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Confronting the shock waves

Chris Nassetta was in a meeting in his office in Bethesda, Md., at 8:45 a.m. on Sept. 11, 2001. Like many meetings that morning, this one ended abruptly when an assistant burst through the conference room door to announce that a plane had smashed into the World Trade Center (WTC) in New York. As was the case with so many Americans across the country, Nassetta had no idea that a terrorist attack had begun.

But Nassetta took an especially keen interest in the news. As president and CEO of Host Marriott Corp., he manages a REIT that owns 125 hotels, one of which was located directly between the twin towers that were struck that morning. “It was a terrible day for all of us,” he recalled.

The New York Marriott World Trade Center Hotel, located at Three World Trade Center, collapsed as a result of damage sustained from the attacks. Two associates of Marriott International, the management company for the hotel, remain unaccounted for at press time. The hotel was evacuated on the day of the attacks, and there have been no confirmed reports of injuries to guests.

The New York Marriott Financial Center Hotel, located two blocks south of the WTC, also suffered damage but remains structurally sound and needs only minor repairs.

‘A war zone’

Nassetta visited the Three WTC site on Sept. 24, as soon as officials would allow him into the area. “If you've seen reports on the news, you have some idea of the death and property damage there,” he said. “But when you see it firsthand, you realize how much you cannot see on television. It's like a war zone.”

Given the circumstances, Nassetta probably had more difficulty than most people across the country returning to work in the days following the attack. But much had to be done. His first task involved insurance.

“Two types of insurance come into play for this: business interruption insurance and property damage insurance,” he said. “We have both and will receive payments for the lost income we would be earning while the damaged hotel remains out of service. We'll also receive payments from property damage insurance.” Host Marriott said it was too early to place a dollar figure on the damage.

In the case of the hotel that was destroyed, complex questions remain as to whether Host Marriott will rebuild or settle on a loss payment of some sort.

As part of the WTC complex, the future of the World Trade Center Marriott does not rest solely in the hands of Host Marriott. Many other groups have an interest in what happens next. The key players will be the Port Authority of New York and New Jersey, which owns the World Trade Center, and a private group led by developer Larry Silverstein and Los Angeles-based Westfield America, which earlier this summer signed a 99-year lease on the property. Other property owners affected by the attack also will influence further development decisions.

“The best estimates so far come from the city,” Nassetta said. “Officials say it will take six months to a year to clean up and begin whatever rebuilding people decide on.”

Big indeed. Everyone has heard the statistics: approximately 13.5 million sq. ft. of space destroyed, and a total of 28.7 million sq. ft. of office space either destroyed or damaged in Downtown Manhattan, according to New York-based Insignia/ESG. New York City contains 380 million sq. ft. of office space in three distinct markets: Uptown, Midtown and Downtown, so the attack affected about 8% of the city's office space. In other words, the space destroyed or damaged in the attack encompassed an area equivalent to downtown Atlanta.

But that's not all. The attack virtually shut down the travel and hotel industries, sent shock waves through the commercial office industry, and mangled personal and business lives across the country and around the world. The massive effects of the tragedy remain by and large incomprehensible. What follows is an examination of how top executives and analysts size up the world of hotel and office REITs in the days before and after Sept. 11.

Dark days for hospitality

Before Sept. 11, the hospitality industry was dealing with a slowdown in the economy. “It felt like we were in a recessionary environment,” Nassetta said. “We were seeing reductions in revenue per available room [RevPAR] equal to some of the largest reductions that the industry had ever experienced. Still, this was within the range of a normal slowdown.”

Despite that slowdown, Nassetta recalls not worrying excessively because the supply side of the business remained favorable, with few new rooms coming to the market. “While we thought we would have to endure a period of weak business, it looked like it would be relatively short-lived and be followed by a rapid snap back,” he said.

After the attack, the supply situation in the hospitality industry actually improved, a difficult word to use in this context. Nevertheless, disruptions in the capital markets have put new hotel construction on the back burner — probably for some time to come — according to industry observers.

Disruptions in the capital markets have affected more than new development. For example, on Sept. 11, Irving, Texas-based FelCor Lodging Trust Inc. planned to finalize its acquisition of Washington, D.C.-based Meristar Hospitality Corp. Within days, both companies announced that the transaction would not occur, citing adverse changes in the financial markets.

