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Introducing the $1,200 Nightly Stay

A year ago Strategic Hotels & Resorts Inc., a publicly traded REIT in Chicago, went on a buyout binge, acquiring nameplates such as the Westin St. Francis in San Francisco and the Hotel del Coronado near San Diego. This year Strategic is embarking on its first major ground-up development, a small hotel called La Solano near Puerto Vallarta on Mexico's west coast. Construction costs will run $1 million per room and rates are expected to start at $1,200 a night after the hotel opens in 2009.

Luxury seems to be breaking through old boundaries. In all facets of prosperous American culture, from $800 Manolo Blahnik shoes to $150,000 Ferraris, luxury is where it's happening. The average income in the U.S. rose a modest 3.4% last year, but among the top one-tenth of one percent of American households, income leapfrogged more than 20% to an average $5.6 million.

In the hotel industry, money is pouring into both the luxury and upper upscale sectors at an unprecedented pace. While acquirers such as Strategic have watched in frustration as affordable high-end assets become scarce, they're turning to plans for new development. That's a daunting challenge considering that sites for luxury hostelries — typically in only the best downtown neighborhoods of the biggest cities and along lush coastal settings — are difficult to get approved.

Meanwhile, there is a frenzy of rehab and remodeling planned for older properties. In a typical year, a hotel places between 5% and 8% of its revenues into capital spending. This year, however, Stanford Hotels Corp. in San Francisco expects to reinvest more than 20% of its $220 million in annual sales into fixing up properties. It will pump $65 million into its 610-room Hilton Waikiki Prince Kuhio and another $20 million into its 400-room Hilton in Charlotte, N.C.

Clyde Guinn, Stanford's senior vice president of operations, reports that the revenue per available room companywide has jumped more than 12% in the past year, the biggest 12-month increase since the late 1990s, and a major impetus for the fresh investment in construction.

In one city after another, luxury-minded hotel guests are demanding 400-thread count linens and $2,500 high-definition televisions. “I can't remember a period when there has been such a push to upgrade hotel design and amenities,” Guinn says. “More sophisticated travelers are demanding that.”

Healthy fundamentals

Recent hotel data is compelling. Overall, total U.S. hotel revenues rose 9% in 2006 to $133.4 billion, while industry profits zoomed 18% to a record $26.6 billion, according to Smith Travel Research in Hendersonville, Tenn. Operating profit margins last year expanded to almost 20% from 18.4% in 2005. The firm projects that room rates will increase 6% in 2007, following a 7% gain last year.

Hotels enjoyed an average 23% return on capital in the past 12 months, reports Jones Lang LaSalle Hotels, compared with 20% for offices, 17% for industrial and 13% for retail. Over the last 10 years, hotels ranked last in returns among other real estate asset classes.

Hotel transaction volume rose 66% in 2006 to $34.8 billion, up 170% over 2004 levels, reports Jones Lang LaSalle. The average sales price was nearly $180,000 per room, a huge jump considering that as recently as 2004, the average price per room was under $70,000.

Luxury hotel projects will increase 2.7% this year, while upper upscale will rise 2.2%, both far ahead of the industrywide average of 1.6%, according to Bjorn Hanson, PricewaterhouseCoopers' lodging practice leader. Hanson also predicts that occupancies will fall 20 basis points industrywide to 63.2% while luxury will hold steady at 71.2% in 2007.

Room rates across all segments are projected to rise 5.9% this year while luxury is expected to rise at a 7.4% clip. “In this environment, it's hard to find any hotels that aren't doing well. Investors have taken notice,” Hanson says.

Luxury pipeline expands

Hanson says much of the luxury growth in coming years will come in markets such as St. Louis, once ignored by blue-chip chains like Ritz-Carlton. “In tertiary markets the success of upper upscale properties has demonstrated the need for at least one luxury hotel.”

And so expansion is coming. Patrick Ford, president of hotel consultancy Lodging Econometrics LLC in Portsmouth, N.H., reports that nine luxury hotels opened in the U.S. in 2006 with 1,826 rooms. That number will dip in 2007 to eight hotels with 1,377 rooms, then rise sharply to 14 hotels with 3,504 rooms in 2008.

In all, 63 luxury projects are in the pipeline spanning 20,000 rooms, says Ford. Leading the pack are 13 W Hotels, a dozen Ritz-Carltons, seven Intercontinentals, a half-dozen Fairmonts and five Four Seasons. “The luxury side of the business right now has the highest occupancies and the highest room rates,” Ford observes.

Upper upscale isn't far behind, however. Lodging Econometrics reports that sector will see 38 new facilities with 8,120 rooms this year, up from 23 facilities with 6,935 rooms in 2006. The total will rise further to 48 hotels with more than 14,000 rooms in 2008, the firm forecasts.

What's driving all the construction and acquisition activity? Foremost, it's easy money. “There is a lot of capital available right now for hotels,” says Elliot Eichner, a principal with the investment banking firm Sonnenblick-Eichner Co. in Los Angeles. “Any hotel financing that comes up, we routinely get 10 to 12 institutional lenders lined up with quotes. The whole debt market wants to be in hotels.”

