How to calculate Return on Investment (ROI) for your hotel.
Calculating return on investment is a must thing you do before deciding to invest in hotel business. You have a hotel? That is terrific. But is it worth your investment? Maybe you should build something else rather than a hotel. That is why you should calculate return on investment for your hotel before you jump in. This article will give you tips calculating return on investment for you hotels, especially if you want to be the hotel owner.
Hotel owner is the company or individual that owns the assets in the hotel, including land, buildings, equipment and vehicles. Hotel operator is the company that manage the hotel for the hotel owners. Hotel owner’s return is the income generated by the assets. Hotel operator’s return in the management fee that the hotel owner has to pay for its services.
In short, if the hotel is full, the owner will enjoy high return. But if the hotel is empty, the owner will lose significantly, while the hotel operator will be paid nevertheless.
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Methods to Calculate Your Return on Investment for Your Hotel
There are several methods you can use in calculating return on investment. The simplest method will be the payback period. Basically, it finds out how many years your future average profit would cover your investment.
If your investment were IDR 100 billion and you expect your profit to be IDR 10 billion per year after costs and tax, you have a payback period of 10 years. It means you are break-even at 10 years. After 10 years, if anything goes as expected, you can enjoy the pure return on your investments. This is the easiest way in Calculating return on investment or ROI.
Professional investors would argue that you need to calculate time value of money. This means that the same IDR 1 billion todays has a larger value than IDR 1 billion 1 year later. It will be able to purchase a larger number of things today that it would 1 year later due to inflation. It also take into consideration risks that emerge from the investment.
Then we arrive at the second method, IRR or Internal Rate of Return. It calculates the discount factor that gives the hotel’s cash flow an NPV of zero. NPV or Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. IRR should be positive and above the risk-free rate, for an investor to consider investing in the hotel. The usual IRR asked is around 20% to cover for risks.
The more sophisticated method is discounted cash flow method or DCF. It attempts to figure out the value of the hotel investment today, based on projections of how much money the business will generate in the future.
And lastly, there is an easier method of simple asset values. It calculates the values if the hotel assets are being sold as an integrated project or as parts. This is usually used for investors buying hotels that are old or almost bankrupt. They consider buying the hotel just to salvage it, and gain profit from the asset sales. If you are thinking of building a hotel, then the method is not for you.
There are also other valuations to consider when you want to really be involved in hotel financial analysis and valuation. But I think the methods above are comprehensive enough to calculate the return on investment for your hotel.
Key Components in Calculating the Return on Investment for Your Hotel
If you have decided on your preferred method, then let’s move on to key components enabling the method to be calculated. For all methods above you at least need to estimate these components:
- Revenues or cash inflow streamed from the hotel
- Cash costs incurred
- And finally, cash flow generated
When you are estimating your revenues, then you need to take into considerations 2 things. First is the pricing of the rooms. Second is the occupancy rate throughout the year. The revenues are the multiplication of the two. Make sure you consider the peers in the area and your hotel’s differentiating factors in setting the two.
Then costs. Costs are usually divided into fixed costs and variable costs. Fixed costs are costs that incur even if your hotel is empty. They include full time employees, maintenance of public areas and interest if you use debt as your financing.
Variable costs are costs that incur only if your rooms are used. They include F&B costs, laundry costs, electricity bills in rooms, and maybe promotion costs. The higher variable costs you have compared to your fixed costs, you are more secure in difficult situation.
Remember these are cash costs. But there are also costs that are not in cash, such as depreciation expenses. These costs are not used for calculation of the return on investment except to calculate taxes. Taxes are calculated based on revenues net of all costs, which include non-cash costs.
Finally, cash inflow minus cash costs results in cash flow generated. This in turn will be the basic calculation for your return on investment for your hotel.
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