To assess the future direction of the hotel industry, a look at its past is in order. Limited new construction occurred in the late 1980s and early 1990s, and more than 20% of hotel inventory was obsolete. New forms of lodging, particularly inns and suites, entered the marketplace. With the strength of the national economy, demand accelerated and industry profits rose higher than ever.

Between 1993 and 1998, new hotels, especially in mid-markets and the mid-priced segment, were planned or constructed on what seemed like every corner. (More than 150,000 rooms opened in 1998 and 1999). Capital, both equity and debt, was easily available. Values rose as REITs purchased hotel organizations and portfolios for top dollar. It was a true seller's market. The hotel industry, as reported in the January 1999 National Real Estate Investor, experienced a "thrilling ride."

However, beginning with the August 1998 credit crunch, the industry faced changing circumstances. Money for all types of commercial real estate ventures was difficult to obtain, but more so for hotels. Available financing sources turned conservative. Capitalization rates rose and prices fell. Money for construction became more difficult to find, although construction continued on the existing projects already in the pipeline. Hospitality company stock prices dropped drastically. Suddenly, people began to recognize that some markets and some segments were overbuilt, and the thrilling ride seemed to be veering into a catastrophe.

Overbuilding continued to put pressure on both occupancy and revenue per available room (RevPAR. Nationally, according to Smith Travel Research, the rate of growth of room RevPAR dropped from 4.3% to 3.1% during 1999. RevPAR at year-end 1999 was $51.42. Occupancy decreased 0.3% to 63.5%, declining for the third straight year because of oversupply.

For the past several years, the percentage increase in supply has risen more than growth in demand. In 1999, demand experienced a 3.3% growth rate, but supply increased by a larger 4.2%. More than 140,000 rooms had yet to open in 2000.

Average Daily Room Rate was up 4% in 1999, reaching $81.27. Overall profits continued to rise due to room rate increases and operating efficiencies. Smith estimates that pre-tax profits in 1999 could reach $23 billion to $24.5 billion, compared to the $20.8 billion recorded in 1998.

All of these statistics refer to the national hotel market. To Jack Ward, president of Hodges Ward Elliott, Atlanta, talking about the market in that sense is illusory. There are sectors and locations that are up and down in the hotel business.

For overbuilt markets, future looks somber Alan Brock of Dallas-Fort Worth-based Alan Brock & Associates recalls that the hotel market peaked in Texas by early December 1998 and occupancy began declining because of new construction. "The national statistics indicate the industry is having record overall profits, but not in our particular area of the country," reports Brock. "Our older properties are really hurting. The older units are going to have to be dramatically changed physically or they are just not going to be competitive." Non-competitive, older hotels, unfortunately for the market, typically remain open, dropping into lower rent tiers or operating without franchises.

"We are presently in a declining front in most phases of the industry," says Jon Fels, president & CEO, Fels Hotel Group, Baton Rouge, La. He believes demand is overstated by industry executives and warns that one has to be extremely careful in assessing trends and data, including the state of the economy. Historically, Fels adds, the hotel industry in the South experiences change first, then the South Central, North Central, East Coast and finally the West Coast. The South and parts of the Midwest, according to Fels, are now experiencing a downturn.

The hotel market's ebb and flow is emphasized by Jim Burba, senior managing director of Development with Newport Beach, Calif.-based Insignia/ESG Hotel Partners Inc. At the beginning of the recent run of construction, the coastal markets were weak, southern and midwestern hotel markets were strong and easy to enter, and in the suburban Midwest and South, land was available at a lower price and capital was available from local lenders. "One thing led to another," says Burba, "and now the South and Midwest are overbuilt, while the urban coasts are now running good."

Other areas continue to see upturn Doug Hercher, managing director of New York-based Jones Lang LaSalle Hotels, believes that most of the major markets (New York, Boston, Washington, D.C., Los Angeles and San Francisco) are still undersupplied relative to demand. "In some instances, significantly undersupplied," says Hercher.

