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Quantifying Net Income Attributable to Business Intangibles for a Hotel-Operated Full-Service Day Spa

Posted on: Friday, 11 November 2005, 03:03 CST

By Wolman, Peter A

abstract

For competitive reasons, upper-upscale and luxury hotels are increasingly adding full-service day spas. Because spas present the opportunity for a separate profit center, appraisal analysis is necessary to determine the existence of business intangibles and their magnitude. The Uniform Standards of Professional Practice (USPAP) requires, depending on the circumstances, that appraisers identify non-realty (tangible and intangible personal property) included in an appraisal and, if appropriate, the effect on value of such non-realty. Based on an actual assignment, this article provides a straightforward methodology for such identification and quantification, followed by a test of reasonableness.

Spa resort hotels, where spa services are integral to the hotel operation itself, have existed for many years as a specialized subset of the hospitality industry. Now, the full-service day spa,1 or some variation of it, is becoming an increasingly common ancillary feature at upper-upscale and luxury hotels.2

In an intensely competitive hotel business environment, a day spa offers another point of differentiation, although certain upper- tier hotels are adding a spa simply to remain competitive. At some hotels, a spa may only amount to high-cost, uneconomic "amenity creep," whereas at others it presents a new potential profit center as an operated department. That notwithstanding, a spa may also incrementally increase hotel revenue per available room (RevPAR) by virtue of being a desirable feature/amenity and by conferring (or enhancing) a prestige factor. Although all business-oriented real estate, including hotels, requires analysis for business intangibles, this article focuses on a day spa because (1) it is one of the newer hotel-operated departments of significance that an appraiser may confront (others include specialized recreational facilities such as a water park), and (2) in many circumstances it is a hotel's highest revenue-generating "other operated department."

In many hotel assignments, appraisers value total assets of the business (TAB), which includes real property, and tangible and intangible personal property,3 because that is typically sold or financed. However, certain situations-such as acquisition accounting, ad valorem tax assessments, and recordation/transfer fees-require valuation (or allocation) of only the real and tangible property components of TAB. In this type of appraisal, USPAP requires a two-phase analysis. First, relevant to the type and definition of value, and intended use of the appraisal, Standards Rule 1-2(e)(iii) requires identification of "any personal property, trade fixtures, or intangible items that are not real property but are included in the appraisal."4 Second, given the scope of work, USPAP Standards Rule 1-4(g) requires analysis of "the effect on value of any personal property, trade fixtures, or intangible items that are not real property but are included in the appraisal."5 This article presents analysis techniques applicable to identifying the existence or absence of business intangibles for a hotel-operated spa, and if present, a methodology to quantify such intangibles.

Spas are a logical extension for upper-tier hotels because of the steady stream of prospective clients in a relaxed atmosphere. Spas and such hotels tend to enjoy a symbiotic relationship, because a day spa is quite complementary to a luxury hotel, as evidenced by the acquisition of Bliss Spas by Starwood Hotels & Resorts Worldwide, Inc., in January 2004. Marketing appeal of a spa as a stress eliminator and luxurious indulgence is well received by clientele already attracted to luxury-oriented hotels. Yet, despite their glamorous image, many day spas do not require especially high- end real estate in which to successfully conduct their business. Although a few spas in hotels are elaborate structures, a recently inspected example was below-grade, windowless, converted space that nonetheless was quite suitable for operation of a rather successful spa business.

Valuation Issues

Similar to other operated departments in a hotel (e.g., conference/convention services, and food and beverages), a successful spa will generate net operating income (I^sub 0^) above market rent for the real estate. That excess net income (that is, I^sub 0^ exceeding market rent that a spa operator would pay for use and occupancy of the real estate) is an intangible because it reflects a return to the spa business, not to the real property. As spas represent primarily a personal service with comparatively minimal real estate (as evidenced by relatively high gross sales per square foot), it is rather obvious that a successful operation involves a considerable amount of business intangibles.

The question of market rent for the real estate is directly answered when a hotel owner/operator decides to lease space at market rate and terms to a spa operator. These arrangements are similar to hotels that lease space to restaurant operators such as Ruth's Chris, Fleming's, Shula's or other popular, branded national chains. Of course, by doing so, hotel owners cede all potential for department business profit to the independent operators. Some hotel owners/operators prefer not to incur the initial capital expenditures of space fit-up (tenant improvements) and furnishing (FF&E), as well as the additional business risk (including start-up costs) of operating the spa, a specialized business that they may not be specifically trained for or experienced in. Some hotels may engage recognized brand-name spa operators such as Canyon Ranch and Golden Door to manage a facility.

