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Who's Going to Blink First?

Facing gasoline prices of more than $4 per gallon, the airlines are busy reducing their fleets of planes while budget-strapped families are parking their SUVs and sedans in their garages and leaving them there. It's hardly a promising time to be investing in hotels.

The acquisition of lodging assets has slowed to a crawl. After a record $45 billion in hotel deals in 2007, up 38% over the previous year (see chart), Jones Lang LaSalle Hotels in Chicago predicted that 2008 volume would fall off to $22 billion. But through May, researchers report less than $5 billion in transactions. With confidence in the sector now at a low ebb, the firm won't make any predictions at all.

“Our original expectations for this year proved to be overly optimistic,” says Kristina Paider, vice president of research for Jones Lang LaSalle. “There is nowhere near the liquidity in the credit markets that we had a year ago. The gap is pretty wide between what sellers are willing to sell for and buyers are willing to pay.”

Construction cranes abound

And yet, all is not doom and gloom. One hotel chain after another has been putting together fresh investment funds with an eye toward either development or acquisition. Kimpton Hotel & Restaurant Group in San Francisco raised $246 million in April and is pushing ahead with plans for new hotels in Chicago and Philadelphia slated to open in 2009 and later. The company is spending $92 million to transform Philadelphia's historic Architects Building into a Hotel Palomar.

“Net operating incomes are flat now and financing is hard to get,” says Michael Depatie, Kimpton's president and CEO. “That's a great time to pull capital together and make contrary investments. We're investing for five years from now, not for tomorrow.”

The hotel construction pipeline is holding up remarkably well. Researcher Lodging Econometrics of Portsmouth, N.H., pegs the pipeline at 5,807 hotels and 779,307 rooms, an all-time record. The firm predicts that 1,190 hotels will open in the U.S. this year, up 21% from the 2007. New openings are scheduled to rise another 30% next year to 1,545 hotels.

“Developers see the financial crisis as something that will right itself,” says Patrick Ford, president of Lodging Econometrics. “They're betting that as they go ahead and make plans to build, financing will be available.”

William Fortier, senior vice president of development for the Americas at Hilton Hotels Corp. in Beverly Hills, Calif., agrees. The company added 120 Hampton Inns last year, and expects to build 130 in 2008, most of them owned by franchisees who get their financing from local and regional banks.

“On the margins some smaller developers who are not as well capitalized may be delaying projects,” Fortier says. “But most owners have done well in the past five years and are betting that two years from now the current economic bubble will have worked itself out.”

Still, those who are building now, Fortier adds, have a sense of reduced expectations. The internal rates of return of 15% and better that were common a couple of years ago will “be cut to low double-digits and high single-digits, which is still good compared to investing your money in bonds.”

Economic pressures build

The hotel industry is running into headwinds. PKF Hospitality Research forecasts occupancies will decline and room rates will rise by 4.1% in 2008, down from 6.2% a year ago. The combination is projected to result in higher revenue per available room (RevPAR) of just 1.5% in 2008 compared with 6.2% last year. Net operating income per hotel is projected to climb 2.9% this year, anemic but far better than the 2001-2003 period. In 2001 alone, hotel profits nosedived 19%.

Over the last 20 years, the average has been an increase of 4.1%, notes Mark Woodworth, president of PKF. “So the marketplace will be soft, but not nearly as bad as what we've experienced in some past recessions.” When will recovery come? “We think things will improve in the second half of 2009, and 2010 ought to be our next normal year in lodging.“

Hans Weger, CFO of LaSalle Hotel Properties in Bethesda, Md., recently raised $250 million for new ventures, but is having trouble finding assets. “Too many sellers think they can still get 2006 valuations for their properties,” he says.

Cap rates, which were as low as 5.5% a year ago on hotel transactions, have moved closer to 6.5% today, says Weger. “Maybe they'll go to 7.5% in the next year. But I don't think we'll see the 9% cap rates again that we had 10 years ago.”

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