By Scott Smith
With few exceptions, it’s all good in US hotel markets. Memories of the problems in 2001 and 2002 that caused hotel income to plummet and value to be compromised have faded. Leisure travelers, who only briefly left the market, continue to board airplanes and drive their automobiles to occupy hotel rooms in cities and resort locations. The huge question looming last year regarding the return of business travelers has been answered in the affirmative for hotel owners and managers. And, while demand surged during the past 18 months in many major hotel markets, the sounds of construction equipment rolling over prime hotel development sites remain surprisingly quiet. Possible explanations for the stall in new construction are abundant including the high cost of land due to residential condominium competition, the high cost of lumber, cement, and other materials, and lender resistance to funding construction. Perhaps developers simply did not want to fill up the tanks of the construction machinery given the price of gas!
Combining data from Smith Travel Research (STR) with the able assistance from our partner Torto Wheaton Research (TWR), PKF Hospitality Research (PKF-HR) continually monitors historical performance of hotels in the 51 largest U.S. markets.
For all cities taken together, impressive increases in occupancy and ADRs were recorded from the first quarter of 2004 to the first quarter of 2005. Occupancy climbed from a 51-city average of 61.8% in 2004 Q1 to 64.2% in 2005 Q1.
Room rate increases usually follow close behind occupancy as occupancy percent move closer to long-run averages, and it appears no different during this cyclical upturn! The average ADR improved from $99.49 in 2004 Q1 to $105.98 in 2005 Q1. This 6.5% increase far exceeds the general rate of inflation for the period.
The following cities experienced double-digit growth of ADR: Fort Lauderdale, Miami, Washington D.C., West Palm Beach, Fort Worth, and Tucson.
So what are the ‘few’ exceptions where it’s not all good? Occupancy in Albany fell 2.2%, but ADR grew 1.8%. Similar results occurred in Baltimore, Cincinnati, and Columbus. Even San Diego registered a small drop in occupancy from 71.1% to 70.1% although ADR was up by 7.5% (a full report on performance in these cities may be found in Quarterly Trends in the Hotel Industry - United States)
It is all ‘going to be’ good in U.S hotel markets.
In addition to monitoring historical performance, PKF-HR and TWR utilize STR data and an econometric model to prepare forecasts of hotel performance in the same 51 cities. These forecasts show continued improvement in occupancy and ADR across the U.S. Most city markets reach stabilization by 2006 when new supply is expected to begin appearing. This new supply will serve to cap financial performance at modest, but still real (i.e., several percentage points above expected inflation) rates of growth. According to our econometric model, only a recession, catastrophic event, or a 1980s-style development cascade will move the U.S. hotel markets off a path of stabilization beyond 2007 (econometric forecasts for these cities may be found in Hotel Outlook reports).
It is also an attractive time for hotel investors in the debt and equity markets.
Follow-up discussions with several respondents to the 2005 edition of our Hotel Investment Survey indicated that there continues to be plenty of money available for hotel lending and equity investment. The lethal combination of low interest rates, rising cash flows, and sluggish markets for corporate securities keeps real estate in the spotlight. Without the friction of lease contracts, many investors view hotels as a very favorable class in this environment. Added to the mix is a sizeable population of hotel owners now willing to sell properties. These investors held hotel properties beyond their expected holding periods and find the current pricing of hotel property very satisfactory for meeting their yield requirements. With both buyers and sellers having motivation to execute transactions, coupled with the availability of both debt and equity, we expect that 2005 will be another (like 2004) banner year for hotel transactions.
Data on hotel transaction activity reveal that the quality of hotels sold during 2004 was considerably higher than in the previous two years. The transaction year 2005, while continuing to show strength in one-off deals, is shaping up to be the year of the large portfolio deal. Already during the first few months of 2005 some very large deals have been signed. Examples of these deals include:
Marriott International, Sunstone Hotels, and Walton Street Capital acquiring a 32 hotel portfolio from CFT Holdings Ltd. for $1.452 billion.
An Ashford Hospitality Trust affiliate purchase of 30 hotels from CNL Hotels and Resorts for $465 million.
Blackstone refinancing its’ hotel portfolio with Banc of America, Bear Stearns, and Merrill Lynch for $5 billion and netting proceeds of $2 billion.
Our survey of both equity and debt investors reflects the continued optimism of both debt and equity capital providers. With both decreases in overall capitalization rates and discount rates, property values remain on an upward path.
The results of Hotel Investment Survey conducted during early 2005 bear out the observations presented in the previous paragraphs. The spread between the overall capitalization rate and the discount rate continues to hover in the four to six percent range suggesting owner expectations for growth in net operating income surpassing recent historical performance. Despite fears of rising interest rates and Federal Reserve actions, the cost of financing continues to fall thereby decreasing investor’s rate of return requirements as compared to 2004. Loan-to-value ratios crept up to more than 70% - territory not visited since our surveys of the 1980s and debt coverage ratios continue to move in favor of borrowers as they seek more leverage. These terms indicate that lenders feel adequately protected from a reoccurrence of delinquency and default risk experienced in 2002 and 2003.
Investors continue to price the cash flows of hotels in the full-service segment higher than limited-service hotels. Discussions with survey respondents suggest a decided preference for the full-service product. With higher barriers to entry for full-service hotel development, investors see more of an upside to increased profits going forward for this segment. Well-branded, full-service hotels in good condition located in major metropolitan or resort locations get the undivided attention of investors. Capitalization rates in the 7.0 percent to 8.0 percent range must be paid for top tier properties. For second tier properties such as mid-market full- and limited-service product, capitalization rates have also sneaked under ten percent. Third and fourth tier properties including older exterior corridor full- and limited-service properties approaching the end of their economic life may be obtained at a capitalization rate over ten percent. Hotels in both segments now offer investors’ very attractive dividend returns on a relative basis, even as interest rates have elevated during the past 12 months. These investors remain somewhat opportunistic as evidenced by the short holding period expectations, relative to historical results from this survey.
Generally, investors’ and lenders’ remain optimistic for 2005 that hotel real estate will continue to produce favorable cash flows and property values will remain firm, if not increase somewhat. This optimism continues to generate interest in hotel acquisitions and the acquisitions have gotten larger in scale this year. Sellers who missed previous peaks in the market or who have strategic reasons not to own hotels are motivated to dispose of even performing assets. Capitalization rates and equity yield rates continue to hold at levels that scare financial journalists. With few exceptions, it’s all ‰€?going to be’ good in U.S hotel markets for the short term. However, as current pricing fast approaches replacement cost, we expect investor yield requirements to move upward and the pace of construction to pick up.
For smaller, limited-service property, this period will begin as early as 2006. For full-service properties, we do not expect a significant number of rooms to appear until 2007. Over the next two-to-three years, therefore, we expect price increases to moderate as the cost of capital rises and supply and demand come into balance.
Scott Smith MAI is a Vice President in the Atlanta office of PKF Consulting.