It's been a long wait for hotel investors, but finally their time has come. For nearly three years following 9/11, hotels were pretty much left out of the party as prices for other types of commercial property soared. In 2001 and 2002, while retail REITs pumped out double-digit returns of 30.4% and 21.7%, hotel REITs were in a prolonged slump, registering returns of negative 8% and negative 1.4%.

Seeking a safe haven, a majority of private and institutional investors shunned hotels and instead chose to plow billions of dollars into shopping malls, office buildings and even warehouses — and for good reason. The combination of a recession and the shock of 9/11 curtailed business travel significantly. The average occupancy rate in the top 50 U.S. markets, which dropped from 68.5% in 2000 to 61.4% in 2002, only began to recover in late 2003.

Now, however, travelers are booking rooms again. Average occupancy in the top 50 markets was projected to be 64.7% for 2004, an increase of 5.2% over 2003 levels. Occupancy should rise to 66.6% this year, say hotel researchers.

Travelers aren't the only ones checking into hotels. Investors are embracing the sector as well. Through Dec. 16, hotel REIT stock returns were up 25.47% for the year. That compares favorably with office REIT stocks, which climbed 19.91% during the same period, according to the National Association of Real Estate Investment Trusts (see table on page 22).

In fact, as the lodging industry picks up steam, hotel investments are expected to generate a significantly higher rate of return than all other real estate segments, including industrial, multi-unit housing, office and retail, according to Torto Wheaton.

Hotels purchased in 2004 and held for the next five years, for example, are expected to generate total returns of 16.6%, compared with 9.1% for retail, 8.7% for multi-unit housing, 5% for industrial property, and 4% for office buildings, says Craig Thomas, managing director of Torto Wheaton, who adds that these average returns factor in both net operating income and asset appreciation. “Without a doubt, hotels are the strongest property types right now,” says Thomas. “The hotel segment is hot.”

“All the stars are aligned,” echoes Jack Corgel, managing director of PKF's Hospitality Research Group. “Income streams are quite attractive, cash flow is up, and interest rates are down (in historical terms). Investors are looking at a run where they can collect nice dividends for the next three years without a lot of risk.”

A Bidding War Ensues

So, it's no surprise that there is an abundance of buyers willing to pay top dollar for hotels. Case-in-point: The Plaza Hotel in Manhattan was sold by Plaza Operating Partners, a partnership of Millennium & Copthorne Hotels and Kingdom Investments, to Elad Properties for $675 million in October — more than double the $325 million Plaza Operating Partners paid for the hotel in 1995.

That price pencils out to about $838,509 per room, the highest for a New York hotel in 2004, according to Cushman & Wakefield, which arranged the sale. Elad, a U.S. subsidiary of an Israeli-based real estate investment company, plans to renovate the property and convert some of the 805 rooms into luxury condominiums. “There are a significant number of large hotels selling because the marketplace is flush with cash. There's a lot of money chasing deals,” says Patrick Ford, who is president of Portsmouth, N.H.-based Lodging Econometrics, which tracks hotel transactions and development.

Most of the competition for high-profile hotels is coming from major hotel groups, REITs, foreign investors and large institutional investors. Many new private funds are also bidding for prime urban properties, as are real estate investors which, like Elad, are buying hotels to convert into condominiums or condo-hotels.

These buyers are primarily seeking larger and more expensive full-service hotels — unlike a few years back when most hotel transactions involved smaller properties. In 2003, for example, 596 hotels with an average of 137 rooms and an average selling price of $71,031 per room changed hands. For the first three quarters of 2004, however, 389 hotels, averaging 165 rooms, were sold at an average selling price of $83,681 per room, according to Lodging Econometrics.

“In 2004, we have seen an increase in the number of larger chain-affiliated, full-service, resort and luxury hotels being transacted,” says R. Mark Woodworth, executive managing director of PKF Consulting in Atlanta.

With interest rates expected to remain favorable for the foreseeable future, the window for buyers should remain open through 2006, says Ford.

