Lesser

One year has passed since the beginning of an economic downturn that many thought would be over by now. Recent US Federal Reserve actions and continued negative news flow--about financial institutions around the globe--indicate that tight credit conditions and an illiquid market will persist into 2009. It is yet to be determined how deeply the rest of the world will be impacted by the slowing US economy. The good news is that bad news cannot last forever and an upturn is inevitable, it is just a matter of when.

INDUSTRY QUICK LINKS Get Listed

Generally speaking, in spite of capital market constraints, operating fundamentals of commercial real estate in the US remain fairly strong. While experiencing a 2.5% decline in occupancy during the first half of 2008, the US hotel market has simultaneously achieved a 4.2% increase in average rate, resulting in relatively modest growth of 1.5% in Revenue Per Available Room (REVPAR). Not bad given all the doom and gloom one hears and reads about these days. It is important to remember that for the U.S. hotel industry, any near term negative economic effects that may occur, will transpire against a backdrop of the record U.S. hotel revenues and record profits that occurred during 2007.

The CB Richard Ellis Valuation & Advisory Services Hospitality & Gaming Group continuously monitors the major US hotel sale transaction market. CBRE's quarterly Major US Hotel Sales survey reports single asset sale transactions above $10 million that are not part of a portfolio allocation.

Interesting observations from my Q2 (Mid Year) 2008 survey compared to the first half of 2007 include:

• 40 US hotel trades of $10 million or more occurred during the first half of 2008 compared with 52 during the same time in 2007. Capital market constraints are the clear cause of this approximate 25% decline in significant US hotel transactions;
• The average size hotel that traded in the Q2 2008 survey was roughly 240 rooms, with an average transaction price of approximately $44 million and an average price per room of nearly $185,000. In comparison, the average size hotel sale in the Q2 2007 survey was roughly 370 rooms, with an average transaction price of approximately $100 million and an average price per room of almost $265,000. Capital market restrictions have changed the complexion of US hotel asset sales. Relatively small hotel deals are getting completed, while the industry’s ability to structure larger institutional grade hotel sale transactions has been limited. Further evidence of the change in the US hotel sale transaction market is illustrated by the following:
  • Of the 40 Q2 2008 trades, 3 transaction were for greater than $100 million, compared with 14 $100-million deals that were consummated during Q2 2007;
  • 7 Q2 2008 US hotel sales transacted between $50 million and $100 million, compared with 14 that were structured during Q2 2007;
  • 17 Q2 2008 deals occurred for between $20 million and $50 million, compared with 20 sales that were arranged during Q2 2007;
  • 13 Q2 2008 trades were for between $10 million to $20 million, compared with 4 sales that were negotiated during Q2 2007.
• Apple REITS, a series of public non listed REITS focused on the ownership of upscale, extended-stay and select-service hotels, continues to dominate the current field of purchasers in the survey with 10 acquisitions--roughly 25% of the total--during the first half of 2008.

During the past decade hotel investments have evolved into mainstream assets that have provided premium risk adjusted returns. As long as this yield gap exists compared with other forms of real estate, hotels will continue to attract a wide array of investors. Lifecycle hotel investors who operate narrowly, but deeply, within the sector will be able to take advantage of arbitrage opportunities. Sponsors with a long term focus on the always evolving hotel sector know how to make money during both expansions and downturns.

Sophisticated lodging investors are currently considering the following:

• The lodging business has historically lagged the overall US economy by several quarters, thus the industry’s recent slow growth may turn negative prior to the ultimate cycle rebound;
• The US hotel industry’s expense structure presents challenges as labor, energy, and the cost of goods and commodities are all rising at fairly rapid rates. Thus far, the industry has generally been unwilling to lower room rates, however this position may weaken as economic conditions begin to weigh more heavily on business travel which generally drives lodging profitability. Upcoming corporate rate renegotiations and the prospect of group/convention attrition will challenge the sector in the near term;
• Generally, the US lodging industry has a favorable supply/demand relationship. Demand for hotel rooms is highly susceptible to sudden rapid change due to outside forces, including terrorism, which is clearly at the top of the risk spectrum, followed by geo-political issues in various unstable regions of the world--including the Middle East. In addition, the air lift capacity of many markets has recently been downgraded as the airline industry has reacted to the rapid dramatic rise in fuel and other operating costs, by pruning and in some cases eliminating unprofitable operations;
• For hotel lenders, the quality of deal sponsorship is now paramount. Today, an investor’s track record of performance in the highly specialized lodging sector during past recessionary periods is being scrutinized, not just achievements within a buoyant environment. The days of a good deal getting done with a marginal sponsor are over for now;
• Although attractive to global investors, commercial real estate assets, hotels in particular, are neighborhood type businesses that are affected by local market conditions. For example, the economics of a hotel investment in New York City are dramatically different than one in Phoenix, AZ. Furthermore, within a major market such as Chicago, the economics of a hotel investment at the O’Hare International Airport submarket are very different than one located in the heart of downtown. Further to the point, in spite of today’s difficult economic environment, many tertiary markets which historically have been under supplied with hotel rooms are ripe for development of small niche lodging projects which today are being financed by local community banks.

All is not doom and gloom if one considers that during the early 1970’s, economic output was declining and today, despite current sluggishness, GDP is still inching ahead. The present national unemployment rate of roughly 5.5% is half of the near 11% experienced during the early 1980’s. Finally, inflation which topped 12% during the 1970’s and 14% in the early 1980’s is currently around 4%. Today, there clearly exists a negative psychology that is a drag on otherwise sound fundamentals. While business may be perceived as difficult in the current environment, it could be much worse and has been during prior downturns. This suggests a positive future for the hotel industry during the next upturn in the cycle.

Daniel Lesser is a specialist in real estate appraisals, economic feasibility evaluations, investment counseling, and transactional services of hotels, resorts, conference centers, casinos, and timeshare properties on a worldwide basis. He currently serves as the Senior Managing Director-Industry Leader of the Hospitality & Gaming Group at CB Richard Ellis (CBRE).

The views expressed in this article are the author's own.