Highest and Best Use Analysis – Enhancing Hotel Value
Presented by: Jonathan Jaeger
The highest and best use of a property as improved pertains to the use that should be made of the property as it exists. As a hotel property progresses through its life cycle, it is imperative for owners to determine if the subject improvements should be maintained as is, renovated, expanded, partly demolished, etc. – or should they be replaced with a use different in type or intensity? The use that maximizes the property’s net operating income (NOI) on a long-term basis is considered its highest and best use. An analysis of a property’s highest and best use as improved can result in a determination that little or no capital expenditure is required. However, significant expenditures may be required to rehabilitate and/or maximize the potential of the existing use. A highest and best use study can be done for the entire property, or for one specific space in the hotel which is not achieving its potential for profits.
Highest and Best Use is defined as “the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible and that results in the highest value” (The Appraisal of Real Estate, Thirteenth Edition, p. 277-278, The Appraisal Institute, Chicago, Illinois). A standard highest and best use analysis will consider four separate tests which are 1) Physically possible; 2) Legally permissible; 3) Financially feasible; and 4) Maximally productive.
Throughout Pinnacle Advisory Group’s experience, many full-service hotel properties have space which is under-utilized and does not represent the highest and best use which maximizes profitability of the overall asset. When conducting a typical highest and best use study, it is important to determine the physical limitations of the space under consideration, such as; how large is the space? What kind of access is available for prospective customers? Is electricity and plumbing readily available? In a highest and best use study, the physical test is always done first to determine which uses are possible to implement prior to undertaking further analysis.
Legal issues are often more palpable. For example, what is the ingress/egress requirements set forth by the local building codes? Hotel owners and managers need to be aware of what licenses and permits are required for specific uses. One of the many options for a hotel owner is to lease out the space in question to a third party operator. Leasing space can often be more profitable than operating internally, and usually presents less risk for the hotel owner. However, with leased space, the landlord loses control over the area, which could potentially become a detriment to value in the future. It is also important to examine franchise agreements to understand what F+B offerings and amenities are required by the brand.
After the physical and legal elements are considered, the analytical and quantitative approach to highest and best use is conducted through a test for financial feasibility. Based on the available uses for the space, a thorough analysis is conducted to determine which option generates the highest NOI and overall positive impact to total value. For example, a night club use may result in the largest increase to profitability of that particular space per square foot. However, the impact of noise and other factors of having a night club on property may be a detriment to the overall operation.
For each scenario, it is important to consider and analyze what, if any impact the alternative use would have on occupancy and average rate of the core business. Does the increase in value justify the cost associated with a new use? For a rooms addition scenario, it is important to analyze the profitability per each additional guest room using the existing financial performance data. This data will help determine the viability of that particular option. Additional rooms have a direct and positive impact on the NOI due to economies of scale with fixed and overhead expenses. To illustrate that statement, increasing the room count in a hotel will not necessarily cause a large increase to administrative and general or sales and marketing expenses. Rooms additions typically have a 40 to 60 percent flow through to the bottom line.
As experienced over the past decade, with many mixed use developments in the United States, ancillary amenities and various real estate uses can benefit hotel guests and enhance the value of the overall asset. It is important to select the particular use which will benefit the property and create the greatest benefit to incremental value. A highest and best use study will determine what is right for a particular asset in a defined market, and will enhance the long term potential for the hotel operation.
Jonathan Jaeger is a consultant with Pinnacle Advisory Group who specializes in valuation services at the Boston office. Mr. Jaeger is a graduate of the School of Hospitality Administration at Boston University and has been with Pinnacle for over three and a half years. During his tenure, Mr. Jaeger has completed over 350 hours of Appraisal Institute Qualifying Education in pursuit of the MAI designation.