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Five Star Efficiency™ is a Program that Helps Hoteliers Implement
Efficiency Projects that Increase Profits & Improve Guest Experiences.
Join the Program: (877) 210-1503
FiveStarEfficiency.com
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
Five Star Efficiency™ is a Program that Helps Hoteliers Implement
Efficiency Projects that Increase Profits & Improve Guest Experiences.
Join the Program: (877) 210-1503
FiveStarEfficiency.com
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.
Five Star Efficiency™ is a Program that Helps Hoteliers Implement
Efficiency Projects that Increase Profits & Improve Guest Experiences.
Join the Program: (877) 210-1503
FiveStarEfficiency.com
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).
Five Star Efficiency™ is a Program that Helps Hoteliers Implement
Efficiency Projects that Increase Profits & Improve Guest Experiences.
Join the Program: (877) 210-1503
FiveStarEfficiency.com
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
Five Star Efficiency™ is a Program that Helps Hoteliers Implement
Efficiency Projects that Increase Profits & Improve Guest Experiences.
Join the Program: (877) 210-1503
FiveStarEfficiency.com
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.
Five Star Efficiency™ is a Program that Helps Hoteliers Implement
Efficiency Projects that Increase Profits & Improve Guest Experiences.
Join the Program: (877) 210-1503
FiveStarEfficiency.com
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.
Five Star Efficiency™ is a Program that Helps Hoteliers Implement
Efficiency Projects that Increase Profits & Improve Guest Experiences.
Join the Program: (877) 210-1503
FiveStarEfficiency.com
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.
Five Star Efficiency™ is a Program that Helps Hoteliers Implement
Efficiency Projects that Increase Profits & Improve Guest Experiences.
Join the Program: (877) 210-1503
FiveStarEfficiency.com