Hotel biz: Flying high, but headed for a soft landing?

The U.S. hotel industry has been flying high for most of 1998, but industry observers say it may be headed for a soft landing.

During the last few years, the hotel industry has experienced phenomenal new hotel construction along with more mergers and consolidations than any period in history. Occupancy levels and room rates have continued to rise, resulting in record profits for public and private hotel companies. Real estate investment trusts (REITs) have acquired new properties at a record pace.

But the scenario has changed in recent months for hotel developers, owners and investors. Public lodging companies have taken a hard hit on Wall Street, and some are scaling back development plans. Many projects are on hold because of lack of capital, says Robert Mandelbaum, the Atlanta-based director of research for PKF Consulting, a San Francisco-based hotel consulting firm.

"We are entering a period of slower growth," Mandelbaum says. "Projects that were sure things in August and September are not coming through because of the capital crunch."

The slowdown comes after five years of steady growth. For the first time since 1991, U.S. hotels in 40 major markets will experience a decline in occupancy, according to PKF's State of the Hotel Industry report. As a result of oversupply in some markets, hotel occupancies are expected to drop from 73.9% in 1997 to 72.8% in 1998, the survey says.

Of more concern is the slowdown in growth of room rates, which have risen along with profits since 1994. Room rates, while projected to rise faster than inflation in 1998 and 1999, are projected to rise at a rate less than inflation in several hotel segments. The slower rate increases are expected to affect hotel profits.

To be sure, the rate of growth in room rates is still 50% higher than it was in 1990. Rates and profits have been growing at an extraordinary pace but are now expected to continue at a normal rate, according to Mandelbaum.

"We are entering a period of normal growth," he says. "The industry shouldn't think that the growth we saw in 1995 through 1998 is standard."

The lodging industry may not be the only industry to experience a slowdown in development, nor are its public companies the only ones to take a hit in recent months. But the industry is usually one of the first hit when an economic downturn occurs and suffers immediate results, according to Len Wolman, chairman and chief executive officer of Waterford Hotel Group Inc., based in Waterford, Conn. Unlike retail or apartments, which rely on leases, hotels rely on daily check-ins and check-outs, he says.

"If a guest doesn't stay in a hotel, it loses income immediately," Wolman says. "Guest rooms are the most perishable income you have. If you don't use it today, it's gone."

Although Wolman doesn't expect a slowdown in development or a decline in occupancies to lead to turmoil, his company is positioned to thrive during slow growth periods and recessions. During the last downturn, Waterford helped manage hotel assets that had been taken back by banks.

If the slowdown continues and a downturn occurs, he says the company would step in to help with divestitures and management. It would also consider the possibility of forming financial alliances with other companies.

"We've built foundations and positioned ourselves for a downturn," Wolman says. "I wouldn't predict gloom and doom, but it could be a tough period when everyone has to focus on operations and generating the best cashflow they can."

Wolman says that Waterford's profits are up this year over last year, and he expects the trend to continue. The company is beefing up its operations staff to prepare the company to grow through management contracts and acquisitions.

Acquisition plans slow as well Meanwhile, other companies are slowing plans for acquisitions. The industry has been in an acquisition mode that has changed the face of the industry over the last few years. In fact, lodging industry observers agree that the industry is coming out of the biggest period for mergers and acquisitions, fueled by the desire to establish global brand names to appeal to travelers.

During the first quarter of 1998, mergers and acquisitions totaled $32.2 billion, according to the Lodging Research Network, PricewaterhouseCoopers' Internet-based resource for data and information. That's more than three times the $8.9 billion that occurred in all of 1997.

