Something odd happened on the way to the funeral for hotel deal making this year — at least a few investors refused to attend. Yes, many banks and other high-profile lenders have officially shut the door on the hospitality industry, and declining occupancies and soft room rates have left experts sour on the near-term outlook. But look closely at the lodging landscape, and it's not quite as barren as you might expect.

The holdouts include entrepreneurs like Patrick Denihan, co-CEO of family-owned Denihan Hospitality Group in New York, which he runs together with his sister Brooke Barrett. Early in the year the firm, which owns seven hotels in Manhattan, spent $119 million to acquire the 300-room James Hotel in Chicago. In August, Denihan spent another $65 million to buy out its majority partner in the 132-suite Surrey Hotel on New York's Upper East Side.

Denihan is hardly done. The company has raised more than $200 million in financing this year, and is sitting on $50 million in equity that could be leveraged to acquire another $150 million in hotels. Patrick Denihan reveals that he is looking at six more properties — two each in Chicago, New York and Washington, D.C. An asset in Miami also is under consideration.

“Everybody is talking about how the hotel acquisition market has been cut back,” Denihan says. “But if you look closely, you'll find there are a lot of sellers around. It's tough to close a transaction right now, but it can be done. We hope to buy another hotel by the end of the year.”

Revealing numbers

After five consecutive years of growth, global hotel mergers and acquisitions plummeted 76% in the first six months of 2008 to $14.7 billion, according to Chicago-based Jones Lang LaSalle Hotels. In the U.S., after four consecutive years of record hotel transactions, volume through June sank 81% to $6 billion.

This year's domestic numbers are close to the figures recorded in 2004 and 2005, and far above the 2000 and 2001 totals. The 2008 volume looks paltry only compared with the unprecedented bonanza of 2006 and 2007, the latter year racking up an eye-popping total exceeding $45 billion.

Because Jones Lang LaSalle Hotels only tracks deals valued above $10 million, the statistics don't tell the whole story. The small-deal market — in which limited-service brands such as franchised Red Roofs and Econo Lodges trade hands for a few million dollars — is holding up comparatively well.

Meanwhile, community and regional banks continue to make loans, albeit carrying recourse. Many of these smaller lenders have been unaffected by the collapse of the housing and bond markets that has pummeled big banks' balance sheets.

Even with the commercial mortgage-backed securities (CMBS) market in cardiac arrest, the big deals continue to close. A 50% stake in the 1,500-room Fontainebleau Resort in Miami Beach went for $375 million in April. In June, a Los Angeles private-equity group, Next Century Associates, paid a hefty $366.5 million for the Hyatt Regency Century Plaza in Los Angeles. There were four other deals priced above $100 million in the first half of this year.

Why the market jitters?

The slumping economy has beaten down hotel fundamentals and made many investors nervous. Aggressive U.S. hotel owners raised their average daily rate 4.2% during the first half of the year, but occupancy fell 2.6%. The end result was 1.5% growth in revenue per available room, the smallest increase since 2003, reports Smith Travel Research.

The strengthening U.S. dollar in August led to more hand-wringing over the future in such strong gateway markets as New York and Washington, which have seen hordes of tourists from overseas with strong euro and yen currencies prop up their hospitality business.

The fundamentals of hotel operations are critical to investors. “Hotels aren't just real estate. They are real estate plus an operating business, which makes them special-purpose real estate that gives them a higher risk premium over other classes of real estate,” explains James Butler, a partner in the Los Angeles law firm of Jeffer Mangels Butler & Marmaro LLP, a hospitality consultant.

“Hotels are viewed as cyclical, and if the economy is headed into recession and corporations and consumers are both cutting back their travel budgets, then you have to assume the cycle is turning negative,” adds Butler.

There is scant evidence of genuine distress so far, however, says Butler. The hotel bankruptcy log at his firm is empty now — not a single hotel is in serious difficulty. During the Resolution Trust Corp. crisis in the early 1990s, Butler presided over the fire-sale auctions of bankrupt hotels that traded at prices 40% or less of their replacement values.

“Hotel owners are more soundly financed now, and the loans they have are at low rates,” says Butler. “Operations are much more efficient. Ten years ago, the average hotel needed 61% occupancy to break even. The average is closer to 50% today. So properties are still cash flowing.”

Buyer-seller standoff

Today's M&A market might be stronger, even with CMBS financing cut off, if hotel owners would accept new realities in the market. “The seller community has its head stuck in the sand,” declares Alan Reay, president of hotel brokerage Atlas Hospitality Group in Irvine, Calif.

Reay reports his business is down 40% this year, but he still completed 84 transactions through June, many involving smaller hotels that attracted financing from local banks and U.S. Small Business Administration loan programs.

Many sellers continue to value properties at 2007 prices. Bidders are looking for discounts of at least 10% to 20% over peak levels. That gap in expected capitalization rates averages a full percentage point, though it rises to two points in some places, says Reay. “The gap between buyer and seller expectations is wider than it's been in a very long time. That's why we aren't seeing more sales.”

Through mid-2007, hotels were regularly changing hands at cap rates under 7%. But mortgage loans, once available at the London Interbank Offering Rate plus 250 basis points, are now offered, if available, at LIBOR plus 350 or 450 points.

That means loans fixed at 5.75% in 2007 are more likely to be fixed at 7.5% now. Hotel buyers commonly require a cap rate that is two percentage points above their cost of money. Thus, the new benchmark is 9% to 9.5% for cap rates on hotel transactions. “A lot of sellers won't swallow that,” Reay says. Instead, they want cap rates of 7%.

