The decision to accept or reject a hotel for a fund often depends on making a comparison between its estimated IRR and the fund’s hurdle rate. To be accepted, each hotel has to achieve returns in excess of the cut-off rate irrespective of the risk class in which they lie. Potentially profitable low risk-hotels are rejected and the fund accepts high-risk hotels, some of which may be overpriced.
Over time the fund will become more risky. The concept is illustrated in the accompanying diagram. With a hurdle return of 18% Hotel B would be accepted and Hotel A would be rejected despite it having less risk! Clearly different cut-off rates need to be used for different risk categories of hotels.
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