Among the significant hotel mergers and acquisitions announced or completed in late 1997 and early 1998 were: Promus Hotel Corp.'s merger with Doubletree; franchising giant HFS Inc. and CUC International's merge into Cendant Corp.; the merger of FelCor Suites and Bristol Hotel Co.; CapStar Hotel Co. and American General Hospitality's merge into MeriStar Hospitality Corp.; Patriot American Hospitality acquisition of Arcadian International, Interstate Hotels, Summerfield Hotel Corp. and Wyndam Hotel Corp.; and Starwood Hotels & Resorts Worldwide's acquisition of Westin Hotels & Resorts and ITT Sheraton.

CapStar Hotel Co. and American General Hospitality was a first for the industry in which a C Corp. and a REIT formed a formal alliance, according to Bjorn Hanson, the New York-based chairman of the PricewaterhouseCoopers LLP's lodging and gaming group. Each company had benefited from its independence when others were consolidating, and then the two decided to form their own union.

In addition, the MeriStar merger set a standard in the industry by forming a paperclip REIT, which is a REIT where two organizations are joined through an intercompany agreement and share certain senior members of management.

All have not been perfect marriages, though. The $4.7 billion merger of Promus and Doubletree, which was billed as a union of equals, has been rocky. A handful of top executives left after conflict between executives at the top. After the $11 billion Cendant merger, accounting irregularities in the former CUC triggered a drop in the company's stock price and concern from industry observers and analysts.

One merger announced earlier even fell through. The union between Memphis, Tenn.-based RFS Hotel Investors and Equity Inns fell apart partly because the stock price fell too low before the proposed merger.

Despite furious consolidation this year, frequency of mergers and acquisitions is expected to slow during 1999, according to Hanson. Smaller companies may merge with stronger companies to gain more marketing power and to stay afloat. Hanson refers to these mergers as "survival mergers."

There may also be some stock-for-stock mergers in the near future, according to a report from PricewaterhouseCoopers. And for companies with available cash, stock buybacks are possible, the report says.

Since share prices for public companies are down 50% since August, says Dana Ciraldo of Hodges Ward Elliott, they're finding that buying their own shares is better than buying other properties.

However, mergers are likely to cool off because the stock prices of public lodging companies have plummeted in recent months. The inability to use stock as currency will significantly reduce the amount of merger and acquisition activity, Hanson says.

Hotel stocks have fallen more than the market as a whole because prospects for growth and acquisition are minimal, according to Frank Nardozza, a partner and national hospitality industry director based in Miami and New York for KPMG Peat Marwick.

"Mergers could be problematic because the stock prices of lodging companies are not necessarily the appropriate value of the company," Nardozza says. "Many lodging stocks are trading below their net asset values."

The alternative: going private With their stock prices and price-to-earnings ratios of public lodging companies falling, many hotel companies may consider going private, industry observers agree. The C Corps. and REITs, which have been the most active bidders for hotel assets in recent years, will have to be more selective because of less access to capital.

During the last two years, the majority of mergers and acquisitions have been accomplished with public capital. There have also been a substantial number of initial public offerings (IPOs) of lodging companies.

But since stock prices of public C Corps. and REITs have tumbled and opportunities for IPOs have dwindled, more opportunities have been created for private capital.

Private groups with significant cashflow like Blackstone, Whitehall Street Real Estate Limited and Northstar Capital Investment Corp. could consider buying hotels and portfolios, Nardozza says. Low stock prices of public lodging companies have created an opportunity for private companies or investment funds to acquire companies and assets at a significant discount, he adds. Shareholders win, too, by receiving a premium over current share prices.

PricewaterhouseCoopers' Hanson explains, "If the share price of a company is $10 dollars, and the value of a company is $20, if an outside investor offers shareholders $13, the shareholders get a 30% premium, and the management company is getting a $20 company for $13 per share."

Already, some private companies are beginning to purchase separate assets and will likely make bids for whole portfolios while prices are low, Hanson says.

The most significant drop in price for individual hotels will likely be in the limited-service sector, according to the PricewaterhouseCoopers report. Full-service and luxury hotels are not as likely to experience such substantial price reductions, the report says.

