Building a Winning Investment Thesis for Hotel Success | Mike & Nate E9

Join Mike and Nate, founders of Malama Capital, as they explore the critical role of a well-defined investment thesis in the hospitality industry. 
With $30 million in current real estate assets and a goal to build a $400 million business, they share detailed insights on creating and refining an investment strategy. 
From understanding guest avatars to leveraging capital expenditures and occupancy rates, this episode is packed with practical advice for both novice deal finders and seasoned investors. 
They highlight the importance of clarity, market research, and realistic benchmarks to ensure profitable hospitality acquisitions. 
Tune in to learn how to protect investor capital while achieving outstanding results. Don't miss out on their tips for navigating the complexities of hospitality assets and maximizing value through strategic property improvements.

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Transcript

Michael Russell 0:00

What's the one thing that can make or break your hotel investment? Clarity. Without a crystal clear investment thesis, you're gambling with your time, your money, and your reputation. If you don't get things right, you could end up with a financial disaster. In today's episode of the Hotel Investor Playbook, we're breaking down exactly how to build an investment thesis that works. You'll learn how to identify your ideal guest avatar, calculate realistic financial metrics like ADR, occupancy, NOI, and exit cap rates. Plus, we'll discuss the most common mistakes most new investors make and how to avoid them. Whether you're a seasoned investor or just starting out in hospitality, this episode is packed with actionable insights to save you time, money, and headaches. Welcome to the Hotel Investor Playbook, your guide to building wealth and freedom through boutique hotel ownership, hosted by Mike and Nate. Get in the game. We are Mike and Nate, founders of Maloma Capital, currently with $30 million of real estate owned, and we are documenting our journey towards building a $400 million business. What's up, Nate Dogg?

Nathan St Cyr 1:23

Yo, how's it? I'm freaking pumped right now to dive into this. Let's go.

Michael Russell 1:28

Right on, right on. Okay. So what's the thesis today? What are we talking about?

Nathan St Cyr 1:32

It is the word. It is the thesis. And that's really the the It's critical in hospitality that you get very, very clear on what your investment thesis is. Hospitality has a ton of moving parts. And I think this is an area that gets missed constantly. We're hearing of, you know, we see deals come through all the time. We listen to deals that are being, you know, taken advantage of throughout the industry consistently. And sometimes when we look at them, we're like, dang, they are not very clear on their investment thesis. And that could bite them and their investors in the butt in the end. So uh yeah, I'm stoked to dig into this to help people really have clarity to get clear, to help them save time and money on ultimately accomplishing their end goal for themselves and their investors.

Michael Russell 2:29

Awesome. Okay. So where do you want to start?

Nathan St Cyr 2:32

I think we start with what are the what are the categories that you need to get clear on when creating an investment thesis?

Michael Russell 2:41

Okay, so what are the key components of an investment thesis, right? So who, like in other words, who your guest profile is or avatar, who ultimately is gonna be the end buyer of your property? Why would someone want to stay at your location? Where is it? How are you gonna accomplish the you know the metrics that you're trying to perform, right?

Nathan St Cyr 3:05

Yeah, and I think with hospitality, it's also it to go to get granular when you're looking at an asset, the potential asset, you're looking at what is this thing now and what's it gonna be? I gotta create hospitality comes down to creating a feeling, right? So at the end of the day, what is it gonna take to create that feeling? And that's gonna tell us whether it's worth it or not. There's a ton that's gonna go into creating that feeling. What is an can I give you an example of how the same asset could have a different thesis and have a different feeling?

Michael Russell 3:39

Let's do it.

