COVER STORY, MARCH 2006

ON THE REBOUND
The “darling” U.S. lodging industry pendulum is swinging positively.
Daniel Lesser

As the end of the first quarter of 2006 approaches, the U.S. hotel market is clearly perceived as a “darling” industry. National hotel operating fundamentals are stronger than ever, with current top-line trends manifesting themselves in more room-rate driven gains. This phenomenon is reflective of a classic lodging industry economic upswing, as occupancies plateau and the pendulum of pricing power currently rests with hotel owners and operators.  

During past hotel industry upswings, new hotel development would typically be in full force at this point in the cycle. What is unique about this current upswing in the cycle is the fact that new hotel construction is fairly muted, due in part to high development costs and the fact that in many markets, hotel development has not represented the highest and best economic use of land. In some major 24/7 urban markets, such as New York, several thousand hotel rooms have been removed from the supply due to the conversion of existing hotels to residential use. As good as hotel economics have been in New York with high levels of occupancy and strong increases in average rate, residential economics have been even better. During the past several years, if a hotel could be purchased in Manhattan free and clear of any management encumbrance and if the floor plates could work for apartment layouts, typically a higher economic return could be obtained from residential conversion as compared to continued use a transient hotel facility. This phenomenon has resulted in hotels such as the famed Plaza Hotel, the InterContinental Central Park South, the Stanhope, and the Regent Wall Street being closed and converted to residential use. Other New York hotels such as the former Mayflower on Central Park West have been razed to make way for new residential buildings. As the New York lodging market continues to experience strong increases in average rates and the robust residential market slows down a bit, we are now seeing in some cases that hotel economics begin to “pencil out” the feasibility of new hotel development.

As the resilient U.S. economy continues to expand, corporate travel budgets continue to grow, resulting in increasing individual business travel and accelerating group conference and convention bookings. Furthermore, leisure travel continues to grow robustly as Americans feel more confident and foreigners take advantage of favorable currency exchange rates.

Lodging supply increases are anticipated to remain relatively modest during the next several years, particularly in major urban markets, resulting in strong room rate increases and growing bottom-line profits. At this point in the cycle, national Room Revenue Per Available Room (RevPAR) and bottom-line earnings are fast approaching pre 9/11 levels — the high-water mark for the industry.

New York City and Washington, D.C., are examples of some of the strongest hotel markets in the country, reflecting a recovery over the past 2 years in large cities on the East and West coasts. Los Angeles, Orlando, Florida and Boston are exhibiting healthy growth, and San Francisco is making a strong comeback after what could be characterized as a recent crash in the local market. The industry's rebound is now filtering down to secondary markets, with an anticipation of a similar phenomenon in tertiary trade areas within the near future.

Evidence of the U.S. lodging industry economic rebound is illustrated by national operating statistics. Industry profits experienced a dramatic drop to $12.8 billion during 2003, down from the 2001 high-water mark of $22.5 billion. With industry earnings at approximately $16.6 billion during 2004 (a 30 percent increase over 2003), profits rose an additional 25 percent to approximately $21 billion during 2005. Record industry profits of approximately $25 billion are forecasted for 2006 and close to $30 billion during 2007.

Further evidence of the rebound is reflected by an extremely fluid hotel transactional market. In addition to improving economic fundamentals, the abundant availability of relatively low-cost debt and equity capital has dramatically increased the activity in the hotel sale transaction market. This phenomenon is expected to continue during the next several years, as investments in lodging are perceived as "darling" investments that provide superior risk adjusted returns that are difficult to achieve elsewhere.

The CB Richard Ellis Hospitality & Gaming Group continuously monitors the major (single assets above $10 million not part of a portfolio allocation) U.S. hotel sale transaction market. Of more than 120 major U.S. hotel sales that were consummated during 2005, 21 exceeded $100 million per asset. The most prolific acquirers of major U.S. hotel properties during 2005 included LaSalle Hotel Properties and DiamondRock Hospitality, each of whom closed on six acquisitions during the year. Highland Hospitality and Innkeepers USA Trust each purchased five hotel assets during the year, while HEI Hospitality Fund and JER partners each acquired three major U.S. hotel assets during 2005.

Hilton Hotels Corporation and Starwood Hotels and Resorts have evolved into “brand” companies that manage and franchise hotels, rather than hotel real estate owners and operators. Each sold more than five significant hotel assets during 2005. Entities such as Host Marriott, Blackstone, and Strategic Hotel Capital seized upon strong market pricing and pruned their respective hotel portfolios with several significant dispositions during 2005. The largest single-asset U.S. hotel sale during 2005 was the $440 million acquisition of the Essex House in New York by the Dubai Investment Group from Strategic Hotel Capital. On a price-per-room basis, the largest amount paid for a U.S. hotel during 2005 was also the Essex House in New York at approximately $727,000 per key, followed by the $617,000-per-unit sale of the Malibu Beach Inn in Malibu, California, and the $535,000-per-unit sale of the Coast Inn in Laguna Beach, California. Nine significant hotel transactions occurred in the both the New York and Washington, D.C., metropolitan areas during 2005. Other major metropolitan markets with numerous significant hotel sale transactions during 2005 included Boston, Chicago and Los Angeles.

Hotel sale transaction activity in first six weeks of 2006 was brisk. Strategic Hotel Capital is reportedly in contract to purchase the Four Seasons in Washington, D.C., for a record $800,000 per key. Other notable hotel sale transactions thus far this year include the pending $545,000-per-key acquisition by Sunstone Hotel Investors for the ground leasehold interest in the 444-room Hilton Times Square in New York from Forest City Ratner. Additionally, the Macklowe Organization is reportedly planning to acquire the 495-unit Drake Hotel on Park Avenue in New York. Industry insiders expect Macklowe to raze the building, acquire additional air rights and develop a mixed-use residential condominium building on the site.

Due to the anticipated continuation of strong growth in the industry, going in hotel capitalization rates are typically higher than many of the sub-7 percent trailing 12 month overall rates on which many sale transactions are currently occurring. Sophisticated hotel investors are pricing assets on a discounted cash flow analysis that factors in perceived upside potential rather than applying stabilized capitalization rates to “in place” cash flow.

With all of the optimism currently on display, U.S. hotel investors should not lose sight of the potential risks that could dampen the industry's fundamentals. Terrorism is clearly at the top of risk spectrum, followed by geo-political issues with various unstable regions of the world including the Middle East. Factors affecting the U.S. economy include rising interest rates, increasing energy and insurance costs, and volatile consumer confidence. With many of the nation's hotel employee union contracts up for renewal during 2006 and with a dramatic rise in the cost of employee benefits, labor issues are also a significant risk for the industry.

Daniel H. Lesser is Senior Managing Director and Industry Leader for CB Richard Ellis' Hospitality & Gaming Group.

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