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Seller Beware

THE BIGGEST HOTEL SALE so far this year — Host Marriott Corp.'s $214 million purchase of the Boston Marriott Copley Place in June — shows how the negotiating advantage can shift to a buyer when an unsteady market is pushed over the edge. During a pivotal stage in the discussions in the second quarter of 2001, the lead bidder pressured the owner to lower its asking price because the economy was slipping and revenues at the hotel were on the decline.

Convinced revenues would bounce back, Bermuda-based Overseas Partners Capital Corp. held firm in its showdown with Westbrook Partners of Boston, but the Sept. 11 terrorist attacks caused room revenues to plummet further. More than one year after putting the property up for sale, Overseas Partners agreed to sell the 1,147-room hotel to Host Marriott, the replacement suitor, at a 35% discount to the property's estimated replacement cost. Although neither side will say how high the original bid was prior to Sept. 11, there was speculation at the time that the owner was seeking as much as $270 million for the property.

Why was Overseas Partners willing to sell at such a discount? The investment company, which wanted to sell the hotel as part of a strategy to liquidate its real estate assets, didn't have much choice but to lower its expectations in the face of plunging hotel revenues.

“Cash flows were down 40% from 2000 at the hotel,” points out Christopher Nassetta, CEO of Bethesda, Md.-based Host Marriott. Since a hotel's income over the previous 12 months is a key measure of value, Host Marriott had ammunition for its effort to obtain the best possible deal.

“It's a good time to buy assets in this kind of market. I think they (Host Marriott) made a great buy,” says Robert J. Webster, executive vice president at Atlanta-based Hodges Ward Elliott, which represented Overseas Partners. He adds that the owners didn't feel like they were robbed in the deal, either. “They thought it was a fair price given the market conditions.”

Although Boston has been hit hard by the nationwide decline in business and leisure travel — only San Francisco has fared worse since Sept. 11 — Nassetta says purchasing the Copley Place isn't a gamble. He says buying a world-class hotel in Boston, one of the country's top hospitality markets, is a can't-lose proposition.

Year Number of sales Total dollar value
2002 first six months 28 $1.10 billion
2001 105 $3.80 billion
2000 150 $4.60 billion
1999 128 $5.10 billion
1998 241 $10.70 billion
1997 280 $9.70 billion
1996 227 $8.30 billion
1995 147 $3.90 billion
1994 108 $3.10 billion
1993 53 $1.90 billion
1992 70 $2.20 billion
Source: HVS International

“It's a great deal,” Nassetta says. “We think there will be pretty terrific growth in this market.”

Host Marriott's discount deal illustrates why sellers are reluctant to list properties at a time when revenues are sluggish. The Hospitality Research Group, based in Atlanta, predicts revenue per available room (RevPAR) will decrease by 1.5% in 2002. And the yardstick of comparison is one of the most dismal performances in the history of the hotel industry — the 10.6% decline in RevPAR in 2001 (see chart on page 64).

That drop in revenue has a direct effect on transaction volume, because sellers are holding out for prices that reflect more normal conditions and buyers don't want to overpay as the market continues to weaken. The result: Sales of hotels valued at $10 million and higher fell by more than 50% in the first six months of this year compared with the same time period in 2001, according to Tony Viens, director of data collection and research at Mineola, N.Y.-based HVS International.

The dollar value decreased from $2.5 billion to $1.1 billion as the number of transactions fell from 68 properties to 28, according to HVS (see chart on left). But there were signs of improvement in the second quarter over the first, when sales jumped to $802 million from $282 million, buoyed by the Copley Place deal and the $155 million sale of the Hilton Waikoloa Village in Hawaii. The number of sales increased from 13 in the first quarter to 15 in the second quarter.

Better to Wait?

Until the RevPAR figures start climbing again, pricing and deal volume won't. “The prudent owners out there are the ones who know the performance of their hotels is down and will wait to sell when the performance goes up,” says Al Calhoun, a principal at Thompson Calhoun Fair, an Atlanta-based brokerage.

Dale Anne Reiss, a global director at New York-based Ernst & Young Real Estate, Hospitality and Construction, cringes when asked to categorize the state of today's sales market. She emphasizes that each deal has its own dynamics, including the quality of the property, the market in which the hotel is located and the financial well-being of the owner. But she acknowledges that now is not the most opportune time for sellers.

“Pricing is normally based on the operations of the property, and the operating revenues of properties has been less than what we all would have liked to have seen,” she says. “If you're pricing off of it, it's just a more challenging environment to maximize price.”

On the other hand, these disappointing revenue trends can present a strong bargaining tool for buyers. “Before, sellers had been pointing to good performance numbers in 1999 and 2000, whereas the buyers today are thinking that's not relevant to the future,” says Don Braun, president of Hall Financial Group, a Dallas-based investment banking firm.

Although RevPAR levels have yet to return to pre-Sept. 11 levels, the speed of the descent has slowed, which provides both buyers and sellers a more stable environment for deal making. In the first quarter of 2002, RevPAR was down by 15.5% nationally compared with the first quarter of 2001, according to the Hospitality Research Group. The RevPAR decline slowed to 11.7% through the first half of the year. The Hospitality Research Group predicts a return to positive RevPAR growth in the third quarter for full-service hotels.

“It was very difficult to put deals together, getting all ends to meet — not only getting the seller to acknowledge where the market was, but getting the lenders to line up and getting the deals through the hoop,” says James T. Merkel, managing director of RockBridge Capital Inc., a Columbus, Ohio-based investment banking firm. “I expect more transactions to get done in the third and fourth quarters of this year and into next year.”