Nathan St Cyr 3:40

Okay, cool. So, like I could look at a uh a hospitality asset and I could look at it and go, okay, look, my avatar here, we're an hour outside of the Bay Area. My avatar here is gonna be high net worth couples that need a couple retreat, right? And I'm gonna go, we're gonna provide everything revolve around them going out and having this experience that is romantic, that is connected, that feels that is filled with status, that they can take photos of and take back with them as high net worth earners and be like on their social media, this is where we are and this is what we're doing, right? That that is a gonna take converting that property, creating the amenities that are going to elicit that feeling are gonna be very different than if, let's say, my avatar was I want to make sure that I'm catering to in that same location to young families that have pets that are active and outdoor enthusiasts, right? So my amenity structure, what I'm gonna need to do to the building, the different offerings, it's gonna look and feel very differently to go and create that feeling if that's my avatar, right? So the building is gonna go through a different transformation, the team is gonna go through a different transformation. One of them one of them may have an absolute remote management staff light team. And on the luxury side, it might need a full staff with you know several different options. So they're they're very there's gonna be a massive amount of different strategies that are gonna go into creating that feeling at the end, but yet it starts with the same asset and it's gonna end with a very different profile. Does that make sense?

Michael Russell 5:36

Yeah. So basically identifying who it is, who's your who's your client avatar? Because that's gonna affect everything from how you design the property to how you market the property to the culture of your staff and you know how they are, you know, what they're developing in terms of programming for on-site experience, whether they're you know kid friendly or adult-friendly, that's gonna dictate are they gonna be catering towards you know, like barbecues and water balloon tosses, or is it gonna be like uh, you know, romantic kind of lighting and music and you know, perhaps like a cocktail hour or something like that, or maybe even an event that's more adult friendly. It could be like, I don't know, some event where people get together and they socialize. But you know, I even experienced when I was a kid, they they there were a lot of elderly people. There was actually a market for elderly people at this hotel that I worked at in my hometown in San Diego where I grew up. And they had like bingo night and they had like uh kind of a mock, uh, what do you call it? Blackjack night. And so the programming of that experience was really geared towards, well, ooh, the clientele. And it kind of depends on what time of year as well. Summertime, right? You might shift towards family. Maybe other times of year you're you're you're kidding more towards, like in that example would be elderly people that are escaping colder climates, which depends on where the property is located. But all these elements of deciding ahead of time who your avatar is is critical for for those purposes, operations, marketing, et cetera.

Nathan St Cyr 6:58

Yeah. And I think that the thesis comes from the concept of number one, what is it that you're passionate about? Right. But also then you're you're really looking to once you have that feeling, then it's like, okay, based on this feeling that I'm creating, what are my average daily rates? What are my occupancies? It from there, you're looking at in the marketplace, what is the value of that feeling? We gotta, we gotta dive deep into am I accurate in my understanding of what value people place on that specific hospitality experience? Right. And that's again, it could be the same property that gets delivered in a different way and have very, very different average daily rates, have very different occupancy levels, have very different capital expenditures to take it to what that what that end property is. You just gave the story of working in, you know, they were really marketing to elderly. Well, your rooms then, when you go through your, you know, your capital expense, if that's what your target market is, right, you're really gonna be focusing on your bathrooms, they are gonna look very different if that's what you're focusing on, on elderly, than if you are focusing on, you know, a young romantic couple. That bathrooms from a design standpoint, from a functional standpoint, there's gonna be different costs involved in taking it to ultimately what that end vision is.

Michael Russell 8:26

Yeah, absolutely. And you see this with certain, you know, flagged hotels and brands, right? They you might have uh what is now the Marriott, they've consumed a lot of these other brands. Like they used, like the W in the West End used to be part of the the Starwood brand. But within that, they had very clear objectives on who they were targeting. The the W clearly is towards a younger generation, hip. There's a bar always with kind of music that's a little bit more like techno or or house music that has a certain vibe to it, which is gonna be completely different than maybe your typical Weston resort or even your Western business resort or hotel, I would say, where they understand if you're in an urban area and you're the Weston, you're gonna be catering towards business travelers and it's gonna be a little bit more, I don't know, just just not stale, but it's it's gonna have a certain feel where it's just like, okay, I'm not here for entertainment. I'm I'm I'm here to get the business done. It's clean, it's organized, it's efficient. I've got a conference space, whatever. But these the programming of the space is significantly different. Now, same ownership group, very different objective in who they're marketing to.

