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Will the Hotel Industry Overbuild?

In January, Ashford Hospitality Trust, a Dallas-based REIT, announced the $2.4 billion acquisition of 51 hotels that had been part of CNL Hotels and Resorts. Soon after, Ashford said that it would not make any more major acquisitions for some time — perhaps years.

Why the sudden loss of appetite? The REIT remains true to its longstanding policy on acquisitions: only buy in the early years of an up cycle. The goal is to buy before the market peaks. Once the cycle shows signs of maturing, it is time to sit on the sidelines, explains Monty J. Bennett, CEO of Ashford Hospitality. “We think business will be healthy for the next couple years, but after that oversupply could start eroding the industry's profitability.”

After enjoying four years of recovering profits, U.S. hotels appear to be nearing the top of the cycle. With construction of new properties rising, the industry faces a growing threat of oversupply. At the same time, rising costs could squeeze margins.

Wages of hotel workers are climbing along with construction costs. Most importantly, financing costs are increasing as interest rates rise and lenders tighten their underwriting standards. In short, hotel assets are no longer a slam-dunk investment. “We are near the peak of the market,” says Scott Smith, senior vice president of PKF Consulting in Atlanta.

Checking in on fundamentals

The market is already showing some early signs of a shift. In 2006, room demand exceeded supply growth. But this year, the demand for hotels is expected to increase 1.3%, the same rate as the growth of new supply, according to PricewaterhouseCoopers. In 2008, supply should increase by 2.1%, while demand will only grow 1.7%.

Room supply at mid-scale properties without food and beverage — a product segment that includes Hampton Inn and Comfort Inn — is expected to rise 6.1% in 2007 and 7.6% in 2008, reports PKF Hospitality Research. Upscale hotels, which include Courtyard by Marriott, are expected to record supply growth of 5.2% in 2007 and 6.3% in 2008.

With the increase in construction, oversupply problems could surface as early as 2008, says Patrick Ford, president of Lodging Econometrics, a global real estate consultant in Portsmouth, N.H. Ford notes that from the time a project is announced, it typically takes two to five years for completion. In 2008 and 2009, there will be a surge of completions in growing markets such as Phoenix and San Diego, says Ford. Seattle also should see a rise in completions in 2008.

“As the hotels open, you could begin to find oversupply first on highways and outer suburbs,” says Ford. “Later you could see problems in the center cities, where it is harder to build and supplies are tighter.”

Mounting cost pressures

Along with a potential oversupply, labor costs could create problems, says Bernard Baumohl, managing director of The Economic Outlook Group, a consulting firm in Princeton Junction, N.J. “As more hotels come on line, companies will be forced to hire workers at a time when the supply of labor is getting tighter,” he says.

Over the past 12 months, average hourly hotel pay has climbed 6%, well above the U.S. average wage gain of 4%. “Hotels want to see the room prices rise faster than labor costs, but that has not been happening,” says Baumohl. “That's why there may be some concerns about profitability down the road.”

While wages climb, construction costs also continue increasing. Bennett of Ashford Hospitality says that with prices of steel and concrete soaring, the total cost of building a new hotel has risen more than 10% annually for the past several years. Developing a new hotel in Dallas now would cost about double the figure of a decade ago, according to Bennett.

Because of skyrocketing construction costs, investors say it is still cheaper to buy an existing hotel and renovate. “When you renovate, you spend money on items like carpets and drapes,” Bennett says. “There has not been a run-up in prices of furnishings because competition from China is providing inexpensive goods.”

Rising rates, flattening prices

As interest rates rise, property values stagnate or drop. The prime rate, the rate banks charge their most creditworthy customers, has climbed from 6% in June 2005 to 8.25% in July 2007. The climb in rates helps explain why prices of hotels have remained flat, or in some cases even dipped slightly.

