As the lodging industry experiences what promises to be a second straight year of record profits, hotels continue to find an abundance of both debt and equity capital from a variety of sources. "Clearly, since the early-1990s, the entire lodging sector has re-capitalize itself," says Jacques Brand, managing director in the real estate investment banking group at BT Securities Corp., part of Bankers Trust, New York. "Equity has led the way, together with high-yield debt," he says.
Money is coming from both public and private sources: from conduits and finance companies, banks, pension funds and a few of the larger insurance companies, led by those who have had long-time familiarity with the industry and familiarity are aware of the continued strength of the sector's underlying fundamentals. "The general performance of the hospitality sector is better than any other segments of the commercial real estate market," Brand says.
All of the industry's benchmark statistic show the reason for the bullishness.
Overall profits, occupancy rates, room rares and breakeven points all remain at impressive levels. New supply has been fairly limited by a general distaste for construction lending and because it remains cheaper to buy than to build in most sector, although the gap is narrowing. Demographic indicators and relative economic stability paint an even rosier long-term picture of sustained demand. And new type of capital structures combined with industry efficiencies and marketing innovations may help stretch the good times even longer - or at least protect much of the industry from any severe downcycle.
Hospitality industry profits are expected to be $10.5 billion in 1996, up from $8.2 billion in 1995, according to Bjorn Hanson, national industry chairman for hospitality at Coopers & Lybrand, New York. "It is a very strange cycle following a very strange cycle,"' lianson says, pointing out that only six years ago, hotels saw their worst year in history, ending 1990 with substantial losses of approximately $5.7 trillion.
Occupancy levels of just over 60% in 1991 were the lowest in decades but have risen to a projected 66% for 1996 - a 10-year high and 2% above the 20-year average. Occupancy stands within only one-tenth of a percentage point more than 1995, which "sounds like limited occupancy growth," Hanson says. But he points out the importance of remembering that the industry is at high occupancy levels, and"revenue is growing much more than occupancy would indicate, because rates are increasing at such a premium over inflation."
Average daily rate (ADR) is rising faster than inflation for the third year in a row, according to a special report on hotel properties by Patrick Corcoran of Nomura Securities' Commercial Real Estate Research Group. Coopers & Lybrand's projects ADR for 1996 at slightly more than 11%, an increase of 5.1%, with inflation at 2.5%, says Hanson.
"From 1987 to 1993, rate increases failed to keep pace with inflation but, since 1994, they are at premium over intiation," Hanson says.
Corcoran says that this has helped push up profit margins and reduce breakeven occupancies. Occupancies are now clown to 62.5%, contrasted to a 1980 level of 66%, according to Hanson.
Thee decrease is attributable not only to rate increase but to an industry forcused on saving money - and more used to living in a "a lower leverage environment," according to Brand, who points out that "interest expense as a percent of total room revenue is at one of the lowest levels since the early-1980s, which points to a more efficient market overall."
Hanson says industrywide interest payments have decreased by approximately $3 billion because of various sales, foreclosures and restructurings as well as lower interest rates. Brand says he expects more prudent leverage levels to continue through the remainder of the 1990s.
"The industry has changed its economics," Hanson says. "In 1987, there were 87.5 employees for every 100 rooms. Now there are only 81 employees for every 100 rooms in the hotel industry" even with higher occupancies. "It shows a leaner industry that is finding ways to make do with fewer employees." Operational reductions that have helped save more than $1 billion in food and beverage operations combined with lower management fees have led to the historically low breakeven cost.
Hanson also mentions that as hotels began their recovery cycle in the early 1990s, "more than 80% of revenue growth was attributable to occupancy increases. Now, more than 90% of the revenue growth is because of rate increases." He also says that this would normally indicate that the upward cycle may be reaching completion within a few years but not necessarily.
Supply and demand factors could help prolong the current cycle. "Because full service properties remain at sizeable discounts to replacement cost levels, their prospects continue to be buoyed by a complete absence of new supply as well as by modest growth in demand," according to the Nomura report, which states that the "most favorable situation here is in the luxury and upscale price segments that face relatively little competition from newly constructed limited service hotels, where new supply has been concentrated.
By contrast, it is the midprice and economy full-service segments that are facing the full onslaught of new limited-service supply."
Hanson says there are conflicting reports regarding the future supply of hotels, with some analysts forecasting an overbuilt market heading toward doom while others report virtually no new construction. Hanson says 89,000 rooms in various stages of planning or construction across the United States in all lodging segments. If viewed as a percentage of growth, this number is about 2%, which is just a fraction above the average 35-year growth rate, he says. New construction is not evenly distributed geographically or by price segment. "There is very little new construction in the Northeast or on the West Coast. Most of it is occurring in the Midwest, Southwest and some in the Mid-Atlantic region." Hanson says that another common misconception is that limited-service hotels, which are seeing most of the new construction are often erroneously considered to be in the budget or economy range. This is not the case, as Holiday Inn, Hampton Inn and Marriott Courtyard, for example, are all midpriced, he says. Hanson has dubbed these the "premium limited service" segment and says he expects a 13% to 14% supply growth in this area this year, with an overall demand growth of 2.2%.
The profusion of capital in the market is helping to drive up hotel prices, which is why Hanson says he believes that by year's end the industry will see "much narrower gaps" in the cost of buying vs. building in both the full-service and luxury segments. "The availability of capital is more important than revenue in determining both the levels of new construction and sales and acquisitions."