Nathan St Cyr 9:37

Yeah. And look, we go through this, you and I go through this as we're looking at different opportunities. And sometimes it's, you know, what type of hostel it could, or what type of hospitality could be as dramatic as, hey, does this property set up best for us to go and implement our hostel model? Or does this property go in and best suit us to utilize a remote management staff light little boutique hotel transformation? Or does this model go, hey, we want to go put a full staff. This is going to be a high rent revenue generator. And so we'll go through this when we look at an asset from a very basic level to start, typically, when we start digging into available assets. That's at a very, very high level. And I the reason that I mentioned that is because I think that it's in my mind, there's there's kind of two levels of an investment thesis. There's number one, and it's we're really it's about the who, who are we catering to in the thesis? One of them is our investors, right? Ultimately, the reason that we want to get so granular and so clear is so that we know that we are protecting with every bit of us that investment dollar, that we feel so confident in our vision, in what it's gonna take to deliver who the end purchaser and the exit is gonna be, at what class that that purchase is gonna happen, the class of the property. So what cap rate or the cap difference is, and we'll go into these a little bit, but that's gonna be so incre so incredibly important that we get that thesis right because ultimately we're stewards of our our investors' capital. So that piece for us is gonna be so incredibly granular and clear. Now, the can I can I stop right there though?

Michael Russell 11:27

Because you just described something that like a light bulb went off in my head. So I just I want to take a minute to recognize it. It's the who consists of the clients or the guests, I should say. But also then ultimately, if you're an investor purchasing a property with the intention of ultimately exiting from it, you just described you also got to consider the who as the end buyer. Who's gonna buy this property from you once you ultimately make the improvements or change the programming of the property? Who's ultimately gonna purchase this from you? And then that could lead to some of these other questions like the why and the how and the when, um, which we'll go into further. But the there's a couple different who's there that you've just alluded to.

Nathan St Cyr 12:12

Yeah. And look, I think we learned this early in our careers that really championship mindset really starts with end in mind, and so does championship execution, right? It's like, okay, we gotta look end in mind. This is who is going to purchase this, right? And this is the experience. And then it get it gets reverse engineered. And I think that that's uh that's a critical skill that's um important, you know, critically important in developing these theses and clear thesis. But there's another who, and that's for more of the beginner, right? So if somebody's beginning coming into the hospitality space and they're like, look, I don't, I don't know that I could go and take down a $7 million property on my own at this point. I don't know that I'm comfortable with that. But what everybody can do, every single person can start with deal finding, right? And I think that we've recognized that, that because people know that we'll go and offer, you know, 1% or up to $75,000 if somebody delivers us a deal that we're able to close, that we get sent a lot of deals. We're we're constantly be given. But what we find so often is we don't give those, we they they get very little attention from us because having somebody send us a deal that's maybe it's expired, maybe it's not on the market, and they just send it over and go, hey, here's a here's a you know, here's a great opportunity. What are your thoughts? Because they want to send us a deal. Well, that's that doesn't get we gets very little attention. It's like, okay. However, if that deal finder wants to go and make active income to start and learn a tremendous amount, if they get good at delivering an investment thesis where they're able to send over a property and say, here's the existing property, here's the existing comps, here's the exist, this is this is the pricing guidance that I would say that this is valued at, or an offer that I would make because of XYZ. And then they're able to say, and then this is where this property would be best served. And they're able to create what cost it would take to take it there, what the experience would be, and then ultimately defend the average daily rates, the occupancies, the revenue, and the NOI and come up with a very clear this property could go from here to here and hit these investment returns. And we look at it, now it's going to have our attention. Maybe we don't end up taking it to that level, or maybe we have a different thesis with that specific property. But if that gets delivered to us in that manner where it's that clear, that deal finder has an unbelievable shot of actually taking the work that they put in and having it translate to somebody actually closing a deal. So I think that this is important for in these, you know, the two who's are hey, you investors in the end, how are they going to benefit from this thesis? And then a deal finder that's out there working their tail off, how can they benefit from this by getting and delivering clear investment thesis to hotel purchasers like ourselves?

