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Will Hotel Investment Frenzy Fizzle?

The prosperity of the U.S. hotel industry has always tracked the fortunes of the general economy. The lodging sector sank into its last major downturn following 9/11. Now the economy is slowing again after years of uninterrupted expansion, and the outlook for hotel investors has turned cautious.

“If there is a slowdown, it should be a nominal slowdown for hotels in 2008,” declares Laurence Geller, chairman and CEO of Strategic Hotels & Resorts in Chicago, the owner of 21 high-end properties. Geller says group bookings are up 10% for 2008, but he expects some cancellations as corporations face the prospect of $100 a barrel oil and slowing demand for their products. “Business confidence is fragile, though there is no sign of a radical fall-off in the economy,” Geller says.

Conflicting indicators

It's not easy to predict where lodging is headed. On one hand, new construction remains buoyant, with researcher Lodging Econometrics LLC of Portsmouth, N.H. forecasting 1,213 new hotel projects with 138,665 rooms coming to the U.S. market in 2008. That's up from an estimated 969 hotels with 96,031 rooms in 2007. The pipeline of new projects has never been bigger, with more than 5,000 hotels encompassing some 654,500 rooms planned or under construction.

On the other hand, experts are bracing for delays and cancellations on the new construction front. Abigail Marks, an economist with Torto Wheaton Research in Boston, says she is nervous about the potential for an oversupply of rooms in many markets by 2009 and 2010. But she doesn't expect developers to pull the plug on projects already committed for 2008. “Yet I don't see a flood of new construction coming on after next year,” she says.

The common perception is that if the economy slows in 2008, travel will fall off and hotel occupancy rates will deteriorate. Hotel occupancies in 2008, however, are likely to average 67% across all categories, predicts Torto Wheaton, down slightly from the 67.2% estimated for 2007.

One of the most closely watched metrics in lodging is revenue per available room. The U.S. average RevPAR in 2007, Torto Wheaton figures, was $82.38, up 5% from the $78.23 recorded in 2006. In 2008, RevPAR will be merely flat at $82.36. “The growth in room rates has reached a plateau of sorts,” Marks observes. She doesn't think RevPAR will get back on a significant upward trajectory before 2010 at the earliest.

Deal velocity to slow

Hotel brokers have enjoyed a golden era in dealmaking during the past few years, but transaction activity is expected to shift into reverse in 2008. Jones Lang LaSalle Hotels in Chicago projects 2007 deal volume at about $48 billion, an all-time record, up 36% from the $35.3 billion in 2006. Mega-deals, such as the $8 billion acquisition of Extended Stay Hotels by Lightstone Group of New York, were ubiquitous in 2007. There were nine transactions during the year priced at $600 million or more.

“We think the mega-deals will continue once the debt markets settle down, albeit at a significantly slower rate,” says Kristina Paider, senior vice president of research at Jones Lang LaSalle. “Some investors are on the sidelines at the moment anticipating that cap rates on acquisitions in 2008 will expand, giving them some nice buying opportunities.”

And yet there is one problem with that scenario: holders of assets may be in no hurry to sell. Paider reveals that a recent Jones Lang LaSalle survey found that potential hotel buyers now outnumber sellers by a 5 to 2 ratio in 2008. Acquirers who were gobbling up assets in the past two years with as little as 10% to 15% of their own equity will be expected to come to deals with at least 30% of their own money in the coming year.

Renovate, remodel or regret

As occupancies flatten out in the next year and hotels compete more strenuously for business, many asset holders will feel compelled to invest in remodeling. Axela Hospitality, a Washington, D.C.-based subsidiary of WexTrust Capital, is rehabbing a former Days Inn on Chicago's near north side into an upscale boutique property to be renamed the Park View Hotel when it debuts in March.

The company has another deal pending to acquire the old 160-room Drake Hotel in Oak Brook, a western suburb of Chicago. The firm will spend $100,000 per room to renovate the property, followed by an expansion to 220 rooms. The payoff: room rates at the Drake, currently running $120 a night, will rise to at least $200 a night post-construction.

“It's a competitive business now,” says Elmer Coppoolse, CEO of Axela. “A lot of markets have old hotel product that needs to be either updated or replaced. That's where we see the opportunities.”

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