HVS Musings: DCF is the most appropriate method of hotel valuations, especially during the COVID era
By Dipti Mohan, Senior Manager - Research, New Delhi and Akash Datta, Senior Vice President - Consulting & Valuation, New Delhi
In a market like India, where land most often than not is mis-appropriately valued resulting in exaggerated project costs and hotel transactions are limited in number, the only viable methodology that remains relevant especially in the current uncertain & volatile market scenario is that of Discounted Cash Flows (DCF). Moreover, the current pandemic has had an unprecedented impact on the hospitality sector, with hotels being temporarily closed and the sector witnessing all-time low performance metrics, by the virtue of which, assessing the value of a hotel on current income fails miserably.
Hotels are extremely cyclical in nature and unlike the previous cycles, the current decline is driven by demand and not supply, and our experience says that most hotels will recover their cashflows quickly. In our India Hotels Outlook Report, August 2020, we anticipate Occupancy & ADR to reach pre-COVID levels by 2022 & 2023, respectively. We also anticipate that the shift in cost structures due to COVID will continue to remain, which combined with the return in performance in 2023 will result in better yields for hotels, by which time we expect cap rate compression to occur.
The DCF method, where the annual expected cash flows are discounted to the present value for a period of 5-10-years after which the cashflows are assumed to grow in perpetuity, is in our opinion the most forward-looking compared to any other methodologies as it takes into account the potential of the asset vis-à-vis the evolving market conditions, which we expect to become favourable by 2023.
Additionally, compared to the other methodologies, DCF also considers the micro and macro-economic intricacies as it acknowledges the fact that the market conditions may not be great in the initial years but would recover strongly post the pandemic. The DCF methodology also helps us understand that hotels are extremely cyclical in nature and can generate yields higher that other asset classes once they recover. So, while presenting a future scenario the DCF method recommends that hoteliers should adopt a hold and buy policy as the market will recover soon.
The HVS Hotel Valuation Index suggests that hotel valuations in India will reach the pre-COVID levels by 2023, making this the best time to buy and invest in hotels.