Michael Russell 15:29

Yeah, absolutely. What you're talking about is a great, really great entryway for people that want to get involved in this but aren't exactly sure how. Maybe they're, you know, concerned that they don't have the financial resources or the network, but they have a passion for this, they want to get started, and you've just described, well, look, it's clear. If you have the ability to go attack deal acquisition and find a good opportunity, well, the only way you're going to know if it's a good opportunity is if you you understand the thesis, right? Well, what you're describing here. If you can outline that and it checks on the boxes, but first you got to have a vision of well, what are what are the boxes? What what are we what are we looking for? What's our buy box? And understanding the components of that is really a part part of that is what you described is is the who. Who's who are the guests gonna be? What's the guest avatar? Again, who's the end buyer? What are the comparables? So who are who is your competition? There's there's a lot of who's here, but I think that to your point about deal finders, uh, understanding the components of an investment thesis is critical.

Nathan St Cyr 16:34

Yeah. Okay, so I want to get a little bit more just specific and just kind of name out. So once you have the feeling that you feel like, okay, here's where, here's where this property is right now. Here's where, here's what we see as our vision, right? This is a feeling, the hospitality feeling we want to execute. Now we got to go in to really create the does this, does this thesis end up being profitable or or not? What are the things that we need to get really, really clear on? And I just wanna I wanna go through and and list those out. What we're really looking for in the end, what we really need clear to get clarity on from really as as factual information as we can. So can I just start clipping through a couple of those? Look, this all is gonna come down to determining what class of building this will end up falling in, what NOI this thesis is going to generate. To get NOI, we need to understand what is the occupancy and average daily rate of this level of experience in this market, what are the expenses, big expenses in there being like, what is it, what is our staffing expenses to execute this gonna be, other than just the standard ones that are you know built in that are fixed expenses that you're gonna pay regardless. And then capital cont the capital expense to convert the property to ultimately what you need, what amenities are gonna be needed to create this experience, what is the quality level? Is this just a cosmetic makeover? Or are there significant property improvements that need to be uh taken into consideration? So we need to get clear on what is the anticipated renovation budget to physically convert the property to provide that experience. So I think that those are a those are some of the most important key metrics that you want to start digging into and gain just you want to feel like what you have is as close to factual as possible. And that can be difficult with ADR and occupancy, but that's that's the goal here.

Michael Russell 18:56

Yeah, so there's a lot to unpack there. Um I'm gonna start in with the last thing you mentioned, which is capital expenditures. I just want to comment on that because man, that is really subjective, right? There's not a lot of benchmarks to use as a rule of thumb because every property is completely different. And then also it's really up to the to the operator to determine what the vision is. And one's vision could dramatic, could vary dramatically from person to person. So that part right there, I feel like is the most difficult in my mind to predict. So you know, I don't know if right now is the time to dig into this, but you know, we've had discussions about commodity properties and how you could take a look at like a Motel 6 or you know, a standard just hotel that that people use just so that they can put ahead in a bed. They're just there for for the Night, or they're traveling through, or they're there for a few nights, but really the objective is not to spend a lot of time in the hotel room. They're they're going to be on their way to you know go somewhere else. And so I'm bringing this up because I think that there is a lot of passion and excitement and fulfillment in pursuing the independent boutique hotel route where you get to bring your creative vision to light and really offer something that's unique. And I'm not knocking that by any means. I'm just bringing up one area where there is some consistency with these commodity hotels that is valuable. If the goal here is to determine sort of a process or to attempt to be able to identify quickly, like, well, okay, what are the assumptive costs going to be? And there is value in these commodity hotels, these holiday ends, motel sixes, best westerns, what have you, in the sense where because a lot of these franchise models have a very similar footprint or they're located in a general area where the purpose is pretty clear, that you're able to reduce some of the variable and some of the risk associated with that component of construction costs, which, like I mentioned in the beginning, is can vary dramatically. So I just, you know, I had that thought while you're speaking. I'm like, whoa, okay. So what's a way to kind of reduce that? And obviously there's an upside in boutique hotels because that's an area you can exploit. If you're good at the construction management and the cost estimating, then that's going to give you a tremendous advantage over others because you you understand how to create value and add value. But it also comes with perhaps an additional layer of risk and possibly, you know, necessitating more experience in that realm.