“Sellers are always the last to realize that the market has changed and they won't get their price,” says Robert Eaton, executive managing director of PKF Capital in San Francisco, which advises clients on debt and equity issues.

Eaton sees many “broken” transactions today, he explains, in which equity investors seeking an internal rate of return (IRR) on a hotel property as high as 20% over the next five years are presented instead with a scenario in which the prospective return will be closer to 10% or 12%. “That's not sexy enough, and so buyers aren't competing for properties like they once did,” he says.

Who's lending?

Less leverage also is hampering M&As. In early 2007, buyers were getting 80% and 90% loan-to-value from lenders. Today the range has fallen to 55% to 65%, says Thomas Fisher, managing director with Jones Lang LaSalle Hotels.

The difference has left many asking prices for properties untenable. Fisher says there is “still a lot of equity available to do deals, but pare back the availability of debt and you constrict the number of transactions that can get done.”

Fisher notes that national lenders such as General Electric and CapMark Financial Group are still lending on hotels. He predicts once buyers see a signal that the market has hit bottom, then bidding on assets will make a comeback.

When will that happen? Fisher says, “We'll face stiff headwinds through the rest of 2008. Then sometime in 2009, maybe in the second or third quarter, the headwinds will let up. Then a lot of buyers and sellers will jump into the market again.” Fisher's best guess is that U.S. hotel M&A activity will end up totaling $12 billion or more this year, then reach $15 billion next year after a slow first half. After that, he figures deal volume could rise again past $20 billion annually.

Something else will be driving sellers into the market by next year, says David Loeb, an analyst with stock brokerage Robert W. Baird & Co. in Milwaukee. Aggressive hotel mortgages written at 90% loan-to-value some three years ago will begin maturing in 2009. Banks will be offering, at best, to replace them with 65% loan-to-value, and at higher interest rates. When that happens, asset owners will want to bail out of investments.

“Hotel operators have been making money so far, but what happens if we sink into a full-blown recession and their debt comes due next year?” Loeb says. “There is a chance that more and more hotel owners will have trouble replacing their debt. That will force more assets onto the market for sale.”

Savvy dealmakers are bulking up. Morris Lasky, who has been managing, buying and selling hotels since the Eisenhower administration, has raised $300 million from overseas institutions in the past year and organized a new fund called the Lodging Opportunities Group in Chicago. With leverage, Lasky plans to complete $1 billion of deals.

Other investors are raising money on a far smaller scale. Penta Hospitality LLC in San Jose, Calif., buys hotels priced at $15 million and less. The firm's initial $7.5 million fund is committed, and now it's halfway to its goal of raising $15 million for a second fund.

This year Penta has spent $4.25 million on a 150-room Regency Hotel in Greeley, Colo., and $6.5 million for a former Best Western with 215 rooms in Denver. Regional lender Pueblo Trust Bank extended generous mortgages on each after studying Penta's plans to spend millions more to upgrade the properties.

“The big banks are gone, and so we lean on local banks, who know their markets and their geography,” says Mukesh Mowji, a principal with Penta. “Pueblo believed in our deals.” Mowji expects to acquire new flags for his hotels, boost their cash flow and flip them within three to five years. “We hope to get north of 20% IRR on properties like these.”

Private equity stays neutral

Private equity giant The Blackstone Group is sitting on a $10.9 billion fund. After spending billions to acquire Hilton and Meristar, Blackstone lately has been a net seller. On Aug. 12, it sold its position in the 367-room Radisson Plaza Hotel Lexington in Kentucky for an undisclosed sum to its joint venture partner in the property, the Webb Cos.

“This is not a good time to be selling hotel assets,” admits Glenn Alba, a Blackstone managing director. “Only deals with strong cash flow can get financed. Overall, we're not a net buyer or seller. We're just sitting back and waiting to see where the world ends up in the next few months.”

At Denihan Hospitality Group, Patrick Denihan isn't so patient. “Two years ago you'd have a deal and call five lenders. Before long, 15 would be calling you back to offer money. Today, you call 15 lenders and hope to get one of them to make you an offer.”

Although the Surrey hotel deal in New York was financed by the Canadian bank CIBC, Denihan will consider partnering with private-equity investors. He expects tight credit conditions to ease in 2009. “But you can't wait until then to act. Now is the time to be looking and lining up potential deals. The market is likely to get a lot more crowded next year.”

H. Lee Murphy is a Chicago-based writer.

TOP FIVE U.S. HOTEL SALES BY PRICE (JANUARY-JUNE 2008)

Through the first six months of 2008, five single-asset hotel sales have exceeded the $100 million mark, down from 19 during the first half of 2007.

Property Name Location Price Rooms Buyer Seller
Fontainebleau Miami Beach Resort Miami $375 million 1,500 (post-renovation) Nakheel Hotels (50% stake) Fontainebleau Resorts LLC
Hyatt Regency Century Plaza Los Angeles $366.5 million 726 Next Century Associates Sunstone Hotel Investors
Renaissance M Street Hotel LLC Washington, D.C. $141.3 million 355 Affiliate of Losan Hotels World Northview Hotel Group LLC & Westbrook Partners
Sheraton Grand Sacramento Sacramento $130 million 503 David Taylor & CIM Group City of Sacramento
James Hotel Chicago $119 million 297 Denihan Hospitality Group The James Group
Source: Jones Lang LaSalle Hotels