Reference no: EM133176004

Introduction to Client Pressure in Hotel Appraisals Hotel appraisals are used as a decision-making tool for hotel investment stakeholders, which include lenders, investors, developers, owners, asset managers, operators and government agencies (Roubi, 2014). To get an appraisal of a hotel's investment value, it is usually the hotel's owner or asset manager who will engage the appraiser. The appraiser is an individual who is certified by a governing body designating his/her expertise to provide an independent unbiased assessment of a hotel's financial value. An appraisal is used by potential investors or banks to assess the investment risk for a hotel. A higher than expected valuation for a hotel reduces the investment risk and leads to more investment or decreased lending costs levied by banks. A lower than expected valuation increases the investment risk and can lead to less investment or increased lending costs levied by banks or other lenders. An appraisal is meant to be un-biased professional advice that can by relied on by lenders and professionals (Rushmore, 1993). The results of an appraisal can represent significant positive or negative financial impact to hotel owners. Due to the financial significance of the appraisal, owners and asset managers sometimes exert pressure on appraisers to alter their values. The pressure can be subtle comments like, "Let's work on this one, I have many projects coming down the line" or more direct comments like "You did not give me the value I needed so I will not pay your fee" (Rushmore, 1993). Even with subtle comments, an appraiser is presented with a dilemma. While in the short-term, a simple change in the assumptions could make their client happy, in the long-term, changing the assumptions in the appraisal could challenge their professional code of ethics, independence and reputation for their professional advice. Client pressure in the commercial appraisal industry is a common issue, but seldom researched. In one of the studies completed, however, a behavioural experiment with 953 subjects reported that 41 per cent of commercial appraisers revised their valuation estimates without having supporting documentation when requested by the client (Kinnard, Lenk & Worzala, 1997). This is problematic because lenders and investors depend upon the appraiser to be credible, objective and unbiased. Client pressure is a form of conflict of interest. Conflict of interest happens when a situation undermines the impartiality of a person because of a self-interest that could compromise their professional commitments. In cases where the client pressures the appraiser, the appraiser must decide between making the client happy in order to get future work and their duty to the appraisal profession. Cases of conflict of interest are never easy and rarely have simple black and white answers. Future managers must not only be aware of potential conflicts, but, most importantly, practice what to do when they happen. The case study to follow represents a situation based on a real account from a hotel appraiser and is designed to make students aware of how a conflict of interest situation comes about and gives them an opportunity to practice a professional SAGE © 2018 International Council on Hotel, Restaurant, and Institutional Education (ICHRIE). All rights reserved. SAGE Business Cases Page 3 of 8 Nigel's Choice: A Hotel Appraiser's Decision-Making Issues When Interests Conflict response. Client Pressure Phone Call "Good morning, Nigel. Ed calling from Smithson Development." "How are you, Ed?" asked Nigel. "Well, a little concerned, actually. We have just reviewed your draft appraisal report for The Apollo Hotel. Are you kidding, Nigel? Do you seriously think the value of this property has diminished this much?" "Well, you saw we used a number of approaches to evaluate The Apollo in order to give it the highest possible, yet probable, value. In this regard, you saw that the Discounted Cash Flow Method1 gives a higher, and, in my opinion, more accurate valuation. This, of course, is not as high as the valuation I did when oil prices were high. You can't ignore, Ed, how the reversals of fortune in the oil industry will impact a hotel located in a town known for its dependence on oil." "Sure, Nigel, there may be a short-term hit, but your points of comparisons to other hotel properties are very limited and geographically confined. You overemphasize the negatives in the marketplace; you fail to account for the growth in tourism with the devaluation of the Canadian dollar; your projections of interest rates are way off base; and you don't fully take account of the fact that this is a quality product under a well-known global luxury brand with the competence and established experience to expand the reach of this property to other markets. We