Nathan St Cyr 21:50

Yeah. But I uh so I love that. And I will also say that, you know, for someone that's not going to go down that road, if they are looking at a boutique hotel, or I can even go through the experience that we're having in our our search right now, right? Once we got to the point where we recognized, look, we we submitted our first LOI and created engagement, at that point, next level, next level construction analysis has to occur. So sending in the contractor at that point, sending in the contractor on two or three different occasions to look at different things so that we could actually get a more clear look. Is our underwriting, are we, before we go into this, is our underwriting correct and where we want to take this or not? Right? Getting very clear in that. And then the third part of that will be once a PSA or a purchase and sale agreement goes up. Well, once we go under contract, then it's even further. It's making sure that that budget, that construction budget, that we are so clear on that and that we're able to stick through it, because you know, you can plug into your, we plug into our underwriting a three or four hundred thousand dollar difference in swing, the impact that that has on investor returns is significant. So we got to get really, really clear on what experience is it that we're gonna have and what's it gonna take to get there. And there's there are different phases, but instead of just, you know, I see all the time, there's very little, sometimes very little energy put into what really is that capital expenditure cost. We'll get deals sent to us and we'll look at it and we'll be like, they're gonna take this from an economy-based property to a luxury-based property. There's no additional amenities that were added. There's no group space, there's no food and beverage. They're doing a staff light model that's remotely managed and their construction cost is massively off. And it's like, no, that that that investment thesis does not work. It throw it out. You're not, you're not doing it for that. So I do feel like digging into this part and doing your best. And part of that is developing your network. I'm gonna develop a network of boots on the ground and having a contractor that that will be willing to help me in this area, you know, just adding that network is is the pieces to your network is is critical.

Michael Russell 24:11

Yeah, absolutely. So let's let's touch upon the other area. So you said building class and then understanding ADRs and occupancy rates.

Nathan St Cyr 24:21

Is that right? Correct. Which ultimately gets us to the most important one, which is NOI. Yeah. Yes.

Michael Russell 24:31

Yeah. So I know in our experience we put a tremendous amount of research into understanding both occupancy and ADR. And you know, in a lot of ways, that this is readily available. There is a bit of you know nuance to this because you're you're making a hypothesis in a sense. What you're doing is you're looking at, well, what can I tell by going online and looking at the competition? I can see what the published rates are for a variety of times throughout the year. That's very easy. That's simple, that's low-hanging fruit. You can also go and visit the uh, or you can you can view the website of like your local, what do you call that, Nathan?

Nathan St Cyr 25:09

It's like the DMO, the Yeah, destination marketing organization.

Michael Russell 25:13

Destination marketing organization. So basically these towns or cities or uh municipalities, they they have uh organizations that help promote tourism. And oftentimes data will be published there on the the quantity of visitors and all the metrics that you might need to evaluate from a general sense. You can go on things like CoStar, where you can get information about a market area in general. And ultimately you can get granular by just calling hotels or preferably going and visiting them and speaking with them in person and get an understanding of number one, what the rates are, because they're going to be public. And then number two, hopefully they'll share with you the occupancy. And what we found in our experience is by just approaching people and being normal and being up front and communicating what you're trying to do, oftentimes people are more than willing to share what their occupancy is. And this is critically important for uh at least the initial phase. Like Nathan talked about that once you get a deal under contract, you get an LOI started, then you can really do second and third level due diligence. But initially, this investment thesis part where you're just trying to understand a market to start there to research ADRs, this will at least give you a general sense. And then you can have kind of some some some borders. You know, you can have a low budget hypothesis, and then maybe, you know, well, if you really crush it, what would it, what would it be? And then kind of have a general sense of, well, maybe this falls right in the middle. But that that at least gets you started. Because again, this is really just to develop the intention of where you want to invest. And then when you find something, well, does this have the potential? This is not the end period of due diligence where you're making the final decision. This is presenting an offer and you know, bringing it into your orbit of, hey, this is something that we see might work. Let's let's engage with the broker and have a conversation.