Year RevPAR Change
2002 forecast $61.41 -1.5%
2001 $62.34 -10.6%
2000 $69.70 6.2%
1999 $65.65 1.4%
1998 $64.74 2.8%
1997 $62.95 5.7%
1996 $59.57 8.3%
1995 $54.98 6.8%
1994 $51.46 7.5%
1993 $47.87 4.5%
1992 $45.83 3.2%
*Average of 50 major U.S. cities
Source: Hospitality Research Group, Torto Wheaton Research, Smith Travel Research

On the Prowl for Opportunities

Certainly, there is no shortage of investors hunting for hotels to purchase. Those lining up include investment banks with opportunity funds — large pools of money from private and institutional sources — at their disposal.

“There are loads of buyers out there — Wall Street funds, private funds,” says Tom McConnell, a senior managing director in the New York office of Atlanta-based Insignia/ESG Hotel Partners. “These guys may not have been in the hotel market two years ago.”

RockBridge Capital and Hall Financial are two firms with big pools of investment money to play with — $125 million and $100 million, respectively.

“We just started focusing on hotels this year,” says Braun. “We saw the hotel market might become an opportunistic area given the reductions in performance levels.”

But Hall Financial has been disappointed with the quality of the properties that have become available so far this year, says Braun. The firm closed only one hotel sale through July. “The opportunities out there are in the weakest financial hands and, frankly, the ones that are in the weakest financial hands are most often the least desirable product — the lowest end of the limited service sector in locations that are marginal — which haven't been attractive to us,” he says.

For now, Braun's firm has shifted much of its investment money into its mezzanine financing business until hotel sales pick up. The firm has provided $20 million in mezzanine financing for eight hotels so far this year. Indeed, Braun points out, the shaky market drives demand for mezzanine financing because banks are reluctant to finance hotel deals now. If banks are willing to provide financing, the loans tend to cover a lower percentage of the project than borrowers are seeking — often only 50% to 60% — and mezzanine financing bridges the gap to finance the remainder of the project.

The company's strategy is to partner with a sponsor to purchase a property at or below replacement cost and reposition the hotels, often with a new brand affiliation. Some observers estimate that the average replacement cost of hotels is 15% to 20% less than in 2000.

Hall purchased a Wilson World hotel near the Dallas/Fort Worth International Airport in Frisco, Texas, in April for $5.1 million and will invest $4 million in improvements to reposition the hotel under the Radisson flag in the fourth quarter of this year.

Business has picked up significantly for RockBridge since the first quarter of this year. After closing only one deal in the first quarter, the firm completed 11 transactions between June and August — five of them involving acquisitions of properties — including teaming with Hospitality Ventures to purchase a three-property portfolio in Texas and New Jersey for $25.1 million. The hotels will be converted to Hilton, Doubletree and Courtyard by Marriott brands. RockBridge lined up a lender to provide 65% of the first mortgage and chipped in to provide $7.3 million in mezzanine debt. The hotels will be renovated at a total cost of $9.3 million.

“We really try to be entrepreneurial and find the deals with the right sponsor that can convince us how they're going to make money on the deal,” Merkel says.

Let's Make a Small Deal

Big hotels are the hardest to move in this market. There have been only six sales of more than $50 million so far this year compared with 63 in all of 1998, which was the biggest sales year in the past 10 years.

The action is in hotels priced $5 million and under, especially those that have fallen on hard times and may require renovations. And there's plenty of action in foreclosed properties, according to Thompson Calhoun Fair. Foreclosures have not reached the levels of the early 1990s, when many overleveraged properties reverted to their lenders. But out of the 18 deals that Calhoun closed in the first half of the year, 13 involved foreclosed properties. Last year, only two out of the 12 deals the firm arranged in the first half of the year were foreclosed hotels.

Al Calhoun says most of these foreclosed hotels are older, economy or mid-market hotels that require improvements to meet the standards of a franchise agreement. These properties provide an opportunity for investors, he says. “I think you would buy today because you can buy at such a discount to replacement cost,” says Calhoun.

Calhoun points out that many of the foreclosed properties he is selling are from owners with portfolios of five to 20 hotels that are choosing to give up a property whose franchise agreement is about to expire or is the poorest performing property in the portfolio. “It's a selective cleansing of the portfolios that's going on out there,” Calhoun says. “The same guy who got foreclosed on is calling me to buy another hotel. I cannot think of one major owner who is going out of business.”

Owners of limited-service hotels looking to add properties to their portfolios are keeping Insignia/ESG busy so far this year. James “J.J.” Johnson, senior managing director in the firm's Chicago office, says properties in the $2 million to $5 million range are in great demand. And many are being sold at or near the listing price. It helps that limited-service, roadside hotels have not been hit nearly as hard by the travel downturn as resort properties in many of the big cities.

“I'm probably going to have my best year ever here in a down market,” says Johnson. “That's why I stay in this type of property, because there's always activity there.”

Insignia/ESG sold a 17-property portfolio of Best Inns and Best Inns & Suites in a series of individual sales from October 2001 through April of this year. The hotels were distressed properties in need of renovations.

One of the firm's bigger deals this year was the sale of the 127 East 55th Street hotel — also known as the British Airways hotel — in Manhattan for $31 million. The deal was another symbol of the shaky economy — British Airways is one of many airlines struggling financially and the company sold the hotel to free up cash. Insignia represented British Airways, which sold the 37-story, 124-room hotel to Hotel Properties Ltd., Singapore.

With the Hotel Research Group predicting only modest revenue increases by the end of the year, McConnell doesn't foresee business picking up for large-scale properties. “Very few markets are seeing any substantial lift as we head toward the end of the year,” he says. “A lot of folks have started to think that the hotel industry won't pull out of its current doldrums until 2003.”

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