Hercher also believes that people are beginning to return to markets that were quiet throughout the 1990s. In Hawaii, for example, he is seeing an uptick in the number of deals being done. The Japanese are finally selling their hotel assets in Hawaii, and mainland tourism, especially to Maui and the Big Island, is growing. With the added resurgence of the Asian economy and the return of Asian tourists, "the fundamentals are getting better every day," he says.

Sharon Lemon, vice president of Communications with HMBA: America's Hotel Broker, Chicago, would agree. "In hot areas such as resorts, Silicon Valley, Boston, New York and southern Florida, demand will remain strong and construction of new properties should continue," says Lemon.

Overbuilt product types add to troubles Not all products are equal in this hotel market. The hotel industry is highly segmented. By price, segments include luxury, upscale, mid-price, economy and budget. Product types include full service (with food and beverage) and limited service (no food and beverage, which includes extended-stay properties). Segments are also divided by location into urban, suburban, airport and resort.

Limited-service and economy hotels appear overbuilt in a majority of geographic markets. Mid-priced and budget properties are considered overbuilt in a number of markets.

Besides affecting older facilities and often being overbuilt, new properties at the lower end of the price spectrum may be damaging other hotel products. Brock thinks extended-stay products are hurting budget hotels. Long-assignment workers who would stay two or three weeks at a Ramada Inn or EconoLodge are going to extended-stay hotels. "Over the long term," says Brock, "extended-stay hotels are cheaper, have more space, and offer more amenities such as cooking facilities."

The hotel market has peaked for most product segments, except for location-specific, full-service hotels, says Rod Apodaca, vice president of Sperry Van Ness, Irving, Calif.

"With all the wealth in the country, full-service hotels are growing and successful," agrees Ward. New construction in urban markets is more expensive and more time-consuming. Land is scarce and expensive. For these reasons, new supply is added more slowly than in mid-sized and mid-priced markets. Lawrence Wolfe, managing director of New York-based Eastdil Realty, says there has been a dearth of notable full-service hotels to open nationally in the last 10 years.

Profits, room rate growth to slow Bill Murney, senior vice president of CB Richard Ellis Hotel & Leisure Services in Phoenix, sees a somewhat wind-becalmed market: "Future increases will be smaller for room rates, depending upon the area of the country. Occupancy is going to be relatively stagnant, although some high-end urban markets like Chicago, San Francisco, New York and Washington, D.C., will still do well. Profits will continue to go up but not at the rate they have recently, as a lot of operational efficiencies have already occurred," says Murney.

Operating profits will become stable or only go up a little, expects Bill Moyer, director of Donohoe Real Estate Service's Hotel Advisory Group in Washington, D.C. Moyer, however, still sees additional savings, as technology causes operating costs to go lower, such as property maintenance systems, energy savings and labor costs (front desk). He also predicts that costs of goods will diminish as the larger hotel companies put pressure on suppliers. Use of the Internet could provide less expensive routes for reservations, says Moyer, but only if people do not have to go through large dot.com companies.

Not wanting to chime the bell of doom, Jerome Cataldo, executive vice president of development for Chicago-based Hostmark Hospitality Group, says, "Operations are still very good, and operating margins are very strong. There are challenges upon operating costs, i.e., labor costs, but [hotels] are strong and profitable now."

Many hotel executives believe that occupancy, especially in the middle of the country, will not climb again until 2001 when additional supply is limited, and only if demand remains strong.

Financing changes affect new construction With the withdrawal of public money and conduit/Wall Street funds in 1998, construction began to decline. The pipeline for hotels, however, was so long that supply continued to increase through 1999 and into 2000. The number of new hotels being developed in 2000, according to Arthur Adler, managing director of New York-based Sonnenblick-Goldman Co., will fall well below 1997 and 1998 "because of the crimp on capital and lack of public equity that was available then."

"It took awhile for public money to have a downstream effect," says Moyer. A number of projects were halted because of lack of financing, but many projects were already under way.

Financing is one of the barriers to construction although, according to Eastdil's Wolfe, several markets can still support new supply. "Capital, though, is very conservative. Lenders don't want to take much project risk. Some lenders want a guarantee on loans as well as hardy loan requirements, possibly up to 40% equity," he says.