Hotels with a profitable full-service spa may find that spa revenue is generated primarily by local residents, rather than by overnight guests. Because in such situations the spa is essentially generating its own business, instead of relying on room-nights sold (although, as noted earlier, a spa may contribute to hotel RevPAR), business intangibles are more readily isolated because spa net income is not a direct function of the hotel business itself. In a recent assignment of an upscale conference/resort-type hotel in an affluent northeast United States suburb, approximately 95% of spa revenue was attributable to non-hotel guests. The alternative to a hotel for a day spa operator is to lease space in a shopping center or in a stand-alone building. Retail-oriented real estate, such as a day spa, is typically leased on a net basis, and is composed of minimum base rent-usually calculated as a percentage of [or at least bearing a close relationship to] gross sales-plus operating expense reimbursements. Although some retail centers, particularly larger malls, may also impose an administrative charge typically equal to about 15% of expense reimbursements (essentially a landlord-added "load"), such a fee is excluded here, because it would not be appropriate to a hotel leasing space to a spa operator.

Methodology

The practical problem facing appraisers is a lack of meaningful, comparable leasing to spa operators by hotels. Therefore, the economics of such a lease must be modeled by alternative means. A straightforward procedure for estimating market rent for the real estate involves a residual technique that eliminates the intangible (business) portion of spa net operating income.6 The result is then validated by a test of reasonableness. The following presents this methodology as applied to an actual assignment, although it has been modified for illustrative purposes.

1. Develop a minimum base rent. As shown in Dollars & Cents of Shopping Centers: 2004, the median percentage rent for day spas is equal to about 5.5% of gross sales (6.0% in a super-regional mall and 5.0% in a community center, upscale versions of which are both high-amenity retail venues).7 Gross sales can be developed from the subject's historical data; competing or other actual day spa data; published benchmark data; or best, a combination of all.8 Relying on the subject's established operating history for this example, gross sales are projected at $1,500,000, which includes all revenue from spa and salon (if applicable) services, as well as retail sales of complementary products. At 5.5%, as per Dollars & Cents of Shopping Centers, minimum base rent would be $19.64 per square foot.9 Note that the space is leased "as is," with the tenant responsible for all tenant improvements.

2. Add operating expense pass-throughs. Similar to common area maintenance (CAM) and other costs allocated to tenants in a retail center, add operating expense pass-throughs (converted to a pro rata, square-foot basis) including total undistributed expense, management fees, and fixed expenses (real estate tax and insurance). These expenses do not include a replacement allowance for furniture, fixtures, and equipment (FF&E) and short-lived items, which would be separately analyzed in aggregate for an appraisal of the real property component of a hotel. (FF&E specific to a spa is in most cases comparatively small relative to a hotel's total FF&E.) In this example, the subject's established operating expense history is analyzed in conjunction with competing hotel-expense comparables and published b\enchmark data.10 Based on this analysis, operating expense pass-throughs are projected at $22,600 per hotel guestroom in aggregate, which converts to $25.58 per square foot. The minimum base rent of $19.64 per square foot is added to operating expense pass-throughs of $25.58 per square foot resulting in total rent for the spa real estate of $45.22 per square foot.

3. Conduct a test of reasonableness. A direct test of reasonableness of the estimate of total rent is comparables of local retail-type leasing activity. As an alternative test of reasonableness, the total rent equates to tenant cost-of-occupancy, i.e., total occupancy costs (base rent plus expense passthroughs divided by gross sales) of about 12.7%, which compares to Dollars & Cents of Shopping Centers: 2004 at about 14% to 16.5%." Note, however, that market rent and tenant affordability are distinct concepts, and are often misapplied as if they were synonymous.12 Cost-of-occupancy analysis only provides guidance to maximum economically sustainable rents, which may well exceed market rent (sometimes significantly).

4. Results. The resulting difference between spa department profit and market rent (base plus pass-throughs) for the spa real estate is tangible and intangible personal property attributable to the spa business. Applying these parameters indicates total rent for the real estate in this example of $189,924 ($45.22 per square foot). Subtracting this amount from spa department profit of $450,000 (developed from the established operating history) equals $260,076, which is the portion of the spa's net income attributable to tangible and intangible personal property (inclusive of spa FF&E), a rather significant amount after capitalization. Table 1 shows the computation of the subject spa business's intangibles.

Table 1 Spa Business Intangibles in a Hotel

Note that a lease could contain an overage rent clause specifying payment of a percentage of gross sales over a certain breakpoint (above minimum base rent), but such overage rent is strictly a function of the business performance of a tenant, not necessarily market rent for the real property, and therefore is itself an intangible. As such, collection of overage rent is usually speculative,13 and thus applicable only to TAB, but not to the real property component.

