This is part of a series of posts about our experience buying a hotel. I suggest reading them from the start And so We Bought a Hotel, as it will help this post will make a lot more sense)
We knew we wanted to own a hotel and we knew just the hotel we wanted to buy . It was located in a small town about 45 minutes south of where we lived in Montana. We both have a love of architecture and this building was a beauty. It was a three story, brick building with a wrap around porch and it was located right in the center of town. The building was originally a hospital, then had gone through a seedier period before being completely renovated and turned into a “boutique hotel” with 7 guest rooms.
We’d seen a For Sale sign on the building while looking at houses, in fact it was this hotel and its For Sale sign that had given us the idea of buying a hotel. We lusted after the building every time we were in the area.
Back then we didn’t know how unusual it is to have a For Sale sign in front of a hotel. In general hotels do not to let guests know they’re for sale because it can hurt reservations. People are concerned the building will be sold and their reservation will be cancelled or the new owners won’t run it well. This is why it was such a shock to our guests when we bought the lodge, they didn’t even know it was for sale even though it had been on the market for over 2 years. The For Sale sign should have been “a sign” that the owners were having a hard time selling.
We made an offer on the property contingent on funding. I’d like to take this opportunity to thank Missoula Federal Credit Union. Not only did they deny our loan application but they also took the time to explain why. It turns out that businesses are valued using two main metrics. One is the value of the actual real estate – this is how much its worth on the open market as a vacant building and land. The other is to assign a value on the business itself. That is how much money it makes currently or how much it could make in a “best use” scenario. In other words what is the best use of the building for making money. For instance, was the best way to make money running it as a hotel or should it be rented as retail space or apartments. If the bank thinks it could be best used in that way, the bank will determine how much money it could make given current vacancy rates and rental costs in the surrounding area. If, on the other hand, the bank determines that the best use for the property is as a hotel then they look at the past few years financials.
Ahh… the financials. After a little more trial and error, we will eventually learn to ask for the financials before we do anything else. Falling in love with a property is of no use if the banks won’t finance it and it can be financially dangerous to lose your perspective.
The “financials” are essentially a profit and loss statement showing the amount of money taken in and the amount of money spent – by category – to operate the hotel. One important part of these statements is the amount of money left over in the end. To the untrained eye, this seems like profit. Unfortunately, this amount is deceptive because one crucial piece of information is left out: mortgage payments.
This was a little hard to get my head around at the start and it led to us over estimating the profit from a hotel more than once. Why are mortgage payments not included? Because if you run the hotel in a similar manner you can assume that most of your expenses will be similar to theirs. But you cannot assume your mortgage payments will be similar to theirs. Here are two examples. Let’s say the sellers bought the property 20 years ago for $150,000 and are now they’re selling it for $450,000 due to inflation and improvements. There’s no way your mortgage payments will be the same. Another scenario that I heard from several owners of overpriced properties was that someone from California was going to swoop in and pay cash for the property, no need to get bankers involved. If someone pays cash they have no mortgage payment at all.
So the long and short of it is that the bank wouldn’t loan on the hotel because with our mortgage payments figured in there wasn’t enough money left over for them to be comfortable with the risk. I have to admit we didn’t accept that answer and went to another bank. The second banker was also hesitant about the financials but agreed to a loan with a higher down payment and interest rate. They required a down payment equal to the cost of us to buying a house in that that town for cash (it was a more rural area so houses were cheaper than the house we had purchased in Missoula).
So we took a good hard look at the numbers and here’s where things stood: If we bought and ran the hotel all of the money the hotel made would only just cover the cost of running the hotel. It wouldn’t cover any of our living expenses with the exception of the use of an apartment built inside the dormers. This means that one of us would have to have a job outside the hotel to bring in money to live on. But the whole reason we were trying to buy the hotel was because we were struggling to find jobs that paid enough to live on. If we bought this hotel not only would one of us have to have an outside job, but the other person would have to be at the hotel the entire time it was open, approximately 5:30 am to put the coffee on until 9 or 10 pm, 7 days a week (this is one of the parts of owning an inn that they don’t show in movies). Plus there would be the risk of something happening to the hotel. A Super 8 could move into town (this 7 bedroom hotel was the only hotel in town), a major repair issue could arise (remember all the repairs on our rental properties), bad reviews or bad weather could turn away guests.
In the end we would be better off both financially and in our personal lives just paying cash for a house in that same area and commuting to our current jobs.
That was a sobering realization and put a kabosh on that hotel. But we hadn’t completely learned our lesson yet.
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