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The Upside of Upscale Hotels

The upscale segment of the lodging industry has earned bragging rights. It is the shining star in the eyes of hotel investors as 2006 begins, and for good reason: key measures of performance continue to rise, and supply is in check. What's more, the favorable investment climate for high-end hotels is expected to last for at least two years, say industry experts.

The upscale segment received a major vote of confidence from Emerging Trends 2006, an annual survey of about 400 industry professionals released late last fall by PricewaterhouseCoopers and the Urban Land Institute: “Investors hungry for alpha upside predict more revenue growth from upscale lodging categories than any other property sector,” the report notes. It's the first time in the 27-year history of the survey that any segment of the hotel industry was rated as the top prospect for investment among real estate property categories.

Smith Travel Research reports that revenue per available room (RevPAR) — the key measure of hotel performance — in both the luxury and upper-upscale segments increased an estimated 14% to 16% in November 2005 compared with November 2004. By this measure, the two segments are slightly ahead of the hotel industry as a whole, which boosted RevPAR 13% to 15% during the same period.

Annual average occupancy also has been climbing steadily since hitting a low in 2001. Through the first 10 months of 2005, according to Hendersonville, Tenn.-based Smith Travel Research, luxury hotels averaged 71.6% occupancy, up from 69.2% during the same period in 2004. In the upper-upscale category, average occupancies increased from 70.9% to 71.6% during the same time frame.

There are a dozen or so major brands in the top two niches. Four Seasons, InterContinental and Ritz-Carlton are among the most dominant in the luxury segment, while Marriott, Hilton and Hyatt are leaders of the upper-upscale segment.

The business and leisure travelers who support these segments are back in greater numbers because the economy has improved and travel fears are fading. “The underlying fundamentals of the economy driving RevPAR and occupancy growth are household wealth and business income, both of which have been expanding in recent years,” says Ray Torto, principal and chief strategist at Torto Wheaton Research.

According to, corporate profits and household wealth have been consistently increasing each quarter on a year-over-year basis since the first and second quarter of 2003, respectively. “Historically, there's a strong correlation between increased income and increased RevPAR, especially for luxury and upscale brands, and we're definitely seeing it again,” says Torto.

Barriers to luxury

But it's more than just recent RevPAR or occupancy growth whetting investor appetite. “Investors see the strong fundamentals, and believe there's going to be a disproportionate increase in profits in the top segments for the foreseeable future,” says Kevin Mallory, senior managing director and U.S. practice leader for CB Richard Ellis Hotels. “It isn't too hard to convince yourself that there will be significant revenue growth over the next three to five years.”

Not only are the prospects for revenue growth encouraging, but limits to new supply also beckon. “Owners don't have to worry about too much [upscale] property coming into the market anytime soon, because barriers to entry are so high,” says Steve Rushmore, president of New York-based HVS International.

In 2005, the total supply of rooms in the luxury segment increased by 654 rooms, or only about 0.8% of the total inventory of 76,730 rooms existing at the beginning of the year, according to Portsmouth, N.H.-based Lodging Econometrics. The growth in 2004 was a little bigger, coming in at less than 1%.

“It's simply difficult to find good sites,” Mallory notes, especially in larger markets. “A hotel is going to compete in a lot of cases with residential development, and residential developers have, for now, a better hand. The demand for condos is still strong enough that they're able to pay more for the sites than a hotel developer, and financing is easier because you can borrow against your sales,” adds Mallory.

Clyde Guinn, senior vice president at San Francisco-based hotel developer and manager Stanford Hotels Group, says that hesitancy among lenders to finance new upscale and luxury hotel projects has been a key factor in restraining development, and he anticipates continued reluctance on their part.

“Without condos or a timeshare element, even in second-tier markets, you can't sell a luxury hotel development project to a bank,” Guinn says. “Bankers remember the days of the RTC [Resolution Trust Corporation]. Some of them were out of work during that time, but now they sit on loan committees. There will be some development, of course, but the cycle of overbuilding has abated.”

Still, not everyone is convinced that the barriers will impede development significantly on a national scale. Patrick Ford, president of Lodging Econometrics, all but dismisses barriers to entry as a critical factor. “The barriers are always there,” he insists. “Developers are skilled at overcoming those.”

Debt financing is available, but in many cases developers must put between 30% and 40% equity into a hotel deal, says Elliot Eichner, co-founder and principal of Sonnenblick-Eichner Co., a Los Angeles-based real estate investment banking firm specializing in commercial real estate, including luxury hotels. “Not only that, construction costs are 15% to 20% higher than a year ago.”