Nathan St Cyr 27:10

Look, I love what you just said. There's an absolute nugget in there. And look, when we put this in our the we want to take a first pass at this and creating our investment thesis. And so doing that initial research on, hey, we've contacted places, we've gone online, we've looked at CoStar, and then we plug in based on what that hypothesis is. Here's the average daily rate, and here's the occupancy of what we believe in our first round of research. And once we get that, a lot of times what we'll find are, okay, well, what are the investor returns? Right. Then that leads to what's our what's our NOI? We'll take based on what that experience is, is it gonna take a heavy staff, a light staff, is it remote, what's it gonna be? And we get plug in all of our expenses. So ultimately we get to an NOI number. And this NOI number that we have is gonna lead to what our returns for our investors will be. And if we get to that point and we're like, okay, so these returns are number one, they're very fat, like what the heck? Then we might second guess ourselves and go, were we too aggressive with, and we'll go in and then we'll get more clear on was our occupancy in ADR, was that was that accurate? Did we put enough, leave enough budget for our capital expenditures? And we'll really start to look at it that way. And then on the flip side, if we go, oh man, this just it's it's not there, it's not gonna deliver the returns that we need, then we'll go back and question, were we too conservative? And just with Mike and I, we're typically always gonna start with, I'll notice, we're gonna start with more conservative by far than being, you know, out there, right? We're gonna be like, okay, look, here's our conservative numbers. And then we'll go through and we'll test ourselves and see if, you know, were we too conservative here, were we too conservative there? And we'll we'll ask ourselves those questions. But um, yeah, that really when you were going through that that process of finding the ADR and finding the occupancy, there's just your first run at it in your underwriting, and that's gonna let you know, are we anywhere in the ballpark? And if you are, then I feel like that's when it's really the next level research comes into play.

Michael Russell 29:26

Yeah, and you just rolled through two major categories of assumption, right? Which is revenue projections and then expense ratio. And if you have experience and you've purchased multiple hotels and you've operated them and you've managed them and you understand, like, sure, you're you're able to refine this to be a little bit more specific. But if you haven't done this before, there typically are some benchmarks with expenses, right? With revenues, you got to go do what we just described, right? You got to go do some research. But with expenses to start, you know, depending on what type of model. So Nathan communicated in the beginning that if you're doing a staff life, you're doing like remote access, like these are going to affect your operating expenses. If you don't have a lot of staff and people are just getting self-check-in codes emailed to them and they they they enter themselves, well, you perhaps you don't have staff there overnight. These these types of things will reduce your uh labor expenses. And you know, depending on where your property is located, there's property tax and insurance and all these other factors that are gonna vary. But just from a high level, when you're just getting started to underwrite this to see if it passes the sniff test, Nathan, what would you say, you know, a range of operating like what would the expense ratio be that you would plug in when you're just kind of doing a quick analysis?

Nathan St Cyr 30:43

Yeah. So if it's gonna be a staff light model, 55, really 50 to 60 percent is the staff light model. So you can go 55 to 60 on feeling conservative and conservative and safe with your staff light model. And that's gonna be if your revenue is gonna tell you whether it should be staff light. If your revenue, your gross revenue is falling between 500,000 and a million, that's the indicator that you're gonna have to run a more of a staff light remote type operation. And then you can you can put in the equation 55 to 60%. If your expenses fall within 55 to 60 percent, you're you're probably safe in your underwriting there. And then once you move up to into over a million dollars of revenue, that's where you have the ability to start actually creating an on-site team. And then we're gonna look at that as really a minimum of you know 65%. 65 to 70 percent is really where you wanna, when you're underwriting in the beginning, where you want to feel like, okay, if I underwrite this at 65 to 70 with a full staff, I'm gonna be pretty safe to to start. And then as the as you do more research, that number will be more refined. But on a first run, those are the those are the basically the benchmarks.