The best deals are not in coastal markets. Top properties in strong markets such as San Francisco and Boston command capitalization rates of 5% to 7%, according to Scott Smith, senior vice president of PKF Consulting. Older properties in weaker markets are trading at cap rates of 7.5% to 9%.

Along with flat prices, hotel developers have other reasons to pause. During the second half of July, stock and bond markets became turbulent. With investors worried about rising home foreclosures, lenders began tightening their terms and rejecting weaker credits. At the same time, yields on junk bonds climbed sharply. That spelled bad news for private-equity funds, which often buy hotels using high-yield financing.

The rates on high-yield bonds climbed from an average of 7.5% at the start of June to 8.4% at the beginning of July, reports, a Web site that provides stock market analysis. “Conditions for borrowing are tightening up,” says Ford of Lodging Econometrics.

Rich profits

Despite the emerging credit crunch in the capital markets, hotel owners still have some reason to remain cheerful. Profits per room peaked in 2000 at $16,545, according to PKF. Then with the economy slowing and the terrorist acts of Sept. 11, 2001 discouraging travel, profits collapsed. Profits per room reached a low of $10,561 in 2003.

Since then, business has improved. This year profits per room are expected to pass the 2000 figure, reaching $16,586. Revenue per room — or REVPAR — has climbed from $43,427 in 2003 to an estimated $57,972 in 2007, reports PKF.

Hotel occupancy remains strong at 63.5%, according to PKF. That number is near the historical peak. Many prime hotels in central business districts have occupancy rates of more than 75%, says Robert LaFleur, lodging industry analyst for Susquehanna Financial Group, an investment bank in Stamford, Conn.

“For business hotels, occupancy can't really grow much more,” he says. “If three quarters of the rooms are filled on average every night, the hotels are filled to capacity at midweek. At a business hotel, you are always going to have some vacancies on Sunday nights.”

Occupancy levels are clearly healthy throughout the country, but the demand is particularly strong in Boston and Los Angeles, which have healthy local economies and plenty of leisure travelers. New York City is a leading market with an occupancy figure of 84.5%.

Bjorn Hanson, a lodging consultant with PricewaterhouseCoopers, says that for the moment New York is essentially full. “Most travelers must book far in advance to get a room in New York, and many are being turned away because Manhattan has no rooms,” he says.

The extra Manhattan travelers are being bumped to hotels in Northern New Jersey and New York boroughs, such as Brooklyn. There are about 10,000 rooms under development in Manhattan, but those will do little to depress Manhattan occupancy, says Hanson. The new rooms would likely take guests away from New Jersey.

With national occupancy near its historic peak, the main driver of growing profits has been increases in room rates. The average daily rate has climbed from $91.02 in 2005 to $102.86 in 2007, according to Smith Travel.

Occupancy rates vary by the type of chain, according to Smith Travel Research. Luxury units enjoy the best performance with a projected occupancy rate of 71.2% for 2007. At the tail end are economy hotels, with a forecast occupancy rate of 57.5%.

A standout in economy segment

Many low-price hotels are suffering because owners have failed to maintain their properties, says Georges Le Mener, president of Accor North America, which owns Motel 6, the budget giant.

Compounding the problem is that developers have spent heavily on building mid-price units without food and beverage. Successful mid-price chains include Days Inn and La Quinta Inns. These have attracted budget-minded business and leisure travelers.

Motel 6 is certainly not discouraged about its prospects. President Georges Le Mener says that the chain is a leader in its segment with occupancy rates of more than 65%. “We like being a strong player in a weak segment,” he says.

Le Mener expects to increase the number of Motel 6 units from 840 to 1,500 in the next five years. In the past several years, the chain has grown primarily by recruiting franchisees. About 50 franchised units will open this year.

But now Motel 6 has begun to alter its strategy to include constructing new company-owned units, and buying competitors. The company expects to continue thriving by promoting its image as the national chain with the lowest rates.

