Navjit Ahluwalia

The hotel business, like most other businesses, is cyclical: when the economy improves, new hotel construction activity tends to accelerate with investors looking for opportunities to develop new hotels. This trend is supported by an increase in the advertisements appearing in local newspapers for auctions of hotel sites. The entire process of setting up a new hotel typically takes three to four years and, given the ‘normal’ delays that take place in India, can take even longer. Common questions being asked today are "how much should I pay for the land?" or, "how much is this hotel site worth?"

The cost of land, building and furnishing must balance out with the ultimate value of the completed project. If one or more of the cost components is excessive, the entire project could become unviable. In a number of cities in India, as well as in cities like Hong Kong, Singapore, Tokyo, Paris, London and New York where land costs are extremely high, it has often been difficult to justify new hotel development.

It is quite obvious that land prices are a function of supply and demand. However, the fact that land is only worth something to someone when it can be put to use explains why land values generally decline by a greater proportion than values of improved properties during a real estate downturn. Generally, three alternate approaches are useful in evaluating what a hotel site is worth:

1. Allocation Method

The allocation method is based on the principles of balance and contribution, which suggest that there is a normal or typical ratio of land value to total property value for specific use categories. Land generally represents 15% to 25% of a hotel’s total development cost, depending upon project and local market conditions. There have been deviations from this trend - during the boom years in the early to mid-nineties in Asia, there were hotels being developed in Hong Kong and Tokyo, and even in Mumbai, where land costs represented 50% of project cost. To better understand the allocation method, let us take an example in which a developer wants to buy a site for a 300-room upscale hotel. Table 1 sets forth a preliminary range of land values derived using the allocation method based on certain assumptions.

Based on the calculation shown in table 1, the value of land for a five-star upscale hotel will range between Rs 1,765 to Rs 3,300 per square foot of land or Rs 880,000 to Rs 1,660,000 per room.

Table 1: Land Values as indicated by the Land Allocation Method
Average square feet per room required for a Upscale hotel

750

750
Total no of rooms

300

300
Total area (sq ft)

225,000

225,000
Assuming allowed FSI is 1.5, Land area required at the minimum

150,000

150,000
Development cost per room for a five star deluxe hotel (excluding land)

5,000,000

5,000,000
Total Development Cost (Excluding Land)

1,500,000,000

1,500,000,000
Assumed cost of Land

15%

25%
Total Development Cost (Rs)

1,764,705,882

2,000,000,000
Cost of Land (Rs)

264,705,882

500,000,000
Cost of Land per square foot (Rs)

1,765

3,333
Cost per acre of Land (Rs)

76,870,588

145,200,000
Cost per room (Rs)

882,353

1,666,667

2. Ground Lease Approach

The ground lease approach is supported by the economies of the individual project. Hotels have routinely been constructed on leased land, with the developer paying a flat rent calling for escalation adjustments or more often, with rents tied to a percentage of revenue formula. Although this approach is more popular in Europe, it is beginning to find favour with real estate developers in India as well. While the terms may differ from hotel to hotel, the basis for rent calculation is generally tied to a percentage of revenue formula. The percentage of revenue can be tied to rooms, food and/or beverage revenue formula. Using the forecasted stabilized revenues for the hotel in question and applying a typical hotel ground lease formula, the income attributed to the land can be determined. The land value is then estimated by dividing the rent payable by a land capitalization rate.

The following example illustrates the ground lease procedure for estimating hotel land values. To see how this approach works, let us take an example of a proposed 300-room upscale hotel to be built on leased land in a suburban location.

In the example, shown in table 2 below, the stabilized revenue is Rs 42.2 crore. Table 3, below, illustrates our assumptions of lease rental formulas. We have assumed three different hypothetical options of fixed rentals plus a percentage share of revenue as examples.