Companies that have merged with other companies unsuccessfully are included in the mix of companies that are likely to go private in the next few quarters, Hanson says. These companies are struggling to generate profits partly because they may have paid too much, he adds.

"When everyone was wrapped up in growth, a merger made sense," Hanson says. "Now it doesn't make sense."

Some public companies have already reached a point where opportunistic private funds are considering taking public companies over, says Bill Hodges, a principal with Hodges Ward Elliott.

"We hear about meaningful conversations companies have had where they have considered going private," Hodges says. "Public companies whose stock prices have not declined are in a good position to buy hotel assets from companies willing to sell."

And although talk of big mergers has quieted considerably and companies struggle to find financing, the situation is likely to be short-lived, Hodges says.

"Once the current inventory and loans are ingested, the investment firms and banks that pulled out of late will be back in the market," Hodges says. "(Mergers and acquisitions) activity will pick up in 23 or 36 months."

But meanwhile, some say companies may find debt and equity hard to come by. Tom McConnell, senior managing director of Insignia/ESG Hotel Partners says the current situation is different from the way it has been in recent years: Debt is increasingly hard to find, while equity is available if you look hard enough.

"Anyone lending now would rather do something less risky," McConnell says. "And debt is the catalyst that greases the industry and keeps it running."

McConnell expects the market to respond to the lack of public capital with more traditional lending. He anticipates that traditional banks will rule the market for the next three quarters.

Banks like Wells Fargo are more likely to lend to lodging companies than First Boston and Capital America, he says. Capital America, Japan's biggest broker, has suffered losses related to the yen, and it has cut its staff and closed many offices.

"The banks are back in the driver's seat," McConnell says.

More than 150 industry experts to speak at UCLA's Hotel Industry Investment Conference The UCLA Extension's 14th Annual Hotel Industry Investment Conference, January 12-14, at the Century Plaza and Tower in Los Angeles will feature more than 150 chairmen, presidents and CEOs of major hotel companies and financial institutions leading the 35 panels, workshops and general sessions.

The general theme of next year's conference focuses on business strategies in the new millennium. Sessions include "The Un-Hotel - Unique Lodging Experiences for the 21st Century," presented by Lou Dobbs of CNN's Moneyline Newshour; "The Outlook from the Top ... Hotel Leaders Speak," featuring several leading industry executives; and "A Hospitality Industry Success Story - Starbucks," presented by Starbucks Coffee Co.'s president and CEO, Howard Schultz.

Special events at this year's conference include the presentation of the "Lifetime Achievement Award" to Jay Pritzker and his family, the founders and owners of Hyatt Hotels. The International Society of Hospitality Consultants' Pioneer Award will also be awarded.

Other companies featuring speakers at the conference include AIG Group, Credit Suisse First Boston, BT Alex. Brown, Morgan Stanley Mortgage Co., GMAC Commercial Mortgage, ORIX USA Corp., Arbor International, Finova Realty Capital and Merrill Lynch & Co.

UCLA Extension's Third Annual Latin America & Caribbean Hotel & Tourism Investment Forum precedes the conference Jan. 11-12 at the same location.

For more information, call UCLA Extension's Real Estate Center at the Department of Business & Management, 310/825-9971 or 818/784-7006; by fax, 310/206-3223; or by e-mail, [email protected]

McConnell says part of the problem with public capital is that many of the REITs may have paid too much for properties. "During the last few years, REITs were outbidding private companies by up to 15%," he says. "Now the equity of private companies such as Hyatt and Radisson remains the same, while stock in many lodging REITs such as Hilton Hotel Corp. have fallen up to 50% or 60%."

Arthur Adler, managing director for Sonnenblick-Goldman Co.'s lodging and leisure group, expects debt lenders to lend aggressively once the market stabilizes. The decline of public money creates opportunities for players that have been watching on the sidelines, Adler says.