Yet, not all is rosy. Hotel owners are faced with increasing pressure to trim costs in order to maintain profits — at a time when fuel prices are at record highs, insurance is spiraling out of control, and payroll is rising to accommodate more guests. This growth in operating expenses can mitigate gains in profitability if owners are not careful, according to PKF.

A SECTOR-BY-SECTOR LOOK AT REIT PERFORMANCE*
2000 2001 2002 2003 2004 (YTD)
Lodging/Resorts 45.32% -8.07% -1.44% 31.75% 25.47%
Retail 17.97% 30.42% 21.07% 46.77% 37.57%
Apartments 35.49% 8.67% -6.13% 25.48% 31.55%
Office 35.46% 6.65% -6.29% 34.01% 19.91%
Industrial 28.62% 7.42% 17.32% 33.14% 30.38%
* The figures represent the year-over-year percentage change in total returns, which include stock price appreciation or depreciation plus reinvested dividends. The figures for 2004 are year-to-date through Dec. 16.
Source: NAREIT Composite Index

No Hiring Binge

In recent years, hotel companies reduced payroll and deferred renovations because occupancy and revenues dipped, says Mit Shah, president and CEO of Noble Investment Group in Atlanta, which owns 28 hotels with 5,000 rooms.

But ironically it's the next few years as the economy recovers that will test most hoteliers' mettle. Owners need to remain vigilant about controlling expenses such as labor even in the wake of rising RevPAR, says Shah. “Even the best of managers will have a hard time managing costs,” adds PKF's Woodworth.

It's tempting for operators to start adding employees to support guest services, says Shah. But it's imperative that companies stick to a plan that makes fiscal sense. This may mean foregoing an extra front desk clerk until the hotel hits 70% occupancy, he says.

To tackle rising costs, many investors are converting properties into condo-hotels. Turning a section of a hotel into condominiums, which can then be sold at a premium, helps offset operating costs. So, what caused the hotel market to heat up so fast? It's necessary to first understand what caused the industry to crash and burn. Flash back to late 2000, when the economy started to soften. The downturn — combined with the terrorist events of 9/11, the war in Iraq, and the SARS virus scare — brought travel to a near standstill in 2001. Leisure travelers put off vacations and business travelers stopped taking trips due to company budget cuts.

Hotels watched their occupancy, rates and revenues plummet. To make matters worse, lenders wouldn't finance large projects in the midst of uncertainty, causing the hotel acquisition market to fizzle, says Doug Artusio, president of Alpharetta, Ga.-based hotel company Dellisart Lodging.

Chicago real estate and investment management firm Jones Lang LaSalle took the Westin Hotel on Chicago's North Michigan Avenue to market right before 9/11 and had to take the prime property off the block because no one would touch it, recalls Arthur Adler, Jones Lang LaSalle's managing director and CEO-Americas.

But starting in July of 2003, travel began to increase amid an improving economy. That spurred a cyclical rebound for the hotel business, which was all the more dramatic because hotels had fallen so hard, so fast compared with other real estate sectors.

Just take a look: PKF projects that average daily rates (ADR) will grow from $94.36 in 2003 to $97.85 in 2004, representing a 3.7% increase (see table on page 24). Also, revenue per available room (RevPAR), in turn, is expected to jump 9.3%, to $63.40.

“In 2005, ADR will be the main driver of RevPAR improvement, and when ADR dominates RevPAR growth, more dollars fall to the bottom line,” remarked Woodworth in a recent hotel industry profit report.

November marked the industry's 17th straight month of higher ADR, occupancy and RevPAR. These positive economics, combined with the dearth of new supply, have created a resurgence in acquisition activity, according to Lodging Econometrics. “The supply constraint really exaggerates the demand,” says Thomas at Torto Wheaton.

