Hotel Valuation in Cuba Nov 28, 2016

James V. Andrews

MAI, CRE, FRICS, ASA/BV

Senior Managing Director, Integra Realty Resources - Miami | Caribbean

Unless you’ve been hiding from the news for the last year or so, you are no doubt aware of the well-publicized normalization of relations between the USA and Cuba which has resulted in business opportunities that have opened up for many entrepreneurs and corporations. My firm, IRR Caribbean, has performed valuation and advisory services in nearly every Caribbean territory, and so naturally, I get often asked if we plan on doing any work in Cuba.

My main concern about valuing real estate and/or business interests in Cuba is of course the marketability and transferability of the assets; as there needs to be a market and a hypothetical transaction in order for there to be market value.  There are also the obvious concerns with respect to property rights.  With few exceptions, real property has to be owned by Cuban nationals, and businesses must be majority controlled by an entity of the Cuban Government.

In this recent case (before the US Presidential election), we were asked to value a foreign-owned, minority interest in a joint venture that operates a well-performing hotel.  In that this minority interest can in fact be sold, and has a market for potential purchasers, we viewed this as an opportunity to undertake our first valuation foray into Cuba.  In this case, the joint venture has a rent-free lease on the property with an initial term of 25 years, and the agreement states that if the lease and/or joint venture agreement is not renewed, the minority interest owner would be bought out by the majority partner (a Cuba Government entity) at a pro rata share of the appraised value.  Also, there is reportedly an interest from the Cuban government to buy out the minority partners.

For these reasons, it made sense to appraise the Fair Value as defined in the International Valuation Standards, which inherently assumes a transaction between parties that are identifiable.  We also employed the extraordinary assumption that the transaction would be between parties who agreed not to discount the minority interest for lack of control or marketability.

There are a number of nuances with regard to performance benchmarking for hotels in Cuba.  The government effectively holds a monopoly when it comes to providing labor and materials to enterprises; which are largely their own.  The government establishes statutory wage rates for various types of employees in CUC which is the “convertible currency” tied to the U.S. Dollar.  The government is paid for such labor in CUC and then pays the employees in CUP (Cuban Pesos) which are worth 1/24th of the CUC.  As such, the government earns a significant profit on labor when it comes to joint venture enterprises.

In addition, the government is the primary importer of goods, and sets the wholesale price of these goods to private enterprise such as joint venture hotels.  Despite the implication of artificially inflated costs, the margins achieved by the subject hotel were significantly higher than similar properties in other parts of the Caribbean.

Perhaps the most complex but important piece of the puzzle is the cost of capital, which affects the discount rate and/or capitalization rate used in the valuation.  In that it is not possible to leverage a transaction through collateralized lending using the property as security, the only debt financing would be an unconventional type of business loan.  As such, the weighted average cost of capital should be heavily weighted to equity, with the return on debt being appropriately high.  The equity discount rate was largely tied to the premise that the country risk premium should be based on the spread of the sovereign debt ratings of the subject country versus a known one, such as the US.  In this case, Moody’s rates Cuba’s sovereign debt at Caa2, implying a significant Country Risk Premium; depending on which formula you choose.

The question, of course, is whether a foreign based hotel investor would apply the same thought process to the cost of capital, as opposed to simply weighting more typical hotel capitalization rates with additional risk due to (a) the risk of doing business in Cuba and (b) the risk of doing business with the Cuba government.  In this case we determined the most likely buyer would be either the Cuba Government or a non-US hotel investor or consortium of high net worth individuals.

Integra Realty Resources (IRR) Caribbean provides valuation and consulting services throughout the Caribbean region; with specialty practices in hotels/resorts and business valuation.  Learn more at www.irr.com/caribbean.