What a difference a year makes. Participants at a recent roundtable discussion at The School of Hospitality Business at Michigan State University were a lot more upbeat about the state of the hotel industry than was the case at a similar event last year. The panel, all members of The School’s Real Estate & Development Advisory Council, was awed at how quickly hotel performance has improved.

“Absolutely, I’m surprised,” said Ryan Meliker, vice president, lodging analyst with Morgan Stanley and a 2005 alumnus of the school. “The recovery was much more rapid than most people thought it would be. Last year, companies like Marriott, Starwood and others issued guidance that their RevPAR would be flat to down 5% in 2010, when in fact generally it was up about 5%.”

In particular, rates rose faster than many thought. Meliker points to last June’s New York University Hospitality Industry Investment Conference as a tipping point. During a general session panel, Marriott President & COO Arne Sorenson said he was “wildly optimistic” about the industry’s future. “The general view was he was sending a signal to Hyatt, Starwood, IHG and other brands and operators that Marriott was going to continue to push rates, just as it had in the prior month to six weeks [before the conference],” he said. “It gave the industry a lot more comfort about their abilities to also push rate.”

Meliker forecasts a 6% hike in rates this year, even though the increase has only been 3% through the middle of March, a phenomenon he attributed to group booking patterns. Most of the meetings scheduled for the first part of 2011 were booked in late 2009 and early ’10, when rates were still suppressed. Many of the meetings set for the latter half of this year were booked later in 2010, when hoteliers enjoyed stronger pricing power.

Buying & Selling
The level of hotel transactions has also spiked, noted several panelists at the Michigan State meeting. Quoting data compiled by his firm, Jones Lang LaSalle Hotels, Adam McGaughy said so far in 2011 hotel transactions for deals of $10 million and more are up 72% over the same time last year. Of course, as he noted, very few hotel sales were registered in the first few months of 2010. “We all could have gone on vacation last year, because nothing was happening,” said McGaughy, who is executive vice president of JLL and a 1990 MSU grad.

He said JLL forecasts a 15-20% rise in transactions for the full year, which translates to about $13 billion in volume, impressive but still pale in comparison to the high-water-mark year of 2007, when $49.2 billion in lodging transactions took place.

Steve Marx, president of Hotel Source, a Chicago-based hotel broker, said the outlook is similar for deals under the $10-million threshold. The 1987 MSU alumnus said while he sees “a very large increase in listings now,” and has a couple of deals under contract, he wonders where the buyers will come from for these types of properties.

“Even if you list something that’s priced right, are there really buyers in this $10 million and under space?” he asked. “It may be priced at a 10 cap rate and have no PIP attached to it, but who’s really buying a $6-million asset in a tertiary market, and how are they funding it and where does the equity come from?”

Another panelist, Ed Walsh (MSU ’93) of Alpine Realty Capital, believes many buyers will be developers unable to find suitable debt to build new product. Their philosophy, he said, is “why go out and fight for 55% debt to build a hotel when I can buy something at 70% of replacement cost.

“You’ve got sellers on one side who are facing PIPs and have either lost their equity or don’t have the money to fund them. On the other side, there are owners and developers storing up their equity, and I’m not just talking about the REITs,” he said. “You’re going to see a lot of these people come together to make deals.”

Another trend discussed by the panel was the increase in transactions through note sales, especially by special servicers who have been overwhelmed by high volumes of distressed hotel product. Fueling the market are mortgage funds formed to buy notes. The competition is so stiff among these funds that prices are rising to a point in some cases above the actual values of assets if they were sold as real estate.

“The era of extend and pretend may be coming to a close,” said Michael Kitchen, MSU ’09 and associate with Paramount Lodging Advisors. “I see the industry changing, where note sales are coming to the forefront of a lot of the larger deals that will be done this year.”

Who’s Buying
While deep-pocketed real estate investment trusts continue to be active in the hotel transactions market, other buyers are emerging. They include institutional funds and foreign buyers seeking the security of hard assets. Hotels, once the stepchild of commercial real estate, are now viewed as investment-grade product by many investors. And inflation, or the threat of inflation, is driving some investment capital to lodging.