More capital is available than a year ago, but has higher return requirements. Fels reports that for projects under $3 million, Small Business Administration capital is still available. For projects costing between $3 million to 10 million, various regional and local banks are still in the market, he indicates. Many of these loans are based on the on-going relationship between developer and bank rather than just the asset, Fels explains. For amounts above $10 million, developers and purchasers have to look to individual lenders (i.e., insurance companies, pension funds and other institutional money), he notes, adding that nonrecourse, non-conduit Wall Street money has disappeared. The interest rate is much higher, and underwriting standards are much more stringent.

Apodaca suspects capital markets will continue to be restrictive on their underwriting and probably will require higher reserves of one-half to a full percentage point for replacement.

Capital is definitely available for the hotel industry, says Hercher, but it is selective. "The numbers have to be there today," he says. "Lenders will only underwrite for what is in place."

When public companies and REITs were buying up everything they could, prices paid for hotels rose tremendously - an example of Federal Reserve Chairman Alan Greenspan's oft-quoted "excessive exuberance." Prices peaked in late 1997 and early 1998, according to HMBA's Lemon, but, with the credit crunch, prices dipped and hotels did not sell.

With prices declining, capitalization rates rose. Cap rates, according to Michael Fels, vice president of Fels Hotel Group, rose 1.5% to 2%, depending on the category, over the past 18 months, because of the rising cost of capital and the increasing hostelry rate, the higher risk part of the cap rate. Increasing cap rates, in turn, caused values to drop further. Michael Fels believes occupancy has plateaued or, in some cases, declined, causing lower revenues and lower profits and ultimately increasing risk.

Last year became an adjustment period. Naturally, sellers did not want to see a reduction in the price of their property. Few transactions, especially large sales, were completed. According to Hercher, there had to be a strategic approach to a transaction to get a deal through. For example, the 290-room Hotel Nikko in Los Angeles was purchased by the British hotel company Meridian for $82.3 million. One of the few transactions with a public company in 1999 was the sale of the 437-room Sheraton Premier Hotel in Tysons Corner, Va., to a joint venture between White Plains, N.Y.-based Starwood Hotels & Resorts and FelCor Lodging Trust, Dallas.

"Values have increased from late 1998," says Robert Koger of Molinaro Koger in McLean, Va. "However, they have not returned to their peak because the public companies are no longer driving the market as they once did."

According to Rod Sibley, managing partner of The Mumford Co., Atlanta, buyers were "skitsy. If there was a hiccup or a blemish on the deal, those buyers tended to retreat to the sidewalk."

2000 will be a much more active market than 1999, says Hercher, as the industry begins to return to a buyer's market. Other brokers are unsure. Murney expects less activity because of the costs of acquisition financing and the limited number of buyers.

Notes Murney, "the financing of hotels is very similar to mid-1998. The price is significantly higher for hotels than for other real estate types. The leverage that can be financed is lower, which makes the acquisition even more difficult, even without regard to the merits of the acquisition." In addition, Murney believes the number of buyers has dropped by 80%.

Sonnenblick-Goldman's Adler believes the buying market in 2000 is better because it is much wider. When most of the buyers were public, the market was narrower. There are fewer buyers today, but there are more types of buyers, including a few REITs, some institutional investors and some private owner/operators. Hercher is seeing the big opportunity funds, such as Apollo and Blackstone, New York, moving back into hotel investments and is seeing more interest by pension fund advisers such as Atlanta-based Lend Lease Real Estate Investment.

"The market is still very punishing for any downturn in occupancy or rate," says Sibley. The market punishes an asset because operating margins are tight due to higher interest rates, and capital costs are doubling in some instances. The only other cushion is price, and Sibley expects to see that continuing in 2000.

"Pricing is down 10% to 20%, or about 15%, from its peak, based on the increased cost of money and possibility of oversupply," says Murney. He thinks the dichotomy still exists between buyers and sellers. Recognizing that values have dropped and accepting a decrease in sale price are two different things. "Many sellers may have yet to face the reality now that pricing trends have reversed."