“The merger always made sense,” said Thomas J. Corcoran Jr., president and CEO of FelCor, noting that FelCor is the second-largest hotel REIT and Meristar the third-largest based on rooms owned. Also, the two companies both buy underperforming hotels and reposition them, he said. Meristar owns Hilton and Sheraton hotels, while FelCor owns Embassy Suites, DoubleTree, Holiday Inn and Crowne Plaza properties.

“Together, we would be the largest hotel REIT,” Corcorcan said. “So merging made a lot of sense. But the financial markets weren't there to do the merger.”

On Sept. 10, the day before the tragedy, FelCor's stock price (NYSE: FCH) closed at $19.95 per share and MeriStar's (NYSE: MHX) at $20.16 per share. At press time on Oct. 25, the company's stock prices closed at $13.58 per share and $9.67 per share, respectively.

In the days following the attack, the entire hospitality industry fell off a cliff. “What was a slowdown has now gone over the edge, well beyond anything I think the industry has experienced in recent times,” Nassetta said. “For example, the RevPAR declines in the days following the attack have been extreme. This clearly produced several weeks of very, very poor results and unprecedented low levels of occupancy.

While he said he couldn't discuss Marriott's numbers at this time, Nassetta noted occupancies for the industry as a whole in the week following the attack were in the 20% to 30% range, compared with 80% at this time of year under normal circumstances.

In the second week following the attack, occupancy rates increased to 40%, Nassetta continued. In addition, the dramatic numbers of cancellations that followed the attack eased. Still, the unprecedented downturn came during the heaviest season of the year for business travel.

Since then, business has continued to improve as Americans recognize the importance of returning to their normal way of life. “I think the depth of the problem is fairly well understood at this point,” Nassetta said. “However, we still don't know what the duration of the downturn will be. Statistics suggest that things are continuing to improve. But we have no idea about the level at which the business will stabilize.”

Nassetta is hoping for a relatively quick rebound, but planning for a material impact on performance. “We are making sure that we have adequate liquidity,” he said. “We are managing our balance sheet with a great deal of discipline, cutting back on capital allocations where we can. I think you'll see people throughout the industry being very cautious, conservative and internally focused for some months.”

While no one has a comprehensive grasp of how long the rough times will last, research firms are looking into that question. “We've been wrestling with a concept we call ‘stigma,’ which principally is a problem that will affect air travel,” said Jack Corgel, managing director of Atlanta-based Hospitality Research Group, an affiliate of PKF Consulting.

After a tragedy, a stigma attaches to various businesses, according to Corgel. “Stigma is a psychological effect that is not captured directly by economic models,” he said. “But history suggests that there will be a persistent stigma affecting air travel. It could last as long as two years, with a smaller residual stigma lasting for perhaps another two or three years.”

Corgel and his team have spent weeks analyzing how this stigma will affect air travel and the hospitality industry in the wake of the WTC attack. “Once we get a grip on this, we can adjust our economic model,” he said.

There are indications this stigma is changing business practices, at least for the short term. At Berkeley, Calif.-based Lend Lease Rosen Real Estate Securities LLC, a REIT money management firm, CEO Kenneth T. Rosen has begun Web-casting personal meetings. “At first, we weren't able to travel,” Rosen said. “To tell the truth, I haven't wanted to travel. While I think people will use these kinds of techniques for a while, I still believe there is no substitute for face-to-face meetings. But this will never be forgotten, and it will take some time for all of us to recover.”

Going forward, hotel REITs and the whole hospitality industry are hoping for the best and planning for the worst.

The new world of work

The WTC attacks transformed the office sector in two of the nation's 24-hour cities: New York and Washington, D.C. In the days following the attack, the media overflowed with stories about firms moving to scatter their offices to avoid centralized operations, abandoning new offices in New York, and exploring the possible benefits of telecommuting.

Preliminary third-quarter statistics assembled by New York-based Cushman & Wakefield confirm a broad reallocation of space in the city. At the time of the terrorist attacks, the city had approximately 25 million sq. ft. of available office space. As a result of the attacks, about 13.5 million sq. ft. was destroyed, while another 8 million sq. ft. is out of commission for some period of time.

“Prior to the end of the third quarter and before the attack, Cushman and Wakefield estimated that the city would see a jump in vacancies from just under 7% to 8.4% at the end of the third quarter,” said Anne Covell, director of analytics for Cushman & Wakefield. “Now we think the vacancy rate will be around 6.5% when the third-quarter figures are complete.”

According to Covell, the vacancy rate in New York needs to be between 7% and 9% for supply and demand to be in balance, which means that space could be tight for the foreseeable future, based on the third-quarter vacancy rate. Although 7.5 million sq. ft. of office space is under construction, 96% of that space has been pre-leased, according to Covell.