However, some private equity funds are waiting to see if pricing goes down further before stepping in. He predicts that capital will be freed up by the first quarter of next year.

"Public markets are a double-edged sword," Adler says. "When there is a cloud on the horizon, they react quickly. Before, institutional capital wasn't as quick to turn the spigot off."

And although financing is hard to come by lately, the industry is likely to emerge from a slow-growth period into a more advantageous position. The industry is more regulated now and less likely to experience overbuilding, Adler says.

1998 Hotel Occupancy Outlook * Hotel occupancies expected to drop from 73.9% in 1997 to 72.8% in 1998.

* Nearly half of the 40 major markets surveyed by the firm is expected to experience occupancy decline in both 1998 and 1999.

* Cities that are expected to have the greatest drop in occupancies:


Salt Lake City

Nashville, Tenn.

Colorado Springs, Colo.

Austin, Texas

* Cities expected to experience occupancy increases:

San Antonio

Portland, Ore.

San Diego


Source: PKF Consulting

Looking at the bright side Meanwhile, a slowdown in new hotel construction likely will force REITs, which have pleased Wall Street in the past by acquiring new properties, to concentrate on operations, PricewaterhouseCoopers' Hanson says.

"Companies can cut expenses by reducing spending on capital improvements and advertising, looking to other departments for revenue such as food and beverage, and charging fees for guests to use banquet rooms," he explains.

In fact, construction is already beginning to slow, giving markets in danger of being overbuilt a chance to breathe. Companies such as Extended Stay America and Prime Hospitality Corp., which were in expansion modes earlier this year, have postponed some of their planned developments. Other companies are struggling to find financing for projects already in the pipeline.

The slowdown is so evident that PricewaterhouseCoopers amended its projections for new room starts in October. The firm is predicting a 23% drop in new hotel rooms, a steeper decline than the firm's projection of 26% earlier this year. The company expects that 113,700 rooms will be started in 1999, down from its original projection of 147,000.

The company also revised its projections for the year 2000 from a 25% drop to a 35% drop, or 96,000 new room starts.

The number of hotel rooms that have opened in recent years has risen sharply partly because of the trend toward extended-stay and limited-service hotels, which are easier to build. These extended-stay properties cater to workers on location or other transients who plan to stay for a week or longer.

Although some markets are oversaturated with these properties and limited-service hotels, they are likely do well during a downturn because their profit margins are much higher than full-service hotels, research shows. In addition, upscale properties are more likely to suffer as business travelers scale down to cut expenses.

Slowdown could help in the long run In the long term, less development could benefit the lodging industry, observers say. The reductions in hotel supply could ease occupancy declines and temper the slowing growth of room rates, according to PKF Consulting.

Supply has been outpacing demand in the hotel industry since 1996. This year, demand is expected to grow by 2.8%, while supply is expected to rise 3. 8%, according to Smith Travel Research in Hendersonville, Tenn. During 1999, th e margin is expected to widen to 2.6% growth in demand and 3.9% supply.

Although supply may not be outpacing demand in every market, nearly half of the 40 major markets that PKF surveyed are expected to experience an occupancy decline in both 1998 and 1999.

Philadelphia, Colorado Springs, Colo., Austin, Texas, Salt Lake City, Dallas/Fort Worth, Orlando, Fla., and Nashville, Tenn., are expected to have the greatest decline in occupancy, while Portland, Ore., San Antonio, San Diego and Boston could see occupancy increases, according to PKF Consulting.

Urban markets have escaped a decline in occupancy, according to PKF's Mandelbaum, because they are insulated from competition from new hotels. The lack of new hotel growth often boosts profits for existing hotels. And in some markets, it even makes sense to build a new hotel, Mandelbaum says.

But even though growth is slowing and occupancies are falling, hotel owners and operators may still have high levels of profitability, according to PricewaterhouseCoopers' Hanson. Through research, Hanson found that break-even levels are considerably lower than they were in the late 1980s. The break-even level dropped from 63% in 1993 to 55% today, after dropping only three percentage points between 1980 and 1993, he says.

