Capital tides shifting in hotel investment

A few years ago, the road to success in the lodging industry was one way and smoothly paved. Industry profitability was the highest in decades, properties were trading briskly and development was providing handsome returns. The dual shocks to the industry that were provided by Wall Street (in the form of plunging lodging stocks and widening CMBS spreads) sent the lodging industry down a rockier, more challenging path.

With the lodging industry cycle entering its later stages, the pack of lodging firms that rode the swell of capital and surging fundamentals together will most likely split into winners and losers as firms navigate issues concerning structure, overbuilding and more conservative capital sources.

Positive but shifting fundamentals Despite forecasts of oversupply and gradually falling occupancy, most national measures of lodging industry performance remain relatively stable. A muscular U.S. economy and more moderate levels of new hotel construction have helped mitigate the risk of downside shocks to the supply and demand picture.

Cristina Ampil, senior lodging analyst with New York-based PricewaterhouseCoopers LLP, forecasts a modulated growth curve. "Occupancy will decline in 1999 at about the same rate as it did last year - around 1%," she says. "Pricing leverage will continue to weaken and we will probably see a moderation in room rates. During 1998 rates were up by 4.5%, and this year we forecast them to [increase by] 3.6%. The decline in occupancy and more moderate room rate growth is slowing RevPAR growth. RevPAR growth in 1998 was 3.7%, and we expect growth to be just over 2% during 1999. That is a much narrower margin over inflation."

Chase Burritt, national director of E&Y Kenneth Leventhal Hospitality Group in Miami, agrees with the hotel sector's stability. "According to measures like revenue and profitability, the hotel business is looking pretty solid," he says. "The numbers will not be as positive as last year, but it is nearly impossible to maintain some of the numbers that were posted last year. More than increasing weakness, we see more moderate levels of growth."

Profitability will also continue to grow, though at a slower rate. Given the industry's sustained profit growth since 1992, current profit levels are nothing to sneeze at. From its break-even point in 1992, industry profits have risen to nearly $20 billion.

Jason Ader, lodging analyst at New York-based Bear Stearns & Co., expects that, despite falling occupancy, lodging profitability will continue to increase in 1999. "Profits in 1998 were up to almost $19 billion, up over 11% from last year," he says. "We expect them to reach $21 billion in 1999 for growth of around 11%."

According to Ampil, hotel companies in recent years have been able to boost profits due to more efficient operations and falling interest rates. "On the operations side, worker productivity has increased markedly over the years and the food and beverage service for full service hotels is not as unprofitable as it once was," she notes. "On the fixed-cost side, the industry has benefited from falling interest rates and significantly lower interest expense, [which], as a percent of revenue, has dropped from over 14% in 1990 to under 4% today."

The industry's ability to attract investors and development capital has sown the seeds of its own decline. Since 1994, new construction has been on the rise, and by 1997, new room starts reached their peak. By most industry estimates, rising room completions will continue until at least the end of 1999.

"Robust supply growth should remain through 1999," predicts Ader. "The capital crunch last year did shrink the development pipeline, but there are still numerous projects under way. We will probably not see a supply growth decline until 2000."

PricewaterhouseCoopers recently adjusted its supply forecast downward to reflect the recent volatility in the capital markets and less REIT development. Instead of room starts slowing by 17.8% between 1998 and 1999, it is expecting 23% fewer starts. During 2000, starts are expected to decline by 15% instead of the originally forecasted 8% decline.

Despite flatter development forecasts, occupancy is also expected to soften due to more conservative demand growth expectations. "We think the probability of a negative shock from either demand or supply is relatively low," says Ampil. "But we have come to view stalling demand as more of a risk."

Randy Heller, senior vice president of FINOVA Specialty Real Estate Finance in Scottsdale, Ariz., characterizes fundamentals as reaching a plateau. "Fundamentals really can't get much better than they are right now, so the biggest risk is on the downside," he says. "However, I don't see anything coming along that will knock occupancy down by 10%."

Wall Street: source of discipline or abuse? The pummeling of lodging stocks on Wall Street was one of the more eye-catching events of last year. The apparent disparity between industry fundamentals and the discouraging performance of public lodging company share prices left many industry observers incredulous. While C-corps were also hit hard by the sell-off, REIT stocks took the brunt of lodging's fall from favor. By the close of 1998, REITs were down a bone-crushing 50% from their recent highs.

"There were a few conditions that prompted last year's declines: the continued threat of overbuilding, the risk of recession going into 1999, and RevPAR earnings estimate reductions by most lodging companies," says Ader. "The earnings estimates were reduced to reflect a slow growth environment coupled with rapid supply growth; they did not reflect a recession scenario. The rising recession risk is what hit multiples."