Other brokers think sellers have adjusted to the new pricing. As Ward observes, more moderate pricing has boosted smaller buyers' ability to move back into the market. REITs and other public companies are now net sellers as they dispose of properties that do not meet their long-term needs. Other companies also will try to sell off non-conforming or non-performing assets that don't meet their strategic plans. Starwood has said it will raise up to $500 million selling hotels this year and will use the money to buy back some of its own stock.

More transactions than in 1999 Regardless of the state of the hotel business, brokers still expect 2000 to be a moderate year. Almost all of the brokers contacted expect more transactions in 2000 than in 1999. Koger, however, expects the average size of transactions will be smaller and deals will take longer to complete.

The difference between late 1998, 1999 and 2000 is that buyers are back in the market. Pricing is more stable. Sellers appear eager. In small and medium transactions, buyers may be willing to stretch because they have not been able to acquire properties for several years. Lemon believes that many owners are feeling good about taking profits now and reinvesting in markets where they would like to be. "In 1997 and 1998, people were buying everything they could, and now the hotel market is like a game of chess," says Lemon.

Brokers definitely want to work only on transactions that will close. "In the hotel market, bid and ask prices can differ as much as 8% to 10%," he notes. "A lot more negotiations are necessary before coming to a final price. The wider the differences, the wilder the ride."

Steering the wild ride Brokers do not mind a wild ride - they just want to be sure they arrive at the right destination. "We need to continue to underwrite business as good, before we take it on," says Wolfe.

Nevertheless, "We will be more selective on the projects we work on," says Murney. He observes that the people who are motivated to sell have less flexibility in price. Many of the assets coming on the market were purchased in the mid-1990s and were rehabbed at the time. With full rehabs every five to seven years, buyers will be looking closely at cash flow and at capital expenditures the hotels will need in the next 12 to 24 months. This will further erode what they are willing to pay for the asset. Hercher adds that it is difficult to make sales on properties subject to long-term management agreements. "In major markets where you can change management, you can make deals," he says.

Apodaca thinks that the phrase "in 2000, cash is king" will be in play. In a competitive purchase, the purchaser buying with fewer financing requirements who can close quickly will have a better chance. It may be that a seller would go for a buyer with a higher down payment than deal with stricter underwriting.

Hercher sees investors looking overseas aggressively for higher returns. Although Jones Lang LaSalle Hotels recently handled a $225 million transaction for the Hilton in Seoul, Korea, there is more interest in Europe than in Asia at this time, he says. The company will be adding staff this year by opening an office in Miami dedicated to handling Central and South American real estate transactions.

Many in the hotel industry are beginning to look globally, both for additional demand in the United States and for company expansion. Moyer thinks international tourism will return to its peak as the rest of the world recovers, especially Asia. Cataldo notes that Hostmark Hospitality has 11 international management contracts today, including operating as a third-party manager in Egypt.

To some companies, the good year has already begun. In January, Hodges Ward Elliott brokered the sale of the 1,176-room Chicago Marriott, a full-service upscale convention center on the Magnificent Mile, to a joint venture of the Carlyle Group and LaSalle Hotel Properties for $185 million. BRE/St. Francis LLC, a unit of the Blackstone Group, has a contract on the 1,192-room Westin St. Francis Hotel in San Francisco for $243 million. Sonnenblick-Goldman will handle the transaction.

Forecasts show improvement Smith Travel Research, Hendersonville, Tenn., is optimistic about 2000 overall, says CEO Randy Smith. Supply is beginning to stabilize and growth in demand appears to be increasing. Smith thinks both supply and demand will grow at nearly 3.8% in 2000.

Smith anticipates room rates and revenues will increase another 4% and expects a record gross profit of $26 billion to $27 billion this year on revenues of almost $100 billion. Overbuilt markets in the South and Midwest will continue to struggle, although they too should experience some relief with a slowdown in new construction. Other markets, such as New York, San Francisco and Los Angeles, says Smith, will continue to do very well.

Thus, for 2000, hotel brokers see more sales activity and opportunities for new construction in major markets. The winds of change still blow, but brokers, always an optimistic lot, believe it's a fair breeze.