are counting on you, Nigel. You know this property, and you know what its leadership can do. You need to rethink your appraisal of The Apollo. I can find another appraiser who will give me the right number!" The Apollo Hotel, Calgary, Alberta, Canada The Apollo Hotel is managed by one of the premier international - luxury hotel brands and is located in Calgary, Alberta Canada. Calgary is a city of more than 1,000,000 people; the livelihood of many of its citizens and the economic health of the city are dependent on the fortunes of its primary industry: oil. When the price for a barrel of oil is high, hotel room rates and occupancies are also high and hotel owners are happy making a profit. Consequently when the price for a barrel of oil falls precipitously, hotel room rates and occupancies decrease and hotel owners are unhappy. For many years while the price of a barrel of oil was high, Calgary hotels witnessed the highest RevPAR 1 growth within Canada. The Apollo hotel was developed by Smithson Development to capitalize on the booming Alberta, Canada economy, driven by high oil prices. The Apollo opened to great fanfare. With 144 exquisitely appointed rooms and suites, an Oyster Bar, Roof Terrace, fitness club and spa, as well as elegant, yet technologically advanced, conference rooms and event spaces, The Apollo quickly became the place to stay, the place to meet and be seen, the place to make deals, and the place to celebrate. After the first year, average occupancy was over 75%; the RevPAR1 index comparing The Apollo to its luxury competitors in the area was 115%, and the average room rate had grown by 25%. The early successes of The Apollo gave both Smithson Development and the bank, which financed most of the development of The Apollo, a satisfying level of confidence. They believed that The Apollo would continue to be a stellar investment. However, as oil prices fell, the economic outlook for Alberta was becoming a source of concern, signalling a reversal in fortunes. The Dilemma for Ed and Smithson Development With the crash in oil prices, the prominent Canadian economist Terence Corcoran had declared, "The dream SAGE © 2018 International Council on Hotel, Restaurant, and Institutional Education (ICHRIE). All rights reserved. SAGE Business Cases Page 4 of 8 Nigel's Choice: A Hotel Appraiser's Decision-Making Issues When Interests Conflict of Canada becoming an energy-exporting superpower is now all but dead." Calgary, Alberta was already witnessing a significant outflow from top-tier commercial office space as companies cut back and either postponed or cancelled projects. The bank, feeling nervous and overexposed in the Alberta market, activated a clause in their mortgage agreement with Smithson Development, demanding that Smithson have The Apollo reappraised by a certified appraiser in the event of a change in economic circumstances. If neither the bank nor Smithson could accept the value set by the appraiser, the case would go to arbitration. Smithson Development is anxious to show the highest possible valuation in order to secure continued financing through the bank on favorable terms. If the value of the property is shown to have fallen significantly, the bank will likely make a margin call and want Smithson to pay down a large part of the principal. The bank could also call into question other aspects of the loan covenant if occupancy and revenue projections fall too much below original expectations, thereby triggering a right to renegotiate rates. A lot is also at risk for Ed personally. His credibility is on the line: he had convinced his partners to develop The Apollo, despite the fact that the more senior partners in the firm had argued that standard hotel investments have generally become too risky, given that hotel revenues are less predictable and more variable than other kinds of commercial arrangements, which rely on long-term leases or shared ownership. The Conflict for Nigel Darwani, the Appraiser Nigel Darwani was chosen by Smithson Development as the appraiser. Now 49 years old, Nigel has worked hard to establish his reputation as a thorough and ethical appraiser, with special expertise in hotel valuation in Western Canada markets like Calgary, Edmonton, and Vancouver. He has a Bachelor of Commerce from Ryerson University, a MBA from Cornell, with a focus in Hospitality, and has earned an AACI Designation 1 while working for various real estate firms and pension fund managers. He is now a key member of the appraisal team for the King Real Estate Group, located in Vancouver, British Columbia, Canada. Smithson Development has been a client of Nigel's for many years. Annually, the work that Smithson provides to Nigel accounts for a significant percentage of his income, and Nigel currently has proposals submitted to Smithson for other work. As part of his work