Table 2: Land Values as indicated by the Land Allocation Method
Subject Property
 Upscale Suburban Hotel
No of Rooms:

300
Projected Occupancy:

70%
Average Room Rate (Rs):

3,500
Projected room revenue (Rs):

268,275,000
Projected food revenue (Rs):

134,137,500
Projected beverage revenue (Rs):

20,120,625
Projected Total revenue (Rs):

422,533,125
Cost of Land (Rs)

264,705,882
Cost of Land per square foot (Rs)

1,765
Cost per acre of Land (Rs)

76,870,588
Cost per room (Rs)

882,353
Table 3: Land Values as indicated by the Land Allocation Method
Options Fixed Rental per Sq ft per month Rental Clause Total Revenue Hotel's Estimated Ground Rental
1 12 Plus 7% 61,977,319
2 22 Minimum Against 8% 59,400,000
3 None Plus 12% 50,703,975

Rent earned from unsubordinated ground lease represents an extremely low risk flow of income. Because tenant improvements typically amount to more than five times the value of the land thus comfortably securing the landlord’s position, the risk of default is almost non-existent. For hotel ground leases where rent is tied to operating revenues, the landlord is also protected from the adverse effects of inflation. Based on these minimum risk factors and the current cost of long-term capital, the analyst must select an appropriate (land) overall capitalization rate. In our example, a land capitalization rate of 12% is used. This is based on what real estate developers in most large cities in India are currently realising.

Applying the indicated capitalization rate to the subject property’s ground rent results in the following estimate of land value:

The example shows a land value of Rs 1,721,592 per room or Rs 15 crore per acre. A quick land value cross check can be made by seeing if the land value is within the normal limits of 15% to 25% of the total project cost.

3. Residual Land Approach

The final method of estimating a hotel site’s value is the residual land approach. This method, if utilized with accurate variables, is most appropriate for determining what you can afford to pay for the land of a specific project. A market feasibility study is performed to estimate the economic value of the hotel, once it is open and operational. The development costs of the hotel including all soft costs, such as interest and pre-opening expenses are estimated. The developer’s profit is added to the estimated costs to compensate the developer for undertaking the project. The amount by which the economic value of the hotel, based upon projected future cash flow, exceeds the hotel’s development cost determines the net residual value to the land. Taking the earlier example of a 300-room upscale suburban hotel, let’s assume that the developer’s consultants have estimated the hotel to be worth Rs 7,000,000 per room, once it is open and operational in the year 2007. The developer estimates that the total development cost of the hotel, exclusive of land costs and developer’s profit will be Rs 5,000,000 per room. The residual value to the land estimates to a future value of Rs 7,000,000 less the development cost of Rs 5,000,000 which is Rs 2,000,000 per room. Since the value and cost figures are estimated in future dollars, the land value can be discounted to the date of purchase by either a deflation rate or safe rate of return. Discounting the land value for a period of three years at 6% per year, results in a land value of Rs 1,679,239 per room.

The three approaches applied to our example result in a range of values for the site. While the choice of variables utilized in such an analysis is subjective, a careful consideration of the attributes of the market, proposed project and site can lead to a prudent analysis and conclusion.

As you can see, a hotel’s room revenue is the deciding factor in the ground lease as well as the residual approach for balancing the land cost component. If a development is faced with an out of balance land cost, as is the case most often in India, the two logical options are to either increase the number of rooms (if zoning and market conditions permit) or enhance the quality of the facilities and service so the property is able to achieve higher average room rates (again if the market conditions permit). These adjustments are quite evident in India with the high land costs resulting in more five-star hotels and practically no two-star or three-star properties.

We are also starting to see the development of office parks, hi-tech complexes and campus style office hubs in some suburbs of India where land values as well as market dynamics encourage the development of mid-market and budget hotels. In our opinion the next wave of hotel development is certainly going to be in this direction.

Navjit Ahluwalia , Associate Director with HVS International, India, has a Masters degree from the Institut de Management Hotelier International (Cornell-Essec) in France and a Bachelor degree from St Stephens College, Delhi. He has over fourteen years of operational and management experience having worked with the Oberoi Group, Hilton and ITC Hotels in India and The Claridges and Dorchester Hotels in London. Since joining HVS, he has worked on several consulting assignments in the United States and India. More...

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