Understanding Hotel Cap Rates: What Investors Often Get Wrong
A few weeks ago, I was talking with an investor about one of our listings.
He toured the property with his team. They liked the property, the area, and the potential. But they thought that the advertised cap rate was misleading.
Their reasoning was straightforward. They planned to hire a third-party management company. They thought some expenses were light. They knew a PIP would be coming up before too long. Looking at the deal through his lens, the returns weren’t what the cap rate suggested.
The funny thing was that we both agreed on the numbers. Our (amicable) disagreement came down to a simple question: what purpose does a cap rate have in hotel valuation, and how does an investor actually use it to determine an offering price?
What a Cap Rate Actually Is
A cap rate is just NOI divided by purchase price (or asking price).
If a hotel produces $500,000 in NOI and is offered at $5 million, the implied cap rate is 10%.
Even though the investor said he disagreed with the cap rate, we both agreed on the math. What he was really questioning was whether he would achieve the same NOI based on his management strategy.
He planned to hire a management company. He thought some expenses were understated. He expected property taxes to increase after the sale. He knew a PIP was coming.
Suppose management adds $50,000 of annual expense and property taxes increase another $25,000 after closing.
The question is no longer whether the seller’s cap rate is 10%. The question is whether the hotel will continue producing $500,000 in NOI after the sale.
That’s the number the buyer actually cares about.
Turning Assumptions Into Value
This is where I think many investors get stuck.
It’s easy to say that expenses look light, or a PIP is coming, or management fees should be higher than they are on the current owner’s P&L.
What’s harder is deciphering what those things mean for value.
Let’s continue with the example above.
Suppose the hotel reports $500,000 in historical NOI.
The buyer reviews the financials and concludes:
-
- Third-party management will cost $50,000 annually.
-
- Property taxes will increase by $25,000 after the sale.
Now the buyer isn’t underwriting a $500,000 NOI property. They’re underwriting a $425,000 NOI property.
At that point, the buyer can value the property based on the income stream they expect to receive. If they target a 10% return, they might conclude the stabilized operation is worth approximately $4.25 million rather than $5 million.
The important thing is that the buyer has translated their concerns into actual numbers.
A PIP should generally be treated differently.
Suppose the buyer believes a $300,000 soft goods PIP will be required shortly after closing.
That doesn’t reduce NOI because it isn’t an operating expense: it’s a capital expenditure.
In practice, the process may look like:
-
- Recast the P&L using your operating assumptions.
-
- Determine what that stabilized operation is worth.
-
- Subtract deferred maintenance, near-term PIP obligations, and other capital expenditures.
That’s a very different exercise than simply deciding whether a cap rate is too high or too low.
The Real Question
I enjoyed sparring with this investor because ultimately we both wanted the same thing: for him to arrive at a valuation that he felt comfortable with based on how he envisioned running the property.
We were just emphasizing different sides of the equation.
To be clear, there are situations where a marketed cap rate can genuinely be misleading. If expenses have been omitted, if owner benefits have been presented as operating income, or if the reported NOI isn’t representative of the property’s actual operation, investors should absolutely challenge it.
That’s a different issue than disagreeing with how the next owner intends to operate the property.
In this case, the investor wasn’t arguing that the seller’s historical NOI was inaccurate. He was arguing that his NOI would be different.
Historical NOI matters. Cap rates matter.
But neither one determines value on its own.
The investor still has to decide what the property will look like under their ownership, what capital expenditures are required, and what they’re willing to pay as a result.
That’s why I view cap rates as a starting point rather than a conclusion. A cap rate can tell you what a hotel has done. Determining what it will do under your ownership—and what you’re willing to pay as a result—is where the real work begins.