for Smithson, Nigel had, in fact, completed a previous appraisal of The Apollo. Smithson had used Nigel's previous appraisal to negotiate very favorable terms with the bank. Nigel is in a difficult position on the reappraisal. If Nigel pays no attention to Ed's feedback about the revaluation of the property, he risks losing Smithson as a client and puts in jeopardy his annual bonus, which he counts on as the sole source of income for a family of four. Ed will likely ask one of Nigel's competitors at one of the larger firms or in private practice to do the appraisal, and with this new relationship established, he may never get Smithson back as one of his more reliable, high-volume clients. Nigel also knows that there are appraisers out there who have fewer scruples than he has about what goes into their valuations, and indeed there are a lot of educated "guesses" when making projections. Yet, professionally, Nigel understands that to be swayed by Ed is the wrong thing to do unless he really believes a more optimistic valuation of The Apollo is plausible. 2 Ultimately, he also has to consider the bank's position. If they perceive that he is just following Ed's and Smithson's bidding, his hard-fought reputation for integrity will be damaged to the point it will be almost impossible to recover. The Appraisal of the Apollo and Nigel's Choice In his usual fashion, Nigel's approach to his reappraisal of The Apollo is comprehensive. Given the abruptness of the drop in oil prices, Nigel feels it is inappropriate to use the Direct Capitalization Method (DCM)1 alone, as it overemphasizes the immediate economic hit of the current situation. Nonetheless, he is uncomfortable with the tenuous nature of forecasting implied by the Discounted Cash Flow Method (DCF)1. Consequently, SAGE © 2018 International Council on Hotel, Restaurant, and Institutional Education (ICHRIE). All rights reserved. SAGE Business Cases Page 5 of 8 Nigel's Choice: A Hotel Appraiser's Decision-Making Issues When Interests Conflict to bolster his forecast assumptions, he carefully researched other markets that had experienced precipitous downturns for various reasons, as well as examined what "normal" looked like for full-service luxury properties in markets that had become less heated. Nigel's detailed analysis shows that most properties take immediate and significant hits when faced with something like a collapse in their major business sector and that many never fully recover to their former glory. While his research did find some properties that were successful in re-establishing themselves after a market collapse, these properties were always located in major cities like New York. Properties in more secondary natural-resource-dependent markets never recovered fully until the price of commodities bounced back. Didn't Calgary become a more secondary market if the price of oil remains depressed? Certainly Smithson argues that this is not the case. While The Apollo is a very well-managed luxury property, is it poor judgement to assume that the hotel will attract sufficient business unrelated to the oil business? Nigel summarized his current findings as follows in the Table 1: Table 1: The Apollo Hotel Appraisal Summary Appraisal: Timing/Method Estimated Value ($ million) Stabilized Annual Net Income ($ million) Overall Cap Rate 1 (%) Previous/Direct Capitalization Method (DCM) 112.9 .9 7.00 Current/Direct Capitalization Method (DCM) 85.5 6.2 7.25 Current/Discounted Cash Flow Method (DCF) 94.7 9.0 Nigel can well understand why Ed is upset. The previous valuation of The Apollo was 19-32% higher than Nigel is now estimating! The bank will certainly be challenging their agreement with Smithson on this project. Ed is most critical of the comparables and economic forecast that Nigel used. Ed argues that Nigel should include in his analysis the tourist properties located in the Canadian Rockies since those travelling to the Rockies are high-spending tourists who will likely stay a night or two in Calgary on their way to and from other Alberta destinations. Ed also thinks that Nigel's economic forecasting assumptions do not adequately account for the positive impact the lower Canadian dollar will have on Alberta's economy. In the aftermath of the call from Smithson, Nigel is faced with a choice: he can leave his appraisal as is, and/ or he can re-examine his use of comparables and his economic forecasting assumptions. He wonders which of his options will be in line with the spirit of CUSPAP1 standards. He also wonders if he should add to his analysis a second Discounted Cash Flow (DCF) appraisal projection that better supports thee assumptions proposed by Ed, and let Smithson argue it out with the bank. What is the right thing to do?

Question:

1. Which option is the right or best thing for Nigel to do? Why is it the best option?