Michael Russell 32:04

Yeah. And of course, these ratios are are related between revenue and expenses, right? Because what you're assuming, if you're being conservative, is you don't want to overestimate your revenue. So you're underrunning this under a conservative model. But then let's say you go out and you crush it. Well, your revenue might grow disproportionately to your expenses. You have fixed costs that no matter how much revenue you bring in, those are going to remain the same. Your property tax is going to remain the same, your property insurance the same. You might see a nominal increase in things like utilities if you're more occupied. You might have to hire a little bit more staff, let's say, if you're more occupied for cleaning and things of this nature. But in general, if you generate more revenue by advertising better, by using marketing techniques, by getting better reviews, all these things that you do to improve revenue and you take market share away from your competitors, you might be underwriting initially based on what your competitors are doing, but not fully realizing that you're going to go and be a better operator. You're going to get more guests because you have better reviews and you're marketing better and all these things. And so if you underwrite the expense ratio, like 65%, let's say, and you go crush the revenue, maybe your expense ratio drops to 55%.

Nathan St Cyr 33:19

Yep, exactly. And that that's that's common. But we start with those as benchmarks. These are all benchmarks to create the thesis, but you're exactly right. So look, ultimately, then here's here's what we're gonna get to. We're gonna we're gonna get to that NOI number, right? And the NOI is going to then lead to all right, what is the this is gonna be the stabilized valuation, right? So post renovation, once this thing is stabilized, here's the NOI we're gonna receive. And then we're gonna be able to figure out what the value is by dividing that NOI by the capitalization rate. And then this is the this is the fun little trick here, but I see it used so often in in a way that is unrealistic. So can we talk about the the changing the class of a property?

Michael Russell 34:15

Yeah. So you're talking about changing a class, let's say from a C class to a B class or maybe B to A, which probably is less common, but it does affect the cap rate. Usually lower class properties have a higher cap rate and ultimately a lower valuation.

Nathan St Cyr 34:34

Yes. And I want to dig in and use real life examples that I see occur in witnessing in masterminds and in different areas where somebody's presenting their thesis and they're like, okay, I look at what the property is to begin with, and maybe they don't have a experience. Maybe this is their first hotel they're purchasing. And so they create a grand vision of I'm gonna take this from an economy property or a C class, and this is gonna be a luxury experience. And this is what it's going to, this is the experience that it's gonna be. And so they're like, I'm gonna up the class of the building, two classes. And and one of the reasons that they're doing that is because that they recognize each class in a market has an associated cap rate to it. And like you just said, the higher the class or the better the property, the lower the cap rate. And and I want to give you an example of just a 1% difference in cap rate. If I go from a C class to a B class and it goes from a 9% to an 8% cap rate, let's I just want to use that as an example. So if my property is generating $500,000 of NOI, either way, as an economy or as a mid-scale, and it takes that jump at 9% at economy, that valuation, $500,000 of NOI, is going to be a $5,555,000 value. If I can take that though, that same $500,000 NOI, and because I've increased the class of the property into that next step up, that B or that mid-scale, if that capitalization rate at that mid-scale level is 8%, even though I'm generating the exact same amount of NOI, $500,000 of NOI, the value jumps up to $6,250,000. So there's a $750,000, same amount in NOI, same amount of if you look at the gross revenue, you go back, can you say that again? I'm sorry.

Michael Russell 36:48

If if you were if you improve the class from C to B, and the NOI is the same, right?

Nathan St Cyr 36:58

The valuation goes from you said roughly, was it five million to so I'm using five hundred thousand dollars of NOI as a benchmark, and then I'm using a nine percent cap for economy, and so then my value of my building is five million five hundred and fifty-five thousand dollars.

Michael Russell 37:16

Okay.

Nathan St Cyr 37:16

If if I use that same five hundred thousand dollars of NOI with a cap rate of eight percent, because now I've raised it to a mid-scale, and mid-scale sell at eight percent versus nine, okay, right, that same five hundred thousand dollars of NOI that I'm generating now leads to a valuation of the building at six million two hundred and fifty thousand dollars. So that's a seven hundred and fifty thousand dollar increase of value with the same amount of NOI because I was able to take it from economy to mid-scale.

