Short-Term Strategies For Long-Term Returns

As we move into 2005, it's important that the lodging industry capitalize on both its improving performance and the strong activity in hotel sales.

A number of questions come to mind: What impact do today's historically low interest rates have on the decision-making process and on due diligence in making a buying decision? What impact has technology made on our industry benchmarks? What are the long-term impacts of Sept. 11, 2001?

Old benchmarks and rules of thumb don't necessarily apply. As Bill Meyer of Meyer Jabara Hotels says, “Finally, there is cash flow. We can start moving rates.” However, as he emphasizes, everything about buying or selling a hotel is market-specific. It is a recurring theme among many hotel professionals.

There has been lots of industry chatter about an abundance of money chasing too few properties available for sale. While the number of transactions and the dollar volumes have increased, particularly after the devastation of 2002 and 2003, closer analysis indicates a few interesting things. Yes, there is substantial money; but typically the properties being chased are trophy properties; the highest per-room sales prices have been for small boutique hotels. But, what about the bulk of our industry — the mid-tier properties that aren't trophy hotels or boutique hotels?

According to Sanjeev Misra of HP Rama Hotels, “There are opportunistic sellers looking to test the waters and offer their hotels at very low cap rates. They want to see if they can capitalize on the market perception of significant equity chasing a smaller pool of deals. While many sellers are moving forward with buyers at cap rates well below historical normal levels, I have not yet seen a significant number of these deals actually close at those cap rates.”

Ironically, in many instances, the decision-making process is not that simple for a roadside, limited-service property in a secondary market. In fact, the level of sophistication required in that process is often disproportionately high. An excellent illustration is an early 2004 purchase of a 30-year-old roadside property near St. Louis. The buyer, Jerry Jarawala, is a local investor who personally conducted most of the due diligence before entering into negotiation for the property; his bankers also visited the site prior to an offer being made. According to Jarawala, “Before initiating discussions, I had a good idea of my loan limits on the property; I knew what its potential was and what its shortcomings were. And, due to early involvement, I had not only a very positive lending experience, but a very competitive one resulting in extremely favorable terms from which to choose.”

While many of the industry basics have changed over the recent past, these changes present new opportunities as well as difficulties. Here is a look at the major trends the industry will face in the coming year and beyond.

Interest rates

Historically low interest rates present opportunities to buyers in the form of more favorable debt coverage ratios and better cash-on-cash returns. Using a $2 million loan as an example and simplifying the calculations, a two-percentage points-lower rate means $40,000 annually in after-debt cash flow. The downside to the current low interest rates is that they are typically tied into relatively short-term financing, especially when compared to the residential market. A five- or seven-year loan doesn't have the long-term stability afforded by a 30-year residential loan at correspondingly low rates.

Room rate transparency

The advent of electronic marketing through third-party Internet providers is another dynamic in transition. Since in today's environment everyone knows your rates, the question is how effectively are you managing those rates and how quickly can you effect changes. You need to know (and be able to manage) whether your customer will find a lower rate at a third-party outlet than on your own website or phone contact.

Changing revenues/new and higher costs

In recent years, and for various reasons, certain revenue points and operating costs have also moved away from long-standing expectations.

Specifically since Sept. 11, liability insurance costs have risen in almost all markets and quite dramatically in some cities. Employee health insurance costs have also risen; new insurance regulations and options are expensive and management-intensive.

Even good news — rising prices and more transactions taking place within the industry — can lead to increases in real property taxes. Look at assessments realistically and make sure that when you buy an underperforming asset, you're clear about the impact of improved performance on this expense category.

Hotels have always had concerns about guest and property security and its cost. Again, Sept. 11 has changed the way we look at this item on a global basis, but local conditions have an impact as well; in some markets, it's a major expense item, sometimes changing, but always a consideration.

The cost of energy is another big consideration. World instability and greatly fluctuating oil prices have again made energy costs a seminal issue. You can take a number of steps to alleviate some impact and to make your property as energy-efficient as possible.

Exterior vs. interior corridor

An increasing number of brands won't renew franchise agreements on outside-corridor hotels. Many lenders won't finance them. What is the remaining term of the franchise agreement and has this item been addressed? Is there a conversion option? Is that property you're considering to purchase at such a good price ready to lose its flag or is it unfinancible?

Hotel condos

In some markets, this is not only an option but a trend. Major players are using this concept in many resort markets, either as new construction or conversions. In one resort area, a hospitality broker I know is selling hotel condo units — not in Marriott's latest property but in a 30-year-old Mom & Pop operation. In 95 percent of markets, this would be laughable; in this case, it's very successful.

Added value

What strategies can you employ to enhance profitability and value? Is there an opportunity presented by an expiring franchise agreement or a hotel abandoning a particular brand in your market? Can a family-type operation create profitability in a high expense ratio market by handling management in-house? Conversely, can an independent or family-run property benefit from the experience and expertise of a brand or management company?

Know your strengths

Corporate travel is in resurgence and research tells us that the typical corporate traveler prefers full-service properties with their attendant amenities. But if your strength lies in roadside limited-service ownership or management, or if your location is suburban or without a strong corporate component, play to that strength and to your market.

In short, know your property or the one you're considering buying or selling; make an honest assessment of its strengths and weaknesses; examine all options to improve or maximize its potential. Above all, understand the market; what do these changes in our industry mean within that market? What are the opportunities that exist, and what are the pitfalls to beware of? By applying short-term strategies in decision-making, you can improve your long-term chances for success.

Contributing Editor Stephen Taylor is managing director of Horwath Investment Advisors' Palm Beach, FL office.

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