu is sold, which is less than the 100% cash flow that they would have received each year under scenario B.

As such, the IRR for investors for scenario B is higher than the IRR for scenario A, 16.42% to 15.19%. The P.P. for the investors is 4.4 years for both scenarios, so the investors would prefer scenario B, which has a higher IRR.

The higher IRR for the investors in scenario B comes at the expense of the principals, as the principals’ IRR for scenarios A and B are 128.52% and 108.81%, respectively.

Moreover, the principals can achieve a P.P. of only 2.4 years for scenario A while achieving four years of P.P. for scenario B. Hence, if the cap rate at the sale assumption stays at 8.5%, the principals would prefer scenario A, whereas the investors would prefer scenario B.

A lower terminal cap rate (higher exit multiple) would mean a higher selling price of Hotel Vertu. 80% of that proceeds goes to the investor in scenario A rather than 70% in scenario B. Therefore, if the terminal cap rate falls below 5%, investors will obtain a higher IRR for scenario A than B, and the principals’ preference based on IRR reverses as well. In this case, scenario A gives a mutually beneficial outcome to both investors (higher IRR) and principals (shorter PP).

3.2 Deal Structure Decision

The demands of the investors should take precedence as they are contributing 99% of the equity capital. To determine the deal structure, the principals need to observe the direction of the future cap rate since it is the main factor that affects the IRR of the investors for each scenario.

Appendix 3 plots the line graph of the U.S. real interest rate and cap rate (CBRE North America, 2015). Assuming that the NOI increases proportionately with inflation and the new property price is equal to (increased NOI /constant cap rate), the cap rate reflects the real interest rate earned on property investment since it is the return less inflation.

Furthermore, the plot shows the somewhat linear relationship between the real interest rate and the cap rate. As the interest rate is expected to increase after 2015…