Lenders are stretching their old loan parameters to new limits, too. Five years ago every hotel developer was expected to bring 40% equity to a project, getting the remaining 60% from a combination of either an institutional lender or a mezzanine source. Today, deals are being consummated with 20% and less in equity, and mezzanine participation is often beside the point.

“We're in that rare period right now when public REITs, pension funds and private equity are all interested in the hotel sector at the same time,” says Kevin Mallory, senior managing director and practice leader at CB Richard Ellis Hotels in Chicago. “Capital chasing the market has to be very competitive.”

Rod Petrik, an analyst with Stifel Nicolaus & Co. in Baltimore, recalls that when he started following the hotel sector two decades ago, “about 15 cents out of every dollar of sales went to debt service.” Today that number is closer to a nickel.

Vying for opportunity

Hotel owners in major cities are dealing from a position of strength in the aftermath of aggressive condominium construction that prompted hotel conversions in some places and gobbled up potential future hotel sites in other places. Manhattan alone has lost more than 3,000 hotel rooms over the past five years to conversions, and replacement capacity isn't coming onto the market very fast.

“U.S cities, as they mature, are becoming more and more like European cities,” says Dan Fasulo, managing director of Real Capital Analytics in New York. “There are fewer sites to build on and there are more stringent restrictions on building that are hampering new construction.” Apartment and office developers are also vying for the same sites as hotel developers, he notes.

This is one reason hotel companies are keenly interested in existing assets, though they're hard to find, too. In February, hotel REIT DiamondRock Hospitality Co. in Bethesda, Md. paid $330 million for the 793-room Westin Boston Waterfront Hotel. But Mark Brugger, the chief financial officer, concedes that outside the Westin purchase, there is less hotel deal flow for his company this year. “The private equity buyers can risk more leverage to generate returns, and so they've pushed prices up. The REITs have to be disciplined and price sensitive.”

DiamondRock is focusing on getting more yield from existing assets. It's spending $35 million on its upper upscale Chicago Marriott on the Windy City's shopping mecca Michigan Avenue to add meeting space and freshen the lobby and restaurants. “We actually still have a lot of investment capacity, Brugger says. “We don't have much leverage at the moment.”

Rehab reaps returns

The returns on rehab work can be startling. Provenance Hotels LLC, a group of 11 hotels in Seattle, bought the aging two-star 130-room Hotel Lucia in Portland, Ore. six years ago for less than $100,000 per room and then spent $100,000 per room on renovations. Gordon Sondland, president and CEO, estimates the property today is worth close to $400,000 per room. “That amounts to a nice return on our investment,” he says.

Similarly, Provenance gutted the old 165-room Vance Hotel in Seattle and spent $150,000 per room on construction. Now rebranded as the Hotel Max, the property would go for nearly $500,000 a room today if it were on the market, says Sondland, who remembers when cap rates on hotel acquisitions typically ranged from 10% to 13% in the 1980s.

Today some deals carry cap rates as low as 4%, he says, though the average is between 6% and 7%. “You're buying a hotel carrying less return than a bond yields, and there is far more risk. Yet there is still plenty of liquidity in the market chasing these deals,” he says.

The profits have exceeded the wildest hopes of property owners in some cases. In Chicago, the Harp Group paid $47 million for the historic 285-room Ambassador East Hotel on the city's near north side in December 2005. Harp executives figured they would have to spend millions to modernize the property. Before they could begin the rehab, occupancies and room rates began to soar, propelled by an expanded McCormick Place convention hall.

Peter Dumon, Harp's president, decided to skip the modernization and put the hotel back on the market. He's in the final stages of an auction that has featured at least a half-dozen eager bidders. He expects to make a $20 million profit on his original investment — after just 20 months or so. “We never thought the market would move as fast as it did,” Dumon says. “We're just taking advantage of rapid valuation increases.”

Posh names jump onboard

Plenty of upmarket nameplates are lined up hoping to jump on the luxury hotel bandwagon. The brands include names such as Armani, Bulgari and Ferragamo from the world of high fashion. They also include foreign-financed names such as the Savoy Group from England, Red Quartz from Ireland and Jumeirah from Dubai. American hotel names seeking national expansion include Waldorf-Astoria, Montage, Capella and Starwood Capital's Le Crillon.

If all these aspiring upstarts begin building, the luxury market could face saturation in short order. But that's unlikely because many won't get very far.

One analyst, who requested anonymity, explained the appeal of the emerging luxury brands: “The established brands are looking pretty crowded in many places now. There are five Ritz-Carltons already around Miami, for instance. If you're a new luxury developer there, would you rather be the sixth Ritz-Carlton or the first Bulgari or Montage?”

For now, nobody is ready to forecast the end of the current cycle. Lawrence Geller, president and CEO of Strategic Hotels, is considering taking his La Solano concept to other locales. His $950 a night Four Seasons Punta Mita Resort in Mexico was 87% filled in the first quarter.

The U.S. economy will keep growing along with the public's appetite for luxury. “There's still a long way to go for more upside on luxury property valuations,” Geller says. “I can't see the end of this positive cycle coming anytime soon. We'll keep investing and building where we can.” His rivals will doubtlessly be doing the same.

H. Lee Murphy is a Chicago-based writer.

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