"In 1987, the lodging industry had 86 employees for every 100 rooms, and now there are 74 employees for every 100 because of greater limited-service, employee empowerment and technology," Hanson says.

Supply and new competition have also affected room rates, but not as much as occupancy. Room rates grew at a rate less than inflation during the downturn between 1989 and 1993, but they have outpaced inflation since 1994. PKF Consulting estimates that room rates will be up 6.8% to $112.96 in 1998, compared with $105.75 in 1997. Rates are only expected to increase 4.9% to reach $118.52 in 1999, according to PKF.

In the past, markets with declining occupancy rates were able to counter their declines with strong room rate growth, according to Mandelbaum. But eventually, decline in growth of room rates, coupled with declining occupancies, could mean lower profits for hotels, he warns.

During the last few years, the ability to raise room rates has resulted in double digit profits. Despite a .3% decline in occupancy, a 7.4% increase in average room rates allowed for a 13.2% growth in operating profits, according to PKF.

The average daily room rate has increased the most in the Northeast, at 9.8% in 1998, and the least in the south central area of the country, at 3.5%. The markets projected to have the least growth in room rates are Colorado Springs, Baton Rouge, La., Philadelphia, Dallas/Fort Worth and Tucson, Ariz.

Mandelbaum notes that a slowdown in the growth of room rates does not necessarily mean consumers will find bargain hotel rates. Hotels will continue to raise rates during peak times for travel, the PKF report says. Yield management systems and revenue management systems will keep rates up.

Growth in revenue per available room has also slowed since peaking at 9% in 1995. This year, revenue per available room is expected to grow at a rate of only 5.3% in 1998 and 4.2% in 1999. Total revenues per room are expected to reach $42,284 in 1998 and $43,975 in 1999, according to PKF.

PricewaterhouseCoopers projects that profits will increase by slightly less than 10% next year.

"That's really impressive, but three years ago it was 35%," Hanson says.

Last year, industry earnings hit $17 billion, according to Smith Travel Research. This year, the number is expected to reach $22 billion. That number could change, depending on development and the economy, observers say.

Staring in the face of recession Rates and revenues could be in danger if a slowdown in the industry couples with an economic recession, which could throw projections off. Compounded with an oversupply of hotel rooms, it could mean turmoil for the industry, PKF's Mandelbaum says.

The economy affects the industry more than overdevelopment. If corporate executives and vacationers quit traveling, occupancies take a dive. If the market is overbuilt, the effect on profits is compounded.

If corporate executives and vacationers reduce travel, the oversupply of hotel rooms combined with travelers' intolerance for higher room rates could prompt rate reductions, according to PKF.

Most industry observers don't anticipate a recession, but many are somewhat prepared if it comes. And many believe the industry is better equipped to handle a downturn or recession than it was in the late 1980s. Property types and locations are more diverse than they were then, and the landscape of the industry has changed, Mandelbaum says.

"Most markets have absorbed supply, and the fundamentals of development are stronger," PKF's Mandelbaum says. "The industry does not have tremendous debt to cover, nor does it have profit pressures. If there is a slowdown, we'll see a healthy industry, not one that is fabulously growing."

During the late 1980s and early 1990s, the Gulf War, high fuel prices and increased operating expenses compounded with the oversupply of hotel rooms created bleak business. This time around, industry observers think it will take more than an overbuilt market to drag the industry down.

Bobby Bowers, president of Smith Travel Research, says the fluctuations in supply and demand are all part of a cycle and that the industry is nowhere near where it was in the late 1980s and early 1990s.

"We are continuing to see pretty good profits because the industry has restructured in a way," Bowers says. "Hotels then were relying on debt refinancing, and now more are publicly held and debt has been financed at better rates."