Michael Russell 37:55

Right. Yeah, so what you're describing there is a lever to increase value by investing in capital expenditures, property improvements, in other words, that ultimately improve the class so that it's valued at a lower cap rate or higher, ultimately higher dollar amount value. And so the question then, this is where the nuance of evaluating things you have to take into account is like, okay, I just gained $750,000 of value, but how much extra did I have to invest in the property to obtain that that extra lift of $750,000? If I had to go put in a million and a half in extra CapEx expenses, then maybe just like you know, on its own, that little simple example on its own, you would say, well, that's probably not worth it. The other variable here to be included, of course, is well, if I'm offering a higher caliber property, and if I have very similar fixed expenses, but I can charge more higher day, you know, higher rate, then I can generate more revenue and ultimately more NOI, then the combination of a higher NOI and a lower cap rate could ultimately lead to a much more significant gain than just 750,000. I know your example is described, making the point of this, but this is the, you know, the the nuance of being like, okay, well, I gotta balance this out. I gotta be conscious of how much I put in so that there is a little bit of a law, uh, you know, the the law of diminishing returns in a sense where if you don't, you know, keep keep track of that or if you lose sight of that, you just may make all these improvements, not recognizing, well, at some point, are these improvements actually driving more revenue? And if they're not driving more revenue, then I gotta be careful that I don't just rely on improving the class of the building because. Then it might not raise the value enough to justify the expenditures.

Nathan St Cyr 40:06

Spot on. And a mistake that's made common, that I see made common is people get too aggressive with that. Like, oh, I'm going to take it from an economy to a and to a luxury, and then they don't account for what it would really take, and that it's not going to create enough NOI. And so now they're going to be short on NOI, and they're going to have put more into their renovation than that was than they had anticipated to get it to that class for another investor to value it as a luxury. Well, wait a minute. There's no food and beverage. There's no meeting space. There's no all of the things that are necessary. And so they they do all of their thesis and they do all of their underwriting based on that jump. But the reality is they're not going to get that from a future purchaser because their property really doesn't hit what it takes to be luxury. And so knowing that, I just see that that happen all the time in underwriting. Oh, yeah, we're taking this from an economy to a luxury. And then it's like, okay, well, so what amenities did you add to the did you did you add the pool? Did you add the meeting space? Did you add the food and beverage?

unknown 41:14

Yeah.

Nathan St Cyr 41:14

No, but we're going to make it really nice. Well, no, that's not good enough. That's that you may create a more luxurious experience through your design and your concept and your experience. But from a purchasing standpoint, you can't use that cap rate because a purchaser will not purchase that unless it has those amenities and qualify it as a luxury property.

Michael Russell 41:38

Yeah, that's so great. Yeah, I feel like we see this all the time where coming from the short-term rental space, where you know, the improvements you make a lot of times are in decor and design and lighting, furnishings, and all of that is important. And presumably by doing so, you're going to get a higher ADR. But to your point, if it looks like a motel and it is a motel, just improving the decor is not going to make it a resort. It is what it is. It's a class C building, you know. Just take the ADR, but be careful not to make your assumption when going into this that the end buyer is going to value it at a higher class building because they're going to go, this is the nicest motel I've ever seen. But not necessarily be like, yeah, this is a luxury resort.

Nathan St Cyr 42:25

Yeah, I love it. So look, I think the lesson here is that, you know, having clarity, taking your investment thesis as serious, really identifying the benchmarks that it takes to create an awesome thesis and to create a realistic thesis is a critical part of hospitality acquisition that is very different from maybe the simplicity of multifamily or some of the other asset classes that exist. So really having a very clear understanding of this is critical for the long term. Cool.

Michael Russell 42:59

Should we wrap up there?

Nathan St Cyr 43:01

Yeah, absolutely.

Michael Russell 43:03

Right on, right on. Well, thanks for listening, guys. Once again, please leave us a review, rate, follow us, share this podcast with people that you love, or if you hate them, either way, just share this podcast. It goes a long way for us. We're building this thing week by week. And the more that we get ratings and reviews, the easier it is for us to get high-quality guests and continue to share high quality information with you guys. So as always, thank you. Aloha and mahalo.