The likelihood of REIT shares recovering to their peak levels is low, according to most market seers, though many expect some modest recovery. "Some challenges still face the industry, though recession appears not to be one of them," adds Ader. "I expect that the recession discount will eventually work its way out of these stocks. However, we don't think this will be an instantaneous, sector-wide phenomenon. The strongest names - owners with the strongest properties in the better markets and the franchisers with the strongest brands - will be the first to shed the recession discount."

Lori Raleigh, president of Travers Group, a Boston-based hotel investment and asset management firm, also sees positives from the capital fall-out. "REIT investments have the potential to attract investors going forward," she says. "They are an attractive dividend-yield play, and relatively small allocations by pension funds would go a long way in improving the REIT picture."

Warren Buffet's recent investment in the REIT market and some recovery of select hotel companies are signs of life. It remains to be seen, however, whether lodging REITs will captivate the wider investment community again.

"After taking a drubbing in 1998, several companies have shown signs of recovery as investors have become more comfortable with the level of development," says John Arabia, an analyst who focuses primarily on lodging real estate companies for Newport Beach, Calif.-based Green Street Advisors. But even with a robust economy, he adds that fear of deflation has lessened while caution remains. "These companies will still remain significantly off of their recent highs," he says.

According to Geoff Baekey, managing director for Boston-based Horwath Landauer Hospitality Consulting Inc., whether or not the REIT sector rebounds, Wall Street sentiment has become a telling attribute of the lodging industry. "Only 19% of the overall lodging industry is public," he says. "Yet most of the coverage in the industry is about that 19%. Right now, when you look at the underlying real estate fundamentals in many markets, they are pretty strong. But the public markets are not casting a very good view on the industry as a whole."

FINOVA's Heller agrees with Baekey's call on Wall Street, noting that recent turbulence there has had a cooling effect on the entire industry. "I think Wall Street had a psychological effect, and possibly scared some people out of the market - both lenders and investors." he says. Plunging REIT share prices and widening spreads certainly inflicted damage to public companies and many conduits, but many market watchers believe that the tumult has improved the long-term health of the industry.

"I believe the securitization of the lodging industry has, in many respects, brought some discipline to the market," says Arabia. "The recent lack of attractively priced capital has significantly reduced the hotel development pipeline, demonstrating the capital markets' ability to positively impact the industry."

The severity of the decline in many lodging REITs' share prices has also spurred discussion of what structure companies will adopt to proceed in the current setting. There already have been some high-profile restructurings of varying results. Host Marriott is adopting REIT status, while Patriot American has shed its REIT structure. Sunstone Hotel Investors and Sholodge Inc. are also on the road to buyouts.

"De-REITing will continue to be an option," says E&Y's Burritt, adding that depressed share prices are not the only reason for companies to reassess their structure at this point in the cycle. "CEOs will continue to critically evaluate if it is time to go private, though I think they will look at it due to the cumbersome nature of the structure, not just because REITs are currently out of favor. The REIT structure is a weak structure for owning hotels and resorts. While the tax impact is substantial, the structure with the lessee and the payout of virtually all operating profits restricts companies from taking advantage of opportunities, and burdens operators with lease terms that often make no economic sense."

"The hotel industry fell into the REIT structure out of desperation," says Baekey. "The question that many REITs are asking is how can they continue to grow and still be accretive? Some REITs had a great run exclusively through acquisition, but the engine slows when acquisition pricing approaches replacement costs. At this point in the cycle, growth occurs either as a result of paying in excess of replacement costs for existing assets or getting into development. The problem with the development game is income cannot be realized for 24 to 36 months. Many are now looking at different structures so that they can develop without hurting their prices."

Available but pricier capital If capital makes the hotel investment world spin, then look for longer days over the next year. The retrenchment of Wall Street and peaking lodging fundamentals have combined to cultivate a more conservative lending climate for lodging deals, especially for development financing. (Please see our related coverage of the 1999 Bear Stearns Lodging Almanac in News Briefs, p. 6).

"Clearly, the cost of both debt and equity has risen significantly for lodging REITs over the past year. Given today's share prices, issuing equity would be dilutive, and for those who can access debt, they are doing so at significantly higher spreads," says Arabia. "Rightly or wrongly, some REITs have turned to joint venture activities for more capital. In general, I think that they can all raise some capital. The question is, 'At what cost?'"

So far, capital is still available. "Lenders are not blacklisting hotel, except for some limited service markets," says Heller. "Lending is more conservative than last year, but now is still a good time to be a borrower. The main difference is that we just aren't seeing the ridiculously slim spreads that we have had in the past. Instead, we are heading to a more logical pricing level."

More conservative capital is to be expected, say experts, with less money originating from Wall Street. With many Wall Street conduits licking wounds from the capital turmoil of last fall, more traditional lenders are able to compete. Raleigh notes that shifts in capital sources have brought the industry front and center.

"We have seen a dramatic shift in sources of capital, and in many ways the industry has come full circle," she says. "In the early-1990s, opportunity funds represented the primary source of capital, then the public markets provided the major source of liquidity. More recently, we are seeing private versus public capital as the primary source of investment capital."

