(EDITOR’S NOTE: This is the final two of a two-part series forecasting the year ahead in lodging. This story focuses on the real estate side of the industry, while Friday’s covered the operations side.)

Unlike the operating side of the hotel industry, the real estate recovery hasn’t been as clearly defined. Transaction volumes rose again in 2011, values have grown faster than anyone expected and overall industry sentiment appears positive starting the new year, yet the forecast for 2012 remains partly cloudy.

The biggest concern is a debt capital market still regaining its footing. This summer’s debt-ceiling debate and ongoing concerns over the European sovereign debt crisis have proven how tenuous the economy is.

In August, plummeting stock prices slowed transactions, even halting a few nearly done deals, and hotel real estate investment trusts were forced to pull back after a frenzy of activity in the first half of 2011 drove trading prices to almost pre-recession levels. The commercial mortgage-backed securities world that was just beginning to ramp back up paused and the financing finally flowing from many lenders slowed.

Another dark cloud hangs over the industry: A potential wave of defaults and foreclosures looms this year as a result of the massive loans originated in 2006 and 2007 at the peak of the cycle and the lack of replacement capital now available. Other owners not overleveraged may face a different kind of distress: Once patient franchisors are no longer looking the other way on property improvement plans and financing for that remains extremely limited.

Even those thick clouds overhead offer a silver lining. Savvy investors will target buying notes and distressed assets, further fueling the recovery of the transaction market and helping unwind the massive amount of distress left in the system. New construction and supply growth are at historic lows, making now a great time to own and buy hotels. The future does look bright, even with a debt capital market still in flux.

CAPITAL MARKET COMEBACK
“Lenders are coming back into this space and everything is moving in the right direction,” says Matt Comfort, an executive vice president in Jones Lang LaSalle’s real estate investment banking office. “There’s a lot of potential for major issues with the global economy, but things aren’t stable now and there’s a lot of uncertainty and fear and the debt capital markets are operating through that. Lenders are quoting and originating deals.”

In the first half of the year, before the Dow Jones Industrial average plummeted more than 1,100 points on Aug. 4 & 5 on the heels of Standard & Poor’s downgrading the U.S. credit rating, the CMBS market was in the midst of a revival.

“New shops were coming in, bidding was very active, leverage was going up and pricing was dropping,” Comfort says. But when the economy flat-lined, albeit briefly, it reignited fears of a double-dip recession and lending ground to a halt.

“The year will be remembered by tremendous peaks and valleys,” reads the December U.S. Delinquency Report from Trepp, an analytics firm tracking the CMBS industry. “The market found its sea legs late in the year [spreads narrowed 20 to 40 basis points in December alone], but not without some collateral damage from the volatility. Many issuers pulled back or closed their doors entirely, leading many CMBS prognosticators to reduce their forecasts for 2012 issuance.”

Almost $30 billion of domestic CMBS was issued last year, well below the nearly $250 billion reached in 2007, but much better than the $10 billion in 2010 and the $3 billion in 2009.

“CMBS will set the tone for 2012 with pricing and proceeds,” says Comfort, who predicts at least another $30 billion in issuance in 2012 and possibly as much as $60 billion.

Traditional lenders are also becoming more active and will consider underwriting more hotel deals as the economy and their balance sheets continue to improve. “It’s been a turbulent year, but one of price discovery,” Comfort adds. “A lot of lenders got their feet on the ground and we’ll continue to see more of that healing.”

DEALING WITH DISTRESS
Revenues are returning, but still nowhere near the levels they were at in 2006 and 2007 when many of the most egregious loans were underwritten. “There’s just not enough replacement capital out there,” says Steve Van, CEO of Prism Hotels & Resorts, a hotel management company also specializing in receivership assignments.

Lodging’s CMBS delinquency rate, according to Trepp, improved to 12.2% in December, slightly better than in November and well ahead of last December’s 14.31%.

The CMBS delinquency rate for all U.S. commercial real estate is 9.58% and the value of those loans totals $58.5 billion, according to Trepp. With another $371.8 billion maturing this year, that number could grow significantly.

Art Adler, managing director and CEO of the Americas for Jones Lang LaSalle Hotels, estimates $80 billion in CMBS loans issued for hotels from 2004 through 2008 still “has to get unwound.”

CLICK HERE TO WATCH AN INTERVIEW WITH ART ADLER

The distress has been percolating the past two years, but foreclosures and forced sales have been far less prevalent than many expected. “Two-thirds of the loans originated in 2005 through 2007 were extended [or worked out] because they were defaulted and nobody wanted to take the loss,” Van says. “There will be more extending and pretending, but at some point, that’s going to change … How long can you hold your breath?”

Attorney Jim Butler, a partner and the head of the global hospitality group for Los Angeles-based law firm JMBM, says servicers may not have a choice. Some of the more aggressive floating rate loans made at the peak of the cycle — “floaters” — have a maximum number of extensions allowed, he says. Extensions will be limited, resulting in more note sales and foreclosures.

