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Wednesday, March 28, 2007 

Innkeeping 105 ~ How Much Should You Pay For Your Inn?

You might think I skipped right over the session on selecting a location and the session on selecting the right inn.

Wrong! The elements that go into determining how much to pay are many and varied and your selection of a location or a specific inn will determine the relative importance of each of these elements. I believe you should be armed with a knowledge of these elements before venturing out to select a location or a specific property.

Some of these elements that factor into the right price include, but are not limited to the following:

  • Revenue
  • Expenses
  • Cash Flow
  • Condition of the Property
  • Location
  • Property value in an alternative use
  • Interest Rates
  • Supply vs. Demand

All of these elements can be summed up in one term, "Total Return."

Total return determines why a property in Bismarck, North Dakota may sell for 3 times annual revenue, while a very similar property on the coast of Southern California may sell for 10 times annual revenue.

Using this same example, with the cost of living lower in ND, that same property's total operating expenses may run 40-45% of revenue. This would leave cash flow at 55-60% of revenues. Doing the math, this property is selling at a multiple of approximately 5 times cash flow.

With a much higher cost of living in Southern California this property has a higher operating expense percentage at 60%. Again, I'll do the math...it turns out this property is selling at a multiple of 25 times cash flow.

It would appear that the Bismarck property is far more attractive. At 5 times cash flow the ND property will pay for itself in just 5 years, while the Southern California property would take a full 25 years to earn back the price of the property.

Simple, isn't it? I'm sorry to disappoint you but, it is nowhere near that simple.

The above analysis only deals with the elements of revenue, expenses and the resulting cash flow. We didn't even adjust the cash flow for expected room rate increases or expense increases. If rates in ND are projected to increase by no more than 1% per year for the forseeable future, and the CA property can expect increases ranging between 8-10% per year, then the picture changes dramatically.

Factor into those adjusted revenues the expected changes in expenses for each market then you will be able to calculate the Projected Annual Operating Cash Flow.

Now what are you going to do with all that cash flow you have projected? You better pay back the money you borrowed from the bank and maybe, more to the point, you will have to pay them interest as well.

So your $100,000 in projected annual operating cash flow is going to be used to pay the 4% interest and a portion of the principal on your loan. If that principal and interest totals $60,000 that would leave you with cash after debt service of $40,000. What if interest rates weren't 4% but rather they are 8%? Now your bank payment just got projected at $100,000. Oops! If all other factors were exactly the same, would you still have been willing to pay the same price for the inn?

Let's step back to comparing our ND inn at 5 times cash flow and our CA inn at 25 times cash flow. Now consider that the ND real estate values can expect to increase/decrease from between -2% to +1% per year for the forseeable future. The CA real estate market is hot and values are expected to continue increasing 8% to 12% per year. This is what real estate agents jokingly refer to as the three most important principals of real estate; location, location, location. Would you be willing to forego some annual cash flow for a dramatically larger pay day in the future? Are you beginning to see the concept of Total Return and its importance?

You should hopefully see why the discussion of which particular inn you select should come after determining how you should value that inn. I haven't even mentioned many of the elements listed above although they all (and others) factor into the equation. If you have other considerations that aren't mentioned here, feel free to post a comment.

Now it's time to mend fences. You folks from North Dakota, don't take offense. I used your great State as an example because it's always on my mind. I've spent lots of time in this beautiful state and have many wonderful memories of visits from Fargo to Medora. I've watched the Northern Lights dance across your sky and I've climbed on horseback up and down several of the buttes in Theodore Roosevelt National Park (the truth is, the horses did the climbing). It's one of the best places on earth.


Thank you for the great posts about innkeeping. My husband and I have always wanted to open a B&B and we find your insites very helpful.
Please keep them coming.
Cheryl T.

Dear George,

My partner, Rick Wolf, brought your Innkeeping 105 post to my attention. Kudos for calling it like it is. This is the kind of stuff that gets my heart pounding (well, sort of, but I try to make the subject fun and interesting when I address groups at PAII or elsewhere).

All of your points about Total Return are valid, and lots of folks don't realize that when they own an inn they can "make money" lots of different ways, not all of which are strictly cash flow related. Lots of folks also don't realize that the same inn, measured different ways, produces a different return on their investment. All are true but come at it from distinct angles.

For instance, there's cash flow before and after tax, which is the money left in a person's account at the end of the year. But there's also cash on cash, which measures the same amount but against the original investment, not the price of the property. One of the most frequently overlooked elements of Total Return is principle reduction. With every amortized mortgage payment, part is interest and the other part is principle, paying down the loan. The money still isn't in the bank account, but a person's liabilities have been reduced, increasing their net worth and potential cash out at sale.

One other key point that everyone should consider and remember when thinking about how much to pay for an inn (or how much to ask for an inn) is whether the inn has the potential to be used as a residence or whether it is fundamentally commercial real estate. In the former, the "real estate value" will be determined by market demands and how much a person would pay to be able to live in that house at that location. But if an inn is so large or so commercial that no reasonable person would consider it as a residence, then the value will be determined on a cash flow basis, and the "real estate value" is determined by the property's ability to generate a stream of income. The total return that an investor, not a homeowner, is seeking will set the benchmarks for value.

Thanks for the great articles and blog. Maybe we could post your "Innkeeping 105" article on our site? Keep up the great work. You are an inspiration!

Peter Scherman
The B&B Team, Inc.
Inn Consultants and Brokers

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