Conclusion

This methodology clearly delineates I^sub 0^ for the spa real property asset based on market rent, from I^sub 0^ of a hotel- operated spa department as a separate profit center. The indicated market rent for the spa is validated by a cost-of-occupancy test of reasonableness. In this example, net income generated by a successful spa business creates intangibles evidenced by profits that considerably exceed market rent for the real estate. For situations where only the income to the real property component of hotel TAB is sought, that portion of spa income can be reliably segregated.

1. A day spa may be defined as "A clean, safe, and nurturing environment offering an array of spa treatments administered by highly trained and licensed technicians. It is usually a self- contained facility, but may also be combined with a salon. Clients frequent this spa for a few hours or a day. Overnight accommodations are not required." Day Spa Association.

2. In 2003, there were an estimated 12,100 spas in the United States that generated approximately 136 million spa visits. The largest segment was day spas, which accounted for 60% of spa visits and 49% of industry revenue. Comparatively, although the resort/ hotel segment captured 27% of spa visits, it garnered 41% of industry revenue. International Spa Association, ISPA 2004 Spa Industry Study; http://www.experienceispa.com/ISPA.

3. See Appraisal Institute, Course 800 Handbook: Separating Real and Personal Property from Intangible Business Assets (Chicago: Appraisal Institute, 2001), 4-11, 5-3 to 5-11; and Appraisal Institute, The Appraisal of Real Estate, 12th ed. (Chicago: Appraisal Institute, 2001), 641-644. Also see David C. Lennhoff, ed., A Business Enterprise Value Anthology (Chicago: Appraisal Institute, 2001).

4. Appraisal Standards Board, Uniform Standards of Professional Appraisal Practice, 2005 ed. (Washington, DC: The Appraisal Foundation, 2005), 17.

5. USPAR Lines 667-668.

6. The Appraisal of Real Estate, 643. Note that such business income would be included for valuation of TAB.

7. Urban Land Institute, Dollars & Cents of Shopping Centers: 2004 (Washington, DC, 2004). For a discussion of the application of percentage of gross sales in minimum base rent, see Richard C. Sorenson, Appraising the Appraisal: The Art of Appraisal Review (Chicago: Appraisal Institute, 1998), 107.

8. See Day Spa Benchmarks and Day Spa Bus/ness Report, Day Spa Association; Benchmarker-Health Club/Spa Report, Hospitality Research Group of PKF Consulting; and International Spa Association, ISRA 2004 Spa Industry Study.

9. Note that in promotional materials, many hotels tend to overstate spa size by including their pools and fitness centers, because non-hotel guest spa patrons may also have use of these hotel facilities that are usually located adjacent to the spa. However, a lease for the spa would typically include only the gross leasable area (GLA) where spa business would be conducted. No adjustment to the rent is necessary for the typical hotel recreational facilities because the hotel would provide them for guests with or without a spa.

10. Annual Trends in the Hotel Industry, Hospitality Asset Advisors International, Inc., http://www.hotel-online.com/Trends/ PKF/Trends/index.html; and The HOST Study, Smith Travel Research, http://www.smithtravelresearch.com.

11. Based on Dollars & Cents of Shopping Centers: 2004 data, computed median cost-of-occupancy (aggregate of all tenants) for super-regional malls is 13.7% for national, and 16.5% for East Region, where the subject is located. Dollars & Cents lists median gross sales (national) at $272 per square foot for day spas compared to $305 per square foot for overall aggregate (non-anchor tenants) in East Region super-regional malls, and at $310 per square foot for spas compared to $268 per square foot overall in East Region community centers. Urban Land Institute, Dollars & Cents of Shopping Centers: 2004 (Washington, DC, 2004).

12. Richard Marchitelli and John Melaniphy, "Counseling for Retail Properties and Performance Measures," in Shopping Centers and Other Retail Properties: Investment, Development, Financing, and Management, ed. John R. White and Kevin D. Gray, 493 (New York: John Wiley & Sons, 1996).

13. James D. Vernor and Joseph Rabianski, Shopping Center Appraisal and Analysis (Chicago: Appraisal Institute, 1993), 209; and The Appraisal of Real Estate, 483.

Peter A. Wolman, is vice president of Delta Associates, a Transwestern Company in Vienna, Virginia. He earned a BS in business administration from the Real Estate Center in the Kogod College of Business Administration at American University in Washington, DC. Contact: T 703-749-9497; E-mail: Peter_Wolman@DeltaAssociates.com

Copyright Appraisal Institute Fall 2005

Source: Appraisal Journal, The

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