Lodging: The Darling of Real Estate

As we move into the second quarter of 2006, the U.S. hotel market is clearly perceived as a “darling” industry in the world of commercial real estate. National hotel operating fundamentals are stronger than ever, with current top-line trends showing gains driven more by rate than by occupancy. This phenomenon clearly reflects a classic lodging industry economic upswing: as occupancies plateau, the pendulum of pricing power rests squarely with hotel owners and operators.

At this point in the cycle of past industry upswings, new hotel development would typically be in full bloom. What is unique about this current upswing is the fact that new hotel construction is fairly muted, due in part to high development costs, as well as the fact that in many markets hotel development has not represented the highest and best economic use of land. As a matter of fact, in some major urban 24/7 markets such as New York City, several thousand hotel rooms have been removed from the supply due to the conversion of existing hotels to residential use. As good as hotel economics have been in New York, with high levels of occupancy and strong increases in average rate, residential economics have been even better.

During the past several years, if a hotel could be purchased in Manhattan free and clear of any management encumbrance, and the floor plates work for apartment layouts, residential conversion would typically yield a higher economic return than could continued use a transient hotel facility. As a result of this phenomenon, a number of hotels such as the famed Plaza Hotel, InterContinental Central Park South, Stanhope and Regent Wall Street were closed and converted to residential use. Other New York hotels such as the former Mayflower on Central Park West have been razed to make way for new residential buildings.

As the New York lodging market continues to experience strong increases in average rates, and the robust residential market slows down a bit, we're now seeing in some cases that hotel economics begin to pencil-out the feasibility of new hotel development.

As the resilient U.S. economy continues to expand, corporate travel budgets continue to grow, resulting in increasing individual business travel and accelerating group conference and convention bookings. Furthermore, leisure travel continues to grow robustly as Americans feel more confident and foreigners take advantage of favorable currency exchange rates to visit the U.S.

I anticipate that lodging supply increases will remain relatively modest during the next several years, particularly in major urban markets, resulting in strong room rate increases and improving bottom-line profits. At this point in the cycle, which is perceived by many as “having legs” and “wind behind it,” national levels of RevPAR and bottom-line earnings are fast approaching pre-9/11 levels, the previous high-water mark for the industry.

New York City and Washington D.C. are examples of some of the strongest hotel markets to reflect the recovery that began during the last two years in the largest cities on both the East and West Coasts. Los Angeles, Orlando and Boston are exhibiting healthy growth, while San Francisco is making a strong comeback after what could be characterized as a recent crash in the local market. The industry's rebound is now filtering down to secondary markets, with an anticipation of a similar phenomenon in tertiary trade areas within the near future.

National operating statistics illustrate the U.S. lodging industry's economic rebound. Industry profits experienced a dramatic drop to $12.8 billion during 2003, down from the 2001 high of $22.5 billion. With industry earnings at approximately $16.6 billion during 2004 (a 30-percent increase over 2003), profits rose an additional 25 percent to approximately $21 billion last year. Record industry profits of about $25 billion are forecast for 2006; by '07, profits should approach $30 billion.

An extremely fluid hotel transactional market is further evidence of the lodging industry comeback. In addition to improving economic fundamentals, the abundant availability of relatively low-cost debt and equity capital has dramatically increased activity in the hotel sale transaction market. This phenomenon is expected to continue during the next several years, as financial positions in lodging continue to be perceived as “darling” investments that provide superior risk-adjusted returns that are difficult to achieve elsewhere.

The CB Richard Ellis Hospitality & Gaming Group continuously monitors the major (above $10- million single asset, not part of a portfolio allocation) U.S. hotel sale transaction market. Of the more than 120 major U.S. hotel sales consummated during 2005, 21 were in excess of $100 million per asset.

The most prolific acquirers of major U.S. hotel properties during 2005 included LaSalle Hotel Properties and DiamondRock Hospitality, which each closed on six acquisitions, followed by Highland Hospitality and Innkeepers USA Trust, which each purchased five hotel assets. HEI Hospitality Fund and JER partners each acquired three major U.S. hotel assets during 2005. Hilton Hotels Corp. and Starwood Hotels and Resorts continue to evolve into brand companies that manage and franchise hotels, rather than hotel real estate owners and operators, as each sold in excess of five significant hotel assets during 2005. Entities such as Host Marriott, Blackstone and Strategic Hotel Capital seized upon strong market pricing and pruned their respective hotel portfolios with several significant dispositions.

The largest single-asset U.S. hotel sale during 2005 was the $440-million acquisition of the Essex House in New York by the Dubai Investment Group from Strategic Hotel Capital. On a price-per-room basis, the largest amount paid for a U.S. hotel during 2005 was also the Essex House in New York at roughly $727,000 per key, followed by the $617,000 per-unit sale of the Malibu Beach Inn in Malibu, CA, and the $535,000 per-unit sale of the Coast Inn in Laguna Beach, CA.

Nine significant hotel transactions occurred in both the New York and Washington metropolitan areas during 2005. Other major metropolitan markets with numerous significant hotel sale transactions during 2005 included Boston, Chicago and Los Angeles.

Hotel sale transaction activity remains brisk during the first part of 2006. Strategic Hotel Capital is reportedly in contract to purchase the Four Seasons in Washington D.C. for a record $800,000 per key. Other notable hotel sale transactions thus far this year include Sunstone Hotel Investors' pending $545,000 per-key acquisition of the ground leasehold interest in the 444-unit Hilton Times Square in New York from Forest City Ratner and the pending $440-million purchase of the 495-unit Drake Hotel on Park Avenue in New York by the Macklowe Organization. The buyer will reportedly raze the building, acquire additional air rights and develop a mixed-use residential condominium building on the site.

Due to the anticipated continuation of strong growth in the industry, hotel capitalization rates are typically higher than many of the sub-seven-percent trailing 12-month overall rates on which many sale transactions are currently occurring. Sophisticated hotel investors are pricing assets on a discounted cash flow analyses that factors in perceived upside potential rather than applying stabilized capitalization rates to in-place cash flow.

With all of the optimism currently on display, U.S. hotel investors should not lose sight of the potential risks that could dampen the industry's fundamentals. Terrorism is clearly at the top of the risk spectrum, followed by geopolitical issues in the various unstable regions of the world, including the Middle East. Factors affecting the U.S. economy, including rising interest rates, increasing energy and insurance costs and volatile consumer confidence, are additional risks the industry faces. With many of the nation's hotel employee union contracts up for renewal during 2006, coupled with a dramatic rise in the cost of employee benefits, labor issues are also a significant concern for the industry.

Daniel H. Lesser is senior managing director-industry leader for the CB Richard Ellis Hospitality & Gaming Group. He specializes in real estate appraisals, economic feasibility evaluations, investment counseling and transactional services of hotels, resorts, conference centers, casinos and timeshare properties. He can be reached at 212-207-6064 or daniel.lesser@cbre.com.

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