Since 1998, new hotel supply has decreased every year — bottoming out in 2004 when only 586 new hotels opened with 59,157 rooms, down from 604 hotel with 73,370 rooms in 2003, says Ford. Supply is expected to creep up to 680 new hotels with 69,488 rooms this year and 723 hotels with 79,871 rooms in 2006. These modest increases will continue to fuel the industry's recovery, he says. “We're in a sweet spot right now,” adds PKF's Corgel.

HOTEL VITAL SIGNS GROW STRONGER
(Yearly Averages for All Hotels in the Top 50 U.S. Markets)
Occupancy Rate
2001 2002 2003 2004* 2005*
62.7% 61.4% 61.5% 64.7& 66.6%
% Change Year-Over-Year
2001 2002 02003 2004* 2005*
-8.3% -2.1% 0.2% 5.2% 2.9%
Average Daily Rate
2001 2002 2003 2004* 2005*
$98.35 $95.33 $94.36 $97.85 $102.44
% Change Year-Over-Year
2001 2002 2003 2004* 2005*
-2.4% -3.1% -1.0% 3.7% 4.7%
*Projected Figure
Sources: PKF Hospitality Research, Smith Travel Research, Torto Wheaton Research

In Demand: City and Resort Hotels

Remember that Westin Hotel in Chicago that Jones Lang LaSalle couldn't give away right after 9/11? Well, in June 2004 it went back on the block. The 751-room property quickly went under contract for $137 million, or about $182,000 per room, says Adler. Likewise, Jones Lang LaSalle recently took the two-year-old Embassy Suites River East in Chicago to market for its owner, a Japanese institutional client. A dozen hotel groups were interested. Host Marriott ultimately bought the property for $89 million last spring. “From start to finish, the deal was done in three months. We've been busy and our pipeline is strong,” says Adler.

Urban and resort markets are the hottest tickets right now — particularly because it's difficult to find suitable sites to build and new construction is considered more costly than buying in these areas. In many cases, resort and urban properties are receiving unsolicited purchase offers.

MeriStar Hospitality Corp. retained Jones Lang LaSalle last November to market the Doral Desert Princess Resort in Palm Springs, Calif., after receiving numerous offers. The 285-room resort is located on an expansive 13.3-acre site, overlooking lush fairways and the majestic San Jacinto Mountains. It has 23,000 sq. ft. of flexible meeting space, three restaurants, and permanent access to an adjoining 27-hole, PGA-championship golf course. Jones Lang LaSalle expects the property to sell for close to $25 million.

Both the Doral and Westin are located in areas where there is little new supply and barriers to entry are high. That makes them prime targets for investors, particularly deep-pocketed institutions, REITs, large hotel companies and private funds.

“We focus on urban markets where it's difficult to build,” says Neil Shah, vice president of acquisitions and development at Hersha Group, a Philadelphia REIT which owns 32 hotels primarily in Northeast cities like New York, Boston and Washington D.C. Hersha, which affiliates most of its hotels with Marriott or Hilton brands, is actively looking to buy properties for $15 to $20 million. In the last year alone, Hersha acquired 12 hotels and has six projects under development.

Equity Inns, a REIT based in Germantown, Tenn., also has been buying urban hotels. The company planned to close on $186 million in hotel deals by the start of 2005. The transactions include 1,871 rooms in 20 hotels, according to Equity Inns President Howard Silver.

Fierce competition for properties in major cities has led some hoteliers to look at other options for gaining entry into these lucrative markets. In October 2004, Hersha acquired a Manhattan office building that it plans to turn into an extended-stay hotel, perhaps a Residence Inn. Dellisart Lodging also acquired a building in Chicago, which it plans to raze and replace with a new 209-room Staybridge Suites. A joint project between Dellisart and Miglin Properties, the $42 million Staybridge Suites, will include four levels of parking and a 10,000 sq. ft. restaurant.

Pruning the Portfolio

Many hotel companies seeking to expand portfolios in the top urban and resort markets are shedding hotels in secondary and tertiary markets, some of which were overbuilt in recent years. Omaha is facing a glut of incoming supply that will limit RevPAR growth to 1.9% between 2004 and 2006, according to PKF, Smith Travel Research and Torto Wheaton.