As a result, many firms in need of replacement space moved, at least temporarily, out of the city in the weeks following the attack. Cranford, N.J.-based Mack-Cali Realty Corp. found itself fielding requests for space from New York companies. “Since we have been in negotiations with several businesses displaced from Downtown Manhattan that are interested in space in Jersey City, N.J., we're seeing firsthand the concerns about the concentration of offices and staffs, as well as a greater emphasis on diversifying the location of a company's disaster recovery operations,” said Mitchell E. Hersh, CEO of Mack-Cali.

Mack-Cali and Melville, N.Y.-based Reckson Associates Realty Corp. each own more than 10 million sq. ft. of office space in suburban New York, according to a report by William E. Hauser, portfolio manager in the New York office of Munich, Germany-based Hypo Vereinsbank.

Hauser's report notes that other REITs with property in New York include New York-based SL Green Realty Corp., which owns 10 million sq. ft. of Class-B property already near full occupancy in Midtown. Saddle Brook, N.J.-based Vornado Realty Trust owns 15 million sq. ft. of office space in Midtown, including redevelopment property near Pennsylvania Station. Meanwhile, Boston Properties' new office development in Times Square was 93% pre-leased before the attack.

At press time, rent statistics for New York City's third quarter were unavailable. According to Cushman and Wakefield, gross rents for Class-A office space declined between the first and second quarters of the year, moving a direct asking price of $56.56 per sq. ft. to $55 per sq. ft. in Midtown and a direct asking price of $44.49 per sq. ft. to $42.68 per sq. ft. in Downtown. Given the loss of space in Downtown, rents likely will move back up throughout the region during the next couple of quarters.

To the south in Washington, D.C., the attack on the Pentagon altered the office space equation throughout the region. “The D.C. central business district probably will be the strongest downtown market in the country in the fourth quarter,” said Covell of Cushman & Wakefield. “The area was doing extraordinarily well, and the terrible tragedy at the Pentagon will create new demand downtown.”

Prior to the attack, Cushman & Wakefield's figures showed that gross rents for Class-A space in D.C. had risen nearly $3 per sq. ft. to a direct asking price of $45.29 per sq. ft. from the first to the second quarter. The overall vacancy rate, including sublease space and direct space, was 5.7% at the close of the third quarter, down from 5.8% in the second quarter. “We haven't see declining vacancy rates in any other market during the first three quarters of 2001,” Covell said.

Covell also noted that 1.6 million square feet of office space was under construction in D.C. at the end of the third quarter, and 72% of that space is pre-leased. Sept. 11 altered this picture as well. Within a week of the attack, the Department of Defense had leased 1 million sq. ft. from Chicago-based Equity Office Properties Trust in the Northern Virginia suburb of Crystal City. “They may take a little more space, but this was the biggest lease,” Covell said.

Back in downtown D.C., the space outlook has begun to change as well. “Various agencies likely will expand,” Covell noted. “We anticipate as much as 200,000 sq. ft. of new office space to accommodate expansions of the FBI, the Federal Aviation Administration and the new Department of Homeland Security.”

Across the country, vacancy rates generally rose during the first half of 2001, according to Rosen of Lend Lease Rosen. “CBD office vacancy rates rose about 2%, while suburban vacancy rates have gone up 3% from historically low levels,” he said. “These figures reflect the cutbacks of the corporate recession that was in progress before the attack, especially in high technology markets.”

While office REITs surely have taken their lumps in the softening office space market, few face problems related to the technology shakeout. “REITs have been very careful not to take dot-com tenants,” Rosen said. “Consultants had been warning them that the dot-com business looked like a bubble and few office REITs have exposure to that kind of problem.”

Will the attack affect the office industry in other areas of the country? A Wall Street Journal examination of this issue concluded that displaced financial companies such as American Express and Merrill Lynch probably will not relocate their headquarters outside New York. However, the Journal suggested that units of those and other companies might find permanent locations elsewhere.

“It's too early to assess the long-term effects on where companies locate their offices,” Rosen said. “The issue is whether or not people want to be in non-descript buildings outside of major cities. I don't know the answer. But I don't think that any location is necessarily immune.”

Such uncertainty leaves the office sector in much the same position as the hotel sector: trying to weather the shock waves, hoping for the best and planning for the worst.

Mike Fickes is a Baltimore-based writer.

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