“Lenders will be more active in selling assets and loans because as values rise they feel they can sell now and hit their marks,” Adler says.

Some owners not overleveraged could also face another form of distress this year. Franchise companies, who in many cases looked the other way the past few years with regard to brand standards and PIPs, are now requiring those as guests and revenues have returned.

“Bill Marriott is tired of giving two- and three-year hall passes on PIPs,” says Van, whose company manages approximately 55 properties, roughly half in the form of a receiver. “Hilton, Starwood — really everyone is cranking this up.”

Financing those PIPs is the challenge for owners and could lead to even more property sales. “There are a couple [lenders] playing in that space, but it’s more costly and not that prevalent,” says Comfort, adding the most likely way to get a PIP done is as part of a larger loan for an acquisition or a refinancing.

BUILDING BLOCKS
New construction continues to be limited, in part due to a lack of financing, but more because of what Patrick Ford calls “developer confidence” issues. “Financing isn’t wildly available, but it’s there for the best projects and most experienced developers,” says the president of Lodging Econometrics, the Portsmouth, NH-based hotel research firm. “The main difficulty is the business outlook. And how rapidly or slowly the economy is recovering.”

Projects currently under construction remain at cyclical lows, with 408 projects and 51,599 rooms in the ground. Scheduled starts in the next 12 months decreased, falling below 100,000 rooms for the first time in memory, according to Lodging Econometrics. Ford says projects in the early planning stage are increasing, but openings will again be limited this year and next.

The overall pipeline — projects under construction, scheduled to start in the next 12 months and those in early planning — has trended down to its lowest point since 2004. “Lower levels of hotel openings is exactly the medicine the market needs,” Ford says. Supply growth well below normal levels will continue to help drive occupancy, rate and revenue gains.

Jones Lang LaSalle’s Comfort believes construction lending will pick up in the second half of the year as lenders continue to clear bad debt off their books, but borrowers now have “to check all the boxes: right market, right brand, right sponsors.”

DOING DEALS
REITs, largely quiet since the summer Wall Street reset, even made an appearance just before the clock struck midnight on 2011. On Dec. 29, LaSalle Hotel Properties closed on the previously announced $396.2 million purchase of the 934-room full-service Park Central Hotel in midtown Manhattan. It was the fourth largest single-asset hotel transaction last year, and at $424,000 per key, is reminiscent of the deals in 2010 and early last year when several trophy assets traded at pre-recession prices.

Global transaction volume reached $30 billion last year, up 13% from 2010, according to Jones Lang LaSalle Hotels, which tracks asset sales of $10 million and up. The real estate investment services firm forecasts volume this year to hold steady at $30 billion.

In the U.S., last year’s volume reached approximately $14.5, up from $11.3 billion. In the first half of the year, REITs accounted for almost half of the $7.7 billion in sales, says Adler of Jones Lang LaSalle Hotels. In the second half, through November, REITs bought approximately a billion of the $5.5 billion traded.

“REITs were driving the feeding frenzy,” JMBM’s Butler says. “The general sense among our clients is now mere mortals can do acquisitions: equity funds, existing owners, people with strong financial relationships. That’s positive. It creates a more normal environment, not a superheated one.”

Adler predicts the U.S. will again see approximately $15 billion in transactions this year, with a slightly different mix of buyers as private equity funds and private investors get more involved.

With the early “superheated” environment last year, the average selling price per room through the fall was $119,287, more than double the 2009 average of $57,261 and almost identical to the average in 2007, according to Lodging Econometrics’ study of transactions with a reported sales price. Future expectations and low interest rates drove capitalization rates to historically low levels (3%-5%) for some of the early REIT acquisitions of trophy assets, but cap rates stayed at more traditional levels (8%-10%) for segments other than luxury.

“The reason prices are very high,” Ford says, “is because only high-end properties are selling. There is very little Main Street investment or lending available and therefore very few midmarket and lower types of properties in this mix.”

Butler predicts that will begin to change this year as the transaction market stabilizes with a mix of both normal sales and distressed dispositions. “Opportunities will be perceived in not just the top two to five markets, but the top 25 and top 50,” he says. “And recovery and purchases will move down the food chain and into secondary and tertiary markets.”

Overall hotel market values, according to the Penn State Index of U.S. Hotel Values, improved 12.3% last year to $87,952 per room and another similar gain is projected this year. The economy segment will lead the way with a 15.5% increase to $23,336 per room, while all other segments will see double-digit growth, including a $36,000 boost in the luxury segment to $325,252 per room.

“In 2011, we were finally able to determine we were looking at the trough in the rearview mirror and finally in recovery,” Butler says. “We’re nowhere near the peak, but we are approaching some long term norms in 2012 and beyond.”

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