Buying frenzy

Amid rising development costs, investors can still buy top hotels more cheaply than they can be built. Indeed, domestic hotel sales in the luxury and upscale segments totaled $9.1 billion in the first 11 months of 2005, compared with sales of $5.1 billion for all of 2004, according to Real Capital Analytics. That's roughly an 80% increase even before end-of-year figures are tallied.

Eichner is adamant that top-tier hotels are trading nowhere near replacement cost. “I have not seen one deal that has come close to replacement cost, not one,” he emphasizes. “And I don't anticipate that happening in the near future, or even the not-so-near future.”

Rushmore of HVS International agrees. “There's no doubt that upper-segment hotels cannot be replaced at the price at which you can buy them.”

In an urban environment, a luxury hotel might cost $350,000 to $500,000 per room to build, Mallory says, “assuming you can compete for the land and raise the required capital.” That price compares to the average sale price of $207,000 per room in the luxury segment during the first 11 months of 2005, based on data from Real Capital Analytics.

Modest growth in supply

While there isn't exactly a torrent of new development just yet in the upscale and luxury segments, new product is in the construction pipeline. According to Lodging Econometrics, nationwide five luxury hotels totaling 1,238 rooms will open in 2006, and 12 properties totalling 2,294 rooms will open in 2007.

Moreover, 18 other projects are being actively pursued by developers, representing another 6,159 rooms that might come on line in 2008 or later.

The upper-upscale segment shows a similar rise in new openings. There are currently 50 hotels under construction in the upper-upscale sector, while 42 will start in the next 12 months, and another 25 are in the early planning stages.

Case of déjà vu

Ford doesn't believe that the cycle of hotel development has changed in any fundamental way since the 1990s. Increasing numbers of luxury and upper-upscale hotels are now entering the pipeline after the initial years of an economic recovery, just as they did back then.

“In the early years of the 1990s cycle, limited-service properties were built because they require less investment, have fewer barriers to entry and don't take as long,” says Ford of Lodging Econometrics.

“Then luxury and upscale development accelerated at the later years of the cycle,” Ford adds, resulting in several hotel openings in those segments during the tough years after 2001. But Ford stops short of predicting that a glut of top-tier rooms is only a matter of time.

Big-ticket transactions

Hardly a week went by toward the end of 2005 without word of another upper-tier hotel trading hands — a frenetic pace sustained throughout the year in both larger and smaller markets.

In November, for example, Bethesda, Md.-based DiamondRock Hospitality Co. entered into an agreement to acquire the Orlando Airport Marriott Hotel for about $70 million; Norwalk, Conn.-based HEI Hospitality bought the Sheraton Hotel-Ft. Lauderdale Airport from Starwood Hotels & Resorts for nearly $32 million; and Arlington, Va.-based Interstate Hotels & Resorts acquired the 195-room Hilton Durham near Duke University for about $13.3 million from MeriStar Hospitality Corp.

Clark Hanrattie, senior vice president and the chief investment officer of HEI, says the Ft. Lauderdale acquisition keeps the company on track to invest $400 million to $500 million in mostly upper-tier properties per year, a pace it established in 2003. “It's also the kind of acquisition that we look for, an airport property in a fast-growing destination city, including both tourist and convention arrivals,” he says.

“Overall, it's a compelling time to be investing in the hotel sector,” Hanrattie continues. “We continue to look for acquisition opportunities that we believe will achieve our minimum return objectives of 20% adjusted for the specific risk profile of each deal.”

Supply-demand fundamentals are critical to HEI's strategy, says Hanrattie. “With supply growth near historical lows and demand rebounding, we anticipate that at least the next two to three years will be a good time to acquire luxury and upper-upscale hotel properties,” Hanrattie says, even though there will continue to be upward pressure on pricing driven by a large inflow of capital.

“The increased competition has caused us to become more selective in what we pursue,” Hanrattie continues, “and more aggressive when we find one that meets our investment criteria.”

With so much capital chasing hotel properties, the loan terms for borrowers have become more attractive. “Hotels — and that includes the top segments especially — have now evolved into a favored class in real estate, and its financing isn't going to be so different from other kinds of real estate,” says Eichner of Sonnenblick-Eichner Co.

The acquirer of a shopping center today could reasonably expect to obtain a 10-year, fixed-rate loan at an interest rate ranging from 95 to 105 basis points over the 10-year Treasury yield. The interest rate on a 10-year loan for a luxury hotel might be approximately 115 basis points over the 10-year Treasury yield.

“If you have any longevity in this business, you'd think, ‘My God, only a 10 basis-point difference between retail and a hotel?’” Eichner says. “The reason is that the hotel business is good, and most individual properties have a positive trend line.”

Dees Stribling is a Chicago writer.

Hotel Openings Total Rooms
2003 11 2,915
2004 3 949
2005 4 654
2006* 5 1,238
2007* 12 2,294
Source: Lodging Econometrics

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