3 Steps to Maximize Investments in Efficiency for Hotels

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Efficiency Projects that Increase Profits & Improve Guest Experiences.

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In our last article, “Strategic Investments in Efficiency for

Hotel REITs”, we explained why investments in energy and

water efficiency upgrades are some of the best investments

hotels can make. To recap this, here are the top 3 benefits:

Low-Risk, High ROI

Increased Asset Value

Increased Profits AND EBIDTA Margin

While these benefits are clear, the path to choosing the best investments is not so much. Decisions are

often made on a gut feeling. At best, some decisions are made using popular metrics, such as Simple

Payback Period (SPP), but these “popular” metrics have some important limitations that increase the risk

of the investment.

That’s why this article was created, to show you the “3 Steps to Maximize Investments in Efficiency”.

With this information, you will know how to choose the highest value projects and make confident

decisions that are based on facts and hard data.

Step 1: Get Accurate Data

To properly evaluate the benefits of an investment, the first thing you need to do is get accurate data. For

efficiency projects, this includes:

First-Costs. The hard costs of equipment and labor, as well as soft costs such as architectural,

engineering, and consulting fees.

Cash Inflows. The savings that result from reduced utility costs. Non-utility-cost financial

benefits must also be factored in, such as reduced maintenance costs, increased employee

productivity, and increased customer retention.

On-Going Operating Costs. The costs to operate the equipment or technology, such as utility

costs, maintenance, and repair costs.

Financing Costs. If financing is used to pay for the project, then you need to factor in the

interest rate and any upfront fees.

Useful Life. The expected useful life of the new equipment or technology before it needs to be

replaced or becomes obsolete.

Salvage Value. The estimated resale value of the equipment or technology at the end of its

useful life.

3 Steps to Maximize Investments in Efficiency for Hotels

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Cost of Delay. The cost of delaying a decision and the cost of not making a change at all. This

varies depending on the type of project, but often includes excess utility expenses, revenue

losses, and the costs of a temporary fix if the equipment or technology will need to be replaced

eventually.

Accuracy of this data is very important to ensure you use the correct inputs when performing the financial

analysis. It is a good idea to have a third-party professional determine these data inputs or validate them

if they are provided by a vendor.

Step 2: Perform Financial Analysis

Once the data inputs have been verified, the next step is to perform a comprehensive financial analysis.

There are 3 important metrics to use:

Life Cycle Cost Analysis (LCCA)

Net Present Value (NPV)

Modified Internal Rate of Return (MIRR)

The reason these 3 metrics are used is because they take into

account the total cost of ownership and not just the first-costs.

They also factor in the time value of money and recognize that

money received in future years is not as valuable as money

received today.

Metrics to Avoid

Two of the “popular” metrics often used are Simple Payback Period (SPP) and Return on Investment

(ROI). As the name suggests, SPP is simple and quick to calculate. The first-cost is divided by annual

cash inflows that result from the investment. This will tell you how many years it will take to payback the

initial investment.

Payback Period = First-Cost

Cash Inflow per Period

While this is an easy and commonly used metric, there are some important limitations because it does

not take into account:

The time value of money.

Cash inflows after the payback period.






Consider the following example:

We are considering a lighting upgrade and have two options, upgrading to T-8 fluorescent lights or LED.

The T-8 upgrade has a payback period of 2.5 years ($25,000 First-Cost ÷ $10,000 Savings). The LED

upgrade has a payback period twice as high, 5 years ($75,000 First-Cost ÷ $15,000 Savings).

T-8 LED

First-Cost $25,000 $75,000

Annual Energy Savings $10,000 $15,000

Useful Life 10 15

Simple Payback Period 2.5 years 5 years

Based on our Simple Payback Period analysis, T-8 lights appears to be the better choice. However, this

would be a bad decision.

The cash inflows of the LED upgrade over its useful life is more than twice as high as the T-8 upgrade.

After subtracting the First-Cost, the LED upgrade has a lifetime value of $150,000 while the T-8 upgrade

has a lifetime value of only $75,000. Therefore, the LED upgrade would be a better choice.

T-8 LED

First-Cost $25,000 $75,000

Annual Energy Savings $10,000 $15,000

Useful Life 10 15

Cash Inflows of Useful Life $100,000 $225,000

Lifetime Value $75,000 $150,000

Because of its limitations, the Simple Payback Period would have led us to make a bad decision. Since

the Return on Investment (ROI) is simply the inverse of the Simple Payback Period (1 ÷ SPP), the

ROI analysis would have led us equally down the wrong path. The T-8 upgrade would have an ROI of

40% (1 ÷ 2.5 years) while the LED upgrade would have an ROI of only 20% (1 ÷ 5 years). But again,

both the SPP and ROI metrics do not take into account cash inflows after the payback period.

Step 3: Follow 3 Golden Rules

The third and final step is the easiest: Follow the 3 golden rules to choose which investments to make.

These golden rules will maximize your investments and ensure you receive the greatest lifetime value

from all projects you implement.

Rule #1: Eliminate projects with a negative Net Present Value (NPV).

Rule #2: Choose projects with the lowest Life Cycle Cost Analysis (LCCA).

Rule #3: Fund projects in order of highest to lowest Modified Internal Rate of Return (MIRR).






While these 3 Steps to Maximize Investments in Efficiency take more time than other “popular” metrics,

such as Simple Payback Period, the investment in time and effort will pay for itself many times over. With

this approach, you will be able to make better, more confident, and less risky decisions.

Next, let’s go over a real-world example of how to conduct a financial analysis using the 3 steps. In this

example, we are considering 4 types of efficiency projects:

Lighting (2 options)

Air Conditioning

Water Systems

Energy Management System

We have a budget of $250,000 and need to determine which projects we should implement to maximize

our investment.