As Meliker of Morgan Stanley pointed out, concerns over rising inflation in the next few years is drawing foreign buyers in particular to consider investments in U.S. hotel real estate.

“The one hard asset that prices itself daily and produces the greatest inflationary hedge is hotels,” he said. “While in the past three or four years the Chinese have been loading up on Treasuries, we’re now starting to see a shift toward real estate, and hotel real estate in particular, because of these concerns over inflation.”

Both the large REITs and foreign buyers primarily focus on full-service hotel product in the top-five urban gateway markets, leaving a lot of room, said some panelists, for deals in secondary and even tertiary markets.

“Some investors are getting smart and instead of bidding against a REIT for hotel in one of the top five markets, they’re looking at the secondary markets, particular those from six to 15,” said Paramount’s Kitchen. “Why go to that trouble when you probably can get as good or better return in places like Seattle or Austin or Charleston, which are all good lodging markets?”

New Builds
Some of the panelists were optimistic new hotel development is poised to make a comeback, thanks to slight loosening of lender purse strings. John Weeman, president of Partners in Development and a 1979 grad, said his firm was able to recently secure financing for a new Hilton Garden Inn. He sought a loan for 65% of the property value; he got a commitment for 60% but will be able to close the gap using new market tax credits.

“I’m encouraged because many community banks are coming out of debt and their restrictions on development financing are lifting,” he said. “Traditionally, we always look to local institutions first for development funding, but in recent years they maxed out their abilities to loan to hospitality and nothing was moving off their books. What they thought was going to be a 36-month construction loan has turned into a five-year hold. But I’m seeing movement now.”

Upscale and luxury development may be coming back, too. One representative of a major REIT said there’s interest in strong barrier-to-entry markets for development. Similarly, Michael Ennes, director, brand development, for Hilton Hotels and MSU ‘01, told of several Waldorf-Astoria and Conrad Hotel development projects that went dormant in 2008 but are now “reigniting.” He sees other development possibilities in mixed-use projects, particularly projects that combine retail with hospitality.

On the other end of the spectrum, Andrew Alexander, president of Red Roof Inns, noted “significant interest in new-build development in Canada,” particularly in secondary markets and near the country’s booming oil industry in the West.

David Johnstone, managing principal and chief investment officer for Miller Global Properties, is less bullish on new construction. His concern is the cost of construction.

“It’s getting expensive to build again,” said the 1979 MSU grad. “With the situation in Japan and the rising oil prices, the price of concrete and steel has shot up in the last 30 days. I don’t see new construction starting to boom for some time.”

Heard in the Crowd
The panel discussion covered a number of other topics related to hotel real estate and finance. Here are a few comments on other subjects:

•“Rising oil prices also affect commodity prices, so food and beverage costs rise and our bottom lines get hit,” said Katherine Button, MSU ’03 and asset manager-hotel investments for Crow Holdings. “Another potential issue for the industry is tax-hungry municipalities. We’ve been somewhat successful getting relief on the tax side in recent years, but if values come back, they’re going to be knocking on our doors looking to get back those tax revenues.”

• “Half of our fund is in office [investments] and my counterparts in that area are struggling to find deals that will generate 8-9% yields,” said Phil Hutchins, vice president of Amstar Group and a 1993 grad. “While at one time I would have expected to generate yields in the mid-20s [on hotels], I can now generate high teens, so I’m still doing twice as good as my counterparts in the office side.”

• “The role of asset management has changed at our firm,” said Matthew Wechsler, senior analyst, investment management for RockBridge Capital and an ’08 grad. “When I first started asset management was siloed off from the rest of the company. But as values dipped, the asset management group has a lot more synergies with the rest of the company. Now they also need to deal with the value and restructuring part of the equation.”

• “To me, the biggest risk is for the lodging industry to no longer be in the hotel business,” said JLL’s McGaughy. “It’s become such a different business in the last 10 years. It’s now a financial mechanism that’s getting away from the basics of hospitality.”