Mike Leven, president and CEO of U.S. Franchise Systems in Atlanta agrees. "I think it has got a long time to run until it hits the wall," Leven says. "A recession would deteriorate profitability, but because of the financial underpinnings, (the industry) should be able to withstand a recovery. Our rate base is high enough that when occupancy drops, we're still going to see a profitable business."

Lodging company executives are observing the world economy closely and watching for additional problems that could have a psychological impact on the industry.

But an industry slowdown can be broken down to both location and segment when considering how much a property could suffer. Hotels, which base business on group meetings, are not likely to be seriously affected during a slow time, says Bob Sales, president of Tishman Realty Corp.

During the last recession, the company kept solid profits because people were canceling leisure trips, not group meetings, he says. Despite worries about the industry, business at Tishman is strong, while publicly held competitors are putting development plans on hold, he says.

"I think 1998 has seen the largest number of hotels built since the mid-1980s," Sales says. "A lot of that is because the limited-service hotels are easier to build. We haven't seen as much development on our end in four-star and convention hotels."

While Sales has seen some meeting planners and companies cutting back expenses, the company has booked meetings as usual for 2000 and 2001. "In terms of group bookings, we haven't seen adverse effects," he says.

The company has felt the effects of a slowdown in its attempt to finance the nearly $300 million E Walk hotel on 42nd and 8th streets in New York. The hotel is part of a mixed-used complex, which will include entertainment venues and retail space. Tishman plans to begin construction on the hotel in 1999 and is slated for completion in 2001.

"Less people are interested in securing construction," Sales says. "People are just nervous about how deep that market is based on risk aversion."

USFS's Leven says the fundamentals of the industry are strong, and he anticipates few problems with new development. While signs of a slowdown are apparent in the midscale sector, his economy hotels have not been affected, he says.

"It's a healthy industry, but I wouldn't call it a dynamic growth industry," Leven says.

Leven adds that construction may take longer, but he is selling the same number of Microtel Inns and Suites and Hawthorn Suites. Financing is not difficult to secure because the company deals with small lenders, he says.

But Leven, who has more than 37 years of experience in the industry, most recently as head of Holiday Inn Worldwide (now Bass Hotels & Resorts), prepared USFS for harder times with the recent acquisition of franchise rights to Best Inns & Suites.

Unlike the company's Microtel and Hawthorn brands, which are new-builds, franchisees convert older hotels to the Best brand. The company has experienced incredible growth with new Microtel franchises, but if hard times hit, conversions make more sense than new-builds, Leven says.

In general converting an existing hotel is quicker than new construction, which can speed up the time between signing a franchise agreement and when the hotel begins paying royalty fees.

"It was a strategic decision on our part," Leven says. "You have to change your strategy when the landscape begins to change."

In addition, USFS is using the Internet for distribution and marketing, which is somewhat uncommon in the budget hotel segment. Leven hopes the Internet will boost efficiency, which will help overall operations.

"What people have seen now is that when Wall Street is in love with you, you can do no wrong," Leven says. "When they're not, you can do no right. It's not easy for everyone to be successful. When the going gets tough, the cream rises to the top."

Other companies are preparing for a downcycle in the United States with across-the-border acquisitions. Opportunities cross-border are huge, says HWE's Ciraldo, who calls emerging markets a contrarian play.

"People forgot that why you put real estate in your portfolio is to be countercyclical," he adds. Since European stock markets are highly connected to the United States, he suggests that investors diversify two ways by investing in real estate - not stocks - in emerging markets.

Although HWE is taking steps to expand operations into the Pacific Rim, Ciraldo says, not a lot of Asian owners are willing yet to admit they need to sell. Until that happens, he says, the best emerging market is Latin America. In particular, Ciraldo points to Mexico, which, since the peso crisis in 1994, has done everything the IMF asked. "The effects are just now starting to hit," he adds. "Mexico paid the price; now it's ready to skyrocket."

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