Valuing Your Bed and Breakfast Acquisition

by Deborah D. Cargill

When our bank evaluates a B&B acquisition or start-up one of our first tasks is to try to determine whether or not the contract price is anywhere close to the true value of the property and enterprise. Although we will eventually order a professionally conducted appraisal, we will do some preliminary study of value during our underwriting process because we do not want our borrower to be overburdened with debt that the inn might not be able to support and we want to make sure that our loan is sufficiently collateralized. While we are bankers, not appraisers, we can usually come within an acceptable range of the value that is later reported in the appraisal. You can too if you use a combination of two or three appropriate valuation methods.

The fair market value, the price at which a willing seller and willing buyer can come to terms, is usually arrived at using a blend of several valuation methods. The direct sales comparison is the method most people are familiar with. You look at similar pieces of property that have sold recently and then draw conclusions based on strengths and weaknesses of the property being appraised. This research can and should be done by anyone interested in buying any piece of real estate - it is just part of doing your homework. Check the public records for sales within the last couple of years, talk with local real estate brokers, and call up some current inn owners. You will be amazed at most people's willingness to tell everything they know. The basic kinds of information that you will want to know includes sale price, last date sold, number of guest rooms, rates, kinds and quality of amenities, and location. Build a database of information and compare your potential acquisition with each of the sold properties. Your due diligence may result in a chart similar to the following:

It looks like the five most recent sales of inns in the community went for a high of $120,000 per room to a low of $53,125 per guest room. If we exclude the high and low and look at the more average sales it looks like $107,500 per guest room might be a good number to start with. At first glance it appears that based on that information your 6 guest room inn could be worth about $645,000; however, more analysis needs to be made. If these properties have separate parking areas for their guests, while your guests will have to find spaces on the street, then your value needs to be adjusted down. If your inn is in a more desirable location or has more historical significance your value could be adjusted upwards. Condition of the property, room rates, occupancy rates, and of course, furniture, fixtures and equipment included with the sale are other points to consider when adjusting for value. The direct sales comparison should tell you what the market participants in your area are doing. This method is important when considering any real estate acquisition, but it is the most appropriate when looking at a start-up B&B venture.

Another important valuation method looks not at what the local real estate market is doing, but instead considers your personal investment expectations. In the financial world the maxim "Risk indicates rate" holds true for an investment in a B&B as well as any other. Investment options in which the risk of loss of principal is the lowest, such as federally insured savings accounts, generally yield no more than 2% to 3%. Certificates of Deposit yield around 6% today. You might expect stock in IBM to have an annual return of 12% and an IPO for a dot com company to return at least 20%. If you are looking at an existing B&B and the historical financial statements indicate that it is a successful, profitable operation, you would expect a slightly lower rate of return because the perceived risk is less; however, if you are considering starting a new B&B venture the risk involved will probably rise. Your personal investment requirements for the existing inn might be 12% and for the start-up it might increase to 18%.If you pay $645,000 for that six guest room inn and finance 75% of it at a rate of 11.5%, you would expect to see it return at least $84,656 to you in addition to any reasonable salary you might draw.

Mortgage Rate 75% X .115 = .08625
Equity 25% X .18 = .04500
Band of Investment .13125%
Total Investment of $645,000 X .13125% = $84,656

I f the profit drops to $60,000 the return on your equity of $161,250 drops to 3%. The bank is still getting its 11.5%; it's your rate that suf fers. Conversely, if the net profit climbs to $125,000 the bank still gets only its 11.5% and your rate of return jumps to 43%. To determine the value of an investment based on the capitalization of net profit merely reverse the equation. Instead of starting with the price, start with the net profit and divide by the band of investment that you have calculated. Returns in the following various amounts would have the values shown:

Keep in mind that if the blend of debt to equity or the required rates of return change, the band of investment would change and so would the resulting value. In my opinion this method is better suited to the valuation of an existing inn. The seller of an inn should be able to document the historical and current profits of the business and you can use real numbers to determine value. In the case of a start-up venture the projected profit is more speculative and less reliable as a means of valuation.

This is also the case when you try to use the present value of projected cash flow for years to come as a basis for valuation. Projections are always a best guess scenario. Think about how tough it is to set a budget for the next twelve months. Trying to project income and expenses for the next five years is particularly difficult. If it is an existing business some assumptions about the future can be made based on the past; however, in a start-up situation there is no such guide. Another consideration that makes this method difficult for casual amateur appraisers, such as ourselves, is that assumptions must also be made about a selling price five or ten years down the road. While this method is best left to professional appraisers, you may want to take a stab at it just to see how your prospective acquisition fares. Using some hypothetical projections and a capitalization rate of 12% we can come up with a present day value for this stream of future cash flows.

Based on those projected annual cashflows and a sale that nets $550,000 at the end of five years, the B&B would be worth $646,815 today.

There are still other methods of valuation including cost to rebuild. In many cases cost to rebuild is not useful in appraising a B&B because so many are old and located in historic districts. Many of them just can not be replicated today. Marshall Valuation Service could tell us how much it would cost to build a new brick six bedroom, six bathroom house today, but it would not address the artistry of the stained glass windows or the plaster medallions on the ceiling or the marble thresholds or any other distinctive feature of an older home.

In this article we have looked at three ways to value this proposed B&B acquisition and have calculated range as follows:

Direct Sales Comparison $645,000
Capitalization of Income $685,714 (based on earnings of $90,000)
Discounted Future Cashflow $646,815.

The bank would probably lean more toward the $645,000 direct sales comparison, but you could feel good in the knowledge that the venture could reach your investment goals even at a price of approximately $686,000. The basis of any good appraisal is accurate information. It takes a lot of time to go through public records looking for details of previous sales. Talking to local real estate professionals and other inn owners is also required. You will be a better informed buyer by the time your bank is ready to call in the professional appraisers. Good luck in your new venture.

Deborah D. Cargill is a loan specialist with Sunbelt Commercial Capital.