Step 1: Get Accurate Data

The first step is to gather all of the information we need to perform an accurate financial analysis. The

following is a summary of this for each efficiency project:

Lighting Option 1:

LED

Lighting Option 1: T-8

Air Conditioning

Water Systems

Energy Management

System

First-Costs $75,000 $25,000 $160,000 $65,000 $175,000

Cash Inflows (annual)

Reduced Utility Costs $15,000 $10,000 $40,000 $22,000 $25,000

Reduced Maintenance Costs $1,000 $0 $5,000 $0 $0

On-Going Operating Costs (annual)

Utility Costs (after upgrades) $22,500 $27,500 $120,000 $51,333 $0

Maintenance Costs $12,500 $2,500

Financing Costs 0% 0% 0% 0% 0%

Useful Life 15 10 15 12 10

Salvage Value $0 $0 $0 $0 $0

Cost of Delay (annual) $16,000 $10,000 $45,000 $22,000 $25,000

Financial Analysis Example






To gather this information about each potential project, we used a third-party engineer to determine the

annual cash inflows and then validated the rest of the information that was provided by the various

vendors.

For simplicity, we assumed that the First-Costs (i.e. hard and soft costs of implementation) would not be

financed and that there would be no salvage value at the end of the useful life of the equipment.

You will also notice in the table that we are considering two different options for the lighting upgrade: LED

vs. T-8 Lighting Fixture Replacement. In Step 3 we will determine which, if any, option is best for this

specific hotel. For now, let’s move on to Step 2.

Step 2: Perform Financial Analysis

The next, and most important, thing to do is perform a detailed financial analysis of all projects under

consideration. These are the 3 metrics we need to calculate:

Life Cycle Cost Analysis (LCCA)

Net Present Value (NPV)

Modified Internal Rate of Return (MIRR)

Click here to learn how to calculate these metrics.

The following is a summary of the financial analysis for each project:

Lighting Option

1: LED Lighting

Option 1: T-8 Air

Conditioning Water

Systems Energy Management

System

LCCA $273,610 $287,129 $1,219,254 $543,218 $276,053

NPV $66,234 $43,641 $237,220 $105,176 -$3,398

MIRR 12% 19% 15% 17% 8%

For simplicity, here are the assumptions we made during this financial analysis:

15 Year Analysis

7.5% Discount Rate

0% Inflation Rate

Replacement cost at end of useful life is the same as the First-Costs

Step 3: Follow 3 Golden Rules The final step is simply to use the 3 Golden Rules to pick which projects to implement within the $250,000

budget.

Rule #1: Eliminate projects with a negative Net Present Value (NPV).

This would eliminate the Energy Management System project since it has a NPV of negative $3,398.


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Lighting Option 1: LED Lighting

Option 1: T-8 Air

Conditioning Water

Systems Energy Management

System

LCCA $273,610 $287,129 $1,219,254 $543,218 $276,053

NPV $66,234 $43,641 $237,220 $105,176 -$3,398

MIRR 12% 19% 15% 17% 8%

Rule #2: Choose projects with the lowest Life Cycle Cost Analysis (LCCA).

When considering multiple options for a project, we need to pick the option that has the LCCA. In the

case of the lighting project, we would select the LED Fixture Replacement since it has the LCCA.

Lighting Option 1: LED Lighting Option 1: T-8 Air Conditioning Water Systems

LCCA $273,610 $287,129 $1,219,254 $543,218

NPV $66,234 $43,641 $237,220 $105,176

MIRR 12% 19% 15% 17%

This rule also applies when first deciding whether to implement a project at all. In this scenario,

you would calculate the LCCA for the project being considered and compare it to the LCCA of not making

a change (e.g. upgrading HVAC equipment now vs. waiting 3 years to make the upgrade).

Rule #3: Fund projects in order of highest to lowest Modified Internal Rate of Return (MIRR).

The final rule states that you should fund projects with the highest MIRR first.

Lighting Option 1: LED Air Conditioning Water Systems

LCCA $273,610 $1,219,254 $543,218

NPV $66,234 $237,220 $105,176

MIRR 12% 15% 17%

In order of priority, these would be the investments we should make:

Water Systems

Air Conditioning

LED Lighting

Within our budget of $250,000, we can implement the Water Systems and Air Conditioning efficiency

projects for a total cost of $225,000. Since there is only $25,000 left in the budget, we have three options

to decide what to do about the LED Lighting project:

Wait until next year’s budget.

Increase the existing budget.

Use outside financing.






About the Five Star Efficiency™ Program

Five Star Efficiency™ is a program that helps hotel owners and operators

make efficiency improvements to their hotels that:

Increase Profits and EBITDA Margin

Increase RevPAR

Increase Asset Value

Enhance Corporate Social Responsibility (CSR) Image

For more information: (877) 210-1503 | www.FiveStarEfficiency.com

In making this decision, it’s important to weigh the following additional considerations:

Cost of Delay. Every year that the project is not implemented you must consider the cost of

delay. In this example, the cost of delay $16,000 annually for the LED Lighting project (i.e.

$15,000 excessive energy costs plus $1,000 excessive maintenance costs).

Impact on Guest Experiences. The existing lighting may cause customers to complain about

safety issues (e.g. it is too dark in the halls or parking garage) or poor light quality in their rooms.

Impact on Employees. The existing inefficient lighting system is likely a burden on the

maintenance staff because the lamps need to be replaced often. In addition, the inefficient

lighting may have a negative impact on productivity due to poor light quality.

While the 3 steps outlined in the article will help you make the best financial decisions, it’s always

important to consider how a project will impact your core business. That is, providing high quality and

memorable experiences for your guests and employees.



3 Steps to Maximize Investments in Efficiency for Hotels

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