Lodging Market Looks Ahead

There's a positive buzz in the hospitality sector as we begin 2005. Our firm's hospitality practice recently produced a report on 10 key issues facing the industry in 2005. Here are some of the reasons, culled from that report, that indicate optimism for the sector in the coming years. Here are some highlights.

Capital Markets. According to a recent report issued by Principal Real Estate Investors, Real Estate Research Corp. and Torto Wheaton, unleveraged average annual returns for full-service hotels are anticipated to exceed 13% over the next 10 years, with real estate-investment alternatives performing at single-digit growth rates (7% to 9%).

Annual lodging returns are anticipated to be greater than for other real estate asset types, and real estate investors appear to be showing more interest in this sector. Even private companies, such as Strategic Hotel capital, Sunstone and Eagle Hospitality are raising funds in the public capital markets. Meanwhile, public companies raised more than $1 billion in secondary equity offerings in 2004, and issuance of commercial mortgage-backed securities for hotels jumped 60% from September 2003 to September 2004. Looking ahead, a relatively low interest-rate environment, coupled with continued improvement in operating trends, should fuel strong activity over the next 12 months.

Lodging Fundamentals. Continuing improvement in lodging fundamentals also continues to provide support to large publicly traded lodging-company valuations, further enhancing investor perceptions. In 2004, the majority of the publicly traded lodging companies outperformed the overall market, and the S&P 500 index (as of November 30, 2004 ) saw a slight 1.4% increase during the year. Comparatively, among the larger C-corp. lodging companies, the average price appreciation was approximately 23% driven by improving RevPAR performance and a favorable supply-and-demand imbalance that is expected to continue for some time. Similarly, the four largest lodging REITs experienced an average price appreciation of 22% during the year. Looking ahead, price appreciation on such a scale may be hard to accomplish this year. Nevertheless, most analysts continue to view the sector favorably.

Supply & Demand. Supply growth increased as much as 4% annually from 1997 through 2000, followed by a sequential slowdown in subsequent years to reach cyclically low levels of 1.3% growth in 2003 and an estimated 1.1% growth in 2004. Given severe performance declines from 2001 to 2003, the financial markets have been strict in terms of funding new projects, and development activity remains at historically low levels. Currently, the pipeline of new lodging supply for 2005 and 2006 remains in check, and further improvement in lodging operating performance should continue for the coming years.

New Development. As the economics of real estate finance continue to evolve, driven by changing demographics, psychographics and investment preferences, the trend toward hybrid real estate investments continues to gain popularity with both developers and owners. For developers, the mixed-use concept offers financing structures often unavailable to pure-play lodging developments. In addition, now more than ever, investors looking for real estate opportunities may consider mixed-use lodging developments that include residential, retail and more significant recreational components such as spa facilities and golf courses. The aging baby boomer generation's desire to spend on vacation real estate has encouraged new timeshare, fractional ownership and condominium-hotel developments, with lodging operators perceiving high-fee growth and brand-expansion opportunities in these products both in resort and urban destinations.

Condo Hotels. During the past several years, under tight capital availability for new development, condominium-hotels have enjoyed a renaissance, with various projects currently under construction in such areas as South Florida, Manhattan and Chicago. Often, the appeal to developers is clearer than the appeal to buyers and management companies, with major incentives being an alternative financing structure and a desire to minimize operating risk. Compared to more traditional financing arrangements for hotels that require equity investments between 30% and 40% of project cost and long-term debt to be serviced by operations, condominium-hotel debt is largely outsourced to individual investor equity or mortgages from unit purchasers. As long as developers don't become over-exuberant in following this trend, the condo hotel sector provides further positive proof that the lodging sector is on track.

Of course, it's not all good news for the sector. The lodging industry still faces significant challenges, particularly in the area of operating costs, where property and casualty insurance premiums, healthcare premiums, energy and overall labor costs have increased dramatically and show little sign of a slowdown. However, there's enough positive buzz to suggest that the sector is steady on its feet and facing a healthy year.

Dale Anne Reiss is global and Americas director of Real Estate, Hospitality & Construction at Ernst & Young LLP. She is based in New York City.