FelCor Lodging Trust, an Irving, Texas-based REIT with 145 hotels in its portfolio is selling 19 properties, including three in Omaha, says Mike DeNicola, FelCor's executive vice president and chief investment officer. The company had six Omaha hotels but sold two already — a Holiday Inn Express and Homewood Suites. FelCor plans to keep only the Crowne Plaza hotel — its top property in Omaha, says DeNicola.

The company prefers to own mid-market and upscale full-service hotels in major markets. “After we finish selling, 55% of our core assets will be in the top 25 markets and 80% will be in the top 50,” emphasizes DeNicola.

To this end, FelCor added a prime property to its fold in March 2004 when it acquired the Holiday Inn in Santa Monica, Calif., for $27 million. The hotel, right near the beach, is located in a dense Los Angeles market where there is little new hotel construction.

Companies like FelCor leave the door open for family-run companies and smaller investors to jump into the market and acquire properties in less expensive areas. No matter which way you look at it, “it's a seller's market,” says DeNicola.

Some hotel companies are opting to get out of the ownership business and concentrate on managing and franchising hotels. InterContinental Hotel Group (IHG) put 137 hotels up for sale last year. Thirty properties were sold by September 2004. “We've been blessed with tons of interest in our portfolio,” says Kirk Kinsell, IHG's senior vice president of franchising and business development for the Americas. “We'll end up owning just a few key properties, like the InterContinental Barclay in New York,” says Kinsell, adding that the company is helping its franchisees buy and reposition hotels as IHG brands. IHG recently sold The InterContinental Central Park South to Anbau Enterprises for $63.5 million, or $300,000 per room. The deal included a 100-year ground lease and Anbau intends to develop the property into cooperative apartments.

Condo hotel developers like Anbau, however, face stiff competition from other aggressive buyers, including funds formed specifically to buy and reposition hotels. A key example is Lowe Enterprises, parent to Destination Hotels & Resorts, which manages 29 mainly upscale properties in distinctive urban and resort settings.

MAJOR HOTEL SALES OF 2004*
(Listed by dollar amount, not including casino hotels)
Name of Hotel # of Rooms Buyer Seller Selling Price Price Per Room
The Plaza New York 805 Rooms Elad Properties Millennium Hotels & Resorts $675 million $838,509
Hyatt Regency, Washington, D.C. 834 Rooms Blackstone Real Estate Strategic Hotel Capital $160 million $191,847
Marriott Hotel. Indianapolis 615 Rooms LaSalle Hotel Partners Kite Cos. $106 million $172,358
Marriott Hotel, Irvine, Calif. 484 Rooms MeriStar Hospitality Cigna Insurance $93.38 million $192,930
Ritz-Carlton, Arlington, Va. 345 Rooms MeriStar Hospitality Walton Street Capital $92.87 million $269,186
*Transactions were the largest 100% fee-simple sales through mid-December 2004 for which a purchase price could be determined, and for which the hotel remained open after sale.
Sources: Lodging Econometrics, National Real Estate Investor

Last year Lowe formed a private fund to buy hotels and has closed on three deals, including the Omni Hotel in Richardson, Texas (now called The Richardson Hotel), The Doubletree Chicago O'Hare Airport and The Miramonte Resort & Spa in Indian Wells, Calif. The fund is pursuing a half-dozen potential deals, says Destination's President and COO Charlie Peck.

Los Angeles-based Lowe is also working with private investors and pension funds to buy aging hotels that Destination can help reposition, manage and turn around — giving investors elevated returns, says Peck.

Destination's ability to turn hotels into crown jewels has created demand for Lowe's real estate services. “There is a lot of money out there competing for properties and we've got five people scouring the country for opportunities,” says Peck. “Yet, we're more likely to buy properties that are broken and need to be fixed.”

Robyn Parets is a Boston-based writer