Long-term hotel demand is bolstered by overall economic health, increased business and consumer confidence levels, and the fact that baby boomers are entering their highest income years, which translates into "more vacations and more hotel stays," according to a report by Bankers Trust, which adds that the "baby boomers were the first generation of Americans to grow up regularly staying in hotels," which should bode favorably for the lodging industry for the next 10 to 15 years.
Hanson says he sees only one possible problem: "a demand disruption" that could be caused by such possible travel-curtailing culprits as another Gulf War, security fears, increased fuel costs or an oil embargo. But short of any substantial demand buster, the industry should see at least two more years, if not longer, before the current cycle ends, Hanson says. "By historic standards, it is a favorable cycle that has lasted longer than ever, with long and rapid growth in revenue that has never before been observed in the lodging industry."
Sustained industry success may also come about because of more creativity from hotel owners who, as Brand mentioned, are busy finding ways to most effectively compete in a hot market by repositioning their product or developing branding strategies that increase market share. "The industry is in a period of experimentation, finding ways to provide services and amenities to maximize revenues and appeal to different types of travellers," Hanson says.
Increased segmentation of the industry may also lead to further niche lenders such as Phoenix-based Finova Capital Corp., which has seen half of its new business in the last four years come from the hospitality sector and has a resort finance group that is one of the largest timeshare lenders in the business, according to Randy Heller, vice president.
Heller says that focusing on resorts and the high end of the market may not appeal to every lender. "Not everybody likes the fact that each deal is unique, and that resorts take more patience." But the upside is in the development of a customized approach that allows Finova the luxury of not having to compete with conduits for every Hampton Inn deal or on projects "where you have to go head to head with those who have to add value," he says.
Yet, similar to other successful lenders to the hospitality industry, Finova has built and maintained a reputation by being "in it for the long haul" with a more relationship- than transaction-oriented approach. Although its lending slowed in the late-1980s because "underwriting was too sloppy," Heller says, Finova was active in the early-1990s "when others were not." Consistently conservative underwriting has helped the firm avoid hospitality horror stories, Heller says, and the increased competition of today's market has forced it to tighten its pricing rather than loosen its lending terms. "As we head into a time when capital is readily available, there is only so far we will go," he says, adding that Finova is prepared for any potential downcycle and will take its share "at terms we like until the market swings hack to a more conservative time."
Many believe, or at least hope, that other lenders share the same prudent lending philosophy. Heller says there are still many lenders who do not want to take construction risk, and any downcycle "will not be as bad as the last one because it is not the same tax game, and there is not as much new construction. Things should not be as exacerbated this time."
The fact that most hospitality lending is now done on a cashflow basis rather than being loan-to-value (LTV) oriented contributes to a more sane environment and is one ingredient of success that was missing in the 1980s, Brand says. "One reason bank lenders are re-entering the market is because they have a greater awareness of prudent and well-monitored financing structures, which are more conservative," Brand says, mentioning that the mechanism of senior secured financings is normally a combination of a trailing 12-month cashflow at a 2.5 debt service coverage (DSC) level plus the added constraint of an LTV test, "which helps protect you against new supply," Brand says, adding that banks are also attracted to the increased liquidity in the market, which makes "the risk premium relative to the risk very attractive."
But Hanson says that except for REITs, many lenders are now once again looking at projected rather than trailing cashflow. Discounted cashflow analysis is back, he says, and "underwriting is reflecting revenue growth" although "using more sensitivity."
Brand says most bank activity, whether it be by banks who had been On the periphery or new banks who have never been involved with hospitality before, is being performed cautiously and on a corporate basis with organized hotel companies rather than being project oriented. Individual project financing "is tough to accomplish," he says, and requires borrowers to have at least 50% equity or some type of surrogate equity. The only individual assets that are being financed are those that are well-located and well-positioned in their market, Brand says, mentioning, as an example, Bankers Trust's $66 million development financing of the $125 million 800-room Loews Hotel Miami Beach, which represents "excellent sponsorship" in the experienced owners of Loews Hotels and "in a market that desperately needs a luxury hotel in order to service a nearby convention center." Another example of a stand-alone financing is BT's $165 million financing for the expansion of the Boca Raton Resort & Club, which was comprised of senior bank debt and a number of layers of mezzanine and equity. Again the ingredients were strong project dynamics, good performance and cashflow, and experienced management, Brand says.
"Just a handful of life companies are interested in hotels because they experienced serious losses and are, therefore, hesitant to jump hack in," Brand says.
Hanson says some of the life companies are back, "but they are not announcing it in a big way because they do not want to be flooded with requests, and they know that their shareholders remember past mistakes."
Other sources of financing are private and foreign entities, as well as Wall Street and hotel management companies that are increasing their equity in acquisitions for their own accounts and with other purchasers, Hanson says. Some pension funds are active, but they do not represent "big dollar numbers," according to Hanson.
Overall, the industry is more public, and "the capital markets for hotels is strong and continues to gain momentum," Brand says. He mentions a spate of new initial public offerings (IPOs) and secondary issues by Host Marriott, Prime Hospitality and other established hotel firms in the last 18 months and that Bristol, Wyndham and CapStar have all gone public within the last six months, "having found a more suitable resting point in the capital markets."
Hanson says he believes there are too many public hotel REITs for institutional investors today, and he expects some consolidations, very few new IPOs but an increase in secondary offerings.
On the debt side, hotel companies are beginning to access the commercial mortgage-backed securities (CMBS) market for long-term financing at attractive fixed rates, Brand says, and CMBS investors are showing interest in pools comprised of only hotel assets.
James B. Frantz writes about real estate issues from his home in New York.