Dan Hanrahan, principal of Boston-based Pinnacle Advisory Group, is more bullish on public capital coming around again. "Traditional sources of lending - banks, insurance companies, pension funds - have emerged, but we expect Wall Street to re-emerge as the year progresses."

A time to reevaluate According to experts, the raucous levels of development and transaction activity experienced in recent years due to favorably priced capital will continue to give way to more subdued transaction volume - both on the entity and the property level. Last year's manic merger and acquisition activity has all but ceased while property transaction activity is taking a breather, according to a new study by PricewaterhouseCoopers. Merger volume totaled approximately $21 billion during the first quarter of 1998, and so far this year, that total has not even reached $1 billion.

"We are presently in a bit of a waiting period," says Burritt. "There are more equity funds like Apollo, Patriot and AEW active in the market, but more traditional acquisitions have slowed. We don't expect a great deal of increased activity for the remainder of the year."

Baekey explains that many lodging companies face strategic challenges. "During the past 24 to 36 months, the lodging industry went through an aggressive merger and acquisition period," he says. "Many REITs entered this period with a portfolio of products that included many brands across several lodging segments. Similarly, several national and international hotel companies merged (Promus/Doubletree and Holiday Inn/Intercontinetal, for example). Now, the newly formed companies face strategic questions: 'How do the pieces fit together?' 'Do the various brands compliment or compete with each other?' And, 'How are decisions to be made about what components of the new system should be retained or disposed of?'"

That is not to say that there are no transactions taking place. However, as the dust clears from the transaction frenzy of the past few years, there is a shift in focus towards assimilating newly acquired assets. "Strategic acquisitions and dispositions are the norm now as companies sort the massive inventory of product transacted through 1998," says Hanrahan.

Arabia also expects to see more strategic reshuffling of assets. "Several publicly traded companies plan on selling non-strategic hotels and assets, either to reduce debt or to trade into assets in which they believe they have more potential to create shareholder value," he says, pointing to White Plains, N.Y.-based Starwood Hotels & Resorts Worldwide - which recently sold off its stake in Madison Square Garden and discarded the hotels and casinos it controlled through its ownership of Caesars World Inc. - as a prime example. The move has had a positive effect on many Wall Street analysts.

According to Ampil, hotel branding is another way hotel firms can add value and recognition. "There will be more hunkering down and more thought to branding," she says. "[Tapping the trend] will be a wise move after this period of brand proliferation."

Arabia adds that there will be, or at least needs to be, more consolidation of brands. "During the past several years, there has been this proliferation of franchises," he says. "The new brands were spurred by growth in hotel development, especially in the mid-priced and extended stay sectors. Several of these brands had enormous growth expectations built into their business plans that will not be met because of the anticipated slowdown in development. As a result, several of the flags will not achieve the critical mass to achieve effective brand awareness.

"Marriott, Hilton, Hampton Inn - those are brands," he continues. "A 30-property franchise is not a brand. Why should hotel owners pay for something for which they are getting little value?"

Burritt further emphasizes the need for companies to concentrate more on branding strategy. "Newly merged or consolidated firms have to have a clear vision," he says. "A focused branding strategy with no divergence and its implementation is key. This is not easy, but it will be impossible to win without it."

The art of operation As the heady days of dealmaking continue to wind down, hotel companies will also seek to improve performance from a business operating perspective. "For a while, with all the capital in the market, firms focused on deal structure," says Raleigh. "Going forward, the industry will need to focus on fundamentals in order to improve performance. Today we are seeing a substantial refocusing on asset management vs. the transaction, or deal structuring side of the business, to improve returns."

If companies have less capital to work with, paying increased attention to internal improvements will be especially important to public companies. "Doing deals quickly answers the pressure to grow for public companies," says Burritt. "To make the same bottom-line difference through internal improvements is certainly a lot harder and takes more commitment, but there are very few options open right now other than improving efficiencies through shaving procurement costs, improved labor management and better use of technology."

As technology maximizes potential across U.S. industry, the high-tech effect is certainly not lost on hotel firms. Allocating profit to high-tech, says Ampil, has allowed many hotel firms to streamline operations. "The profits gained during the past two years have enabled the industry to invest more in technology," she says, citing point-of-customer interfaces and guest history databases as examples.

David Levy, president of Milestone Investment Advisors, a Boston-based firm that provides investment counseling to the hospitality industry, believes that market conditions may push the use of information technology into new directions. "Now that there is more supply and increased competition, it will be increasingly important for operators to know who their demand generators are," he says. "Also, very few operators have warehoused information about a property's market or competition."

In recent memory, the hotel industry has experienced outstanding performance as an investment vehicle. But gradually softening fundamentals and Wall Street bears have made the future of the industry less predictable, with varied outcomes for individual lodging companies expected predicted over the next few years.

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