Le Mener says his company can reach more budget-minded leisure and business travelers. “We have a strong niche that includes guests who pay their own bills and want to save when they can,”

Among the upscale properties, some of the healthiest have been extended-stay hotels. The strong brands tend to produce steady sales because more executives are spending long periods on the road. Many long-term travelers develop an attachment to a chain and become regular guests.

To gain a foothold in the sector, ING Clarion Partners, a real estate advisor in New York, recently paid $877 million for Apple Hospitality Two, a REIT that owned 63 upscale extended-stay hotels in 24 states.

Selective buyers

With prices of upscale hotels still strong, some operators only buy when they find unusual opportunities to turn around a property or exploit an unusual space in a particular market.

Noble Investment Group, a private Atlanta firm that owns and manages hotels, is currently building an upscale Hyatt Place in Dadeland Mall, a huge property in Miami owned by Simon Property Group, the largest shopping center REIT in the country.

The hotel developer will build 175 rooms in a space that once housed a Macy's outlet. “This is a natural location for a hotel,” according to Mitesh Shah, CEO of Noble Investment. “Consumers want to stay at a hotel where they can go downstairs, shop and see a movie,” he says.

In 2006, Noble Investment bought a Sheraton in Midtown Atlanta and began converting the space to a W, the upscale chain created by Starwood Hotels. Noble Investment plans to spend $50 million on the property, which is expected to open in February 2008. “We often aim to get a double-digit yield on our projects,” says Shah. “Even in a strong market, you can only get that sort of return by finding values that others overlook.”

Stan Luxenberg is based in New York.

Has hotel M&A activity hit a speed bump?

Like so many industries, the lodging sector experienced a flurry of mergers and acquisitions in the first seven months of 2007. According to Dealogic, a New York-based research firm, the total value of announced hotel transactions year to date through July reached $57 billion. To put that in perspective, the $57 billion figure roughly equals the total for all of 2006 and is nearly double the $29 billion recorded in 2005.

In lodging, as in other industries, the biggest deals have involved buyers taking public firms private. Altogether five public REITs announced privatizations, during the first seven months of this year, reports SNL Financial, a consulting firm in Charlottesville, Va.

Notable buyers included Apollo Investment Corp., which bought Innkeepers USA Trust for $1.5 billion, and Inland American Real Estate Trust, which acquired Winston Hotels. The biggest buzz centered on the Blackstone Group, which announced that it would buy Hilton Hotels Corp. for $25 billion, not including debt.

But in July, the private deals began hitting obstacles amid a climate of rising interest rates and tighter underwriting standards by lenders. “It is not unusual for private-equity firms to lever their deals with 90% debt,” explains Keven Lindemann, director of SNL's Real Estate Group. “If the financing costs go up, the potential returns decline.”

Will the private deals screech to a halt? Not necessarily, says Mitesh Shah, CEO of Noble Investment Group, a private firm in Atlanta that owns and manages hotels. But buyers will have to be more conservative about how they structure the deals.

In some of the recent hotel acquisitions, income from the project barely covered debt service, says Shah. Now deals will have to provide income that is 1.4 times debt service. “Instead of using 85% debt, you will have to use 70%, which was the normal figure in the past,” he says.

In recent years, public companies were handicapped when they bid against private firms, says Robert La Fleur, lodging analyst at Susquehanna Financial Group, an investment bank in Stamford, Conn.

In the past, if a public company's stock traded at 11 times earnings before taxes and interest, then the company couldn't match the private buyers that might be willing to pay a multiple of 14. Such a rich purchase would dilute the earnings of the public company.

But now prices may soften and become affordable for public companies. “All of a sudden, the pool of private buyers will be diminished,” says La Fleur.

Tighter lending standards are healthy for the industry, emphasizes James Merkel, managing director of Rockbridge Capital, a hotel lender in Columbus, Ohio. “Because of market conditions, we will not see more weak players doing marginal deals. But the fundamentals of the industry remain strong. Sound deals with the best owners will get done.”
Stan Luxenberg

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