Although the overwrought exuberance experienced by the hotel industry continues into 1998, caution signs have begun to flicker, indicating that the party may finally be winding down.

"1997 was the most profitable year in the history of the lodging industry and there is no reason why 1998 will not surpass 1997 in revenue," says Robert Rauch, a director of business development for Interbank/Brener Hospitality in San Diego. Rauch likes the market so much he bought his first hotel. But even he has concerns. Real estate investment trusts, which shook up the hotel industry last year with acquisitions and mergers, may be hitting the wall. "They are not going to constantly be able to improve internal performance so they are going to have to make acquisitions and mergers which need to be accretive to their earnings," he says. "Eventually, high-quality deals will dry up and that pattern is certainly developing."

Last year was a record year for M&A activity, with volume totaling in excess of $40 billion. Just a partial list of deals completed and announced last year include Patriot American's acquisitions of Carefree & Resorts Ltd., California Jockey Club, Grand Heritage, Wyndham and Carnival Hotels; Starwood Lodging Trust's taking of Westin and ITT Sheraton, Doubletree marrying Promus, Extended Stay America nabbing Studio Plus, CapStar Hotel Co. getting together with Winston Hospitality, and Marriott grabbing Renaissance.

So far this year, the deals are still coming fast and furious, with headliners such as Meditrust grabbing La Quinta Inns, Servico Inc. buying Impac Hotel Group, Patriot American taking Summerfield Hotel Corp., FelCor Suite Hotels merging with Bristol Hotel Co. and most recently CapStar buying up American General Hospitality to form MeriStar.

There are going to be more mergers, says Jim Burba, a senior vice president at Hotel Partners Capital Group, in New York. "If you look at the landscape of management firms, there are over 1,000 such companies ranging in size from one or two properties to very large companies. And while they are not all merger candidates there are certainly a lot of economies of scale that can be gained by the proper selection of a new partner. We shall see more and more mergers as the year unfolds," says Burba.

Hilton Hotels, which was at the epicenter of merger activity last year, may end up having the most impact on the industry even though it was outbid by Starwood for ITT Sheraton in a bitter takeover attempt. Thanks to complaints by Hilton and other traditional hotel companies such as Marriott that the paired-share structure gives some companies advantages over other hotel owners and operators, the heads of both Congressional tax committees agreed to adopt Clinton administration proposals restricting the growth of paired-share REITs such as Starwood and Patriot American. Neither of the two has been as active this year as they were in 1997.

"You have seen a back-up in the REIT stocks in the last couple of months. The valuations that we saw in the REIT hotel market for the last two years are going to come back to reality," says Hilton's Matthew Hart, executive vice president and chief financial officer. "Last year, REITs were printing money in the basement and calling it stock. They were able to sell very lofty valuations based on the underlying value of the real estate."

Any pullback in stock prices makes it harder for REITs to make acquisitions by essentially trading stock for companies. Which is why, Hart observes, the pace of acquisitions by REITs "probably is slowing down."

This is not to say REITs won't or can't have their way in the market. Today's lodging sector enjoys a $70 billion market capitalization as compared to $7 billion in the early-1990s. It is also far more institutional and corporate. "There has been a gravitation by management to more public ownership which has resulted in lenders in the capital market gravitating toward lending and investing in the format where their investments and loans can more easily be monitored," says Jacques Brand, a managing director and head of the Lodging and Leisure Group at BT Alex. Brown in New York.

Over the past two years, BT Alex. Brown itself has been involved in 28 bank facilities, lending to 20 hotel companies in deals totaling over $14 billion in bank debt. If anything, the size of the financings has gotten larger. As recently as a year ago, Brand recalls, his company did a $200 million financing for Starwood, which was followed by a $1.2 billion financing, which was followed by a $2.6 billion financing and then the most recent, a $5.6 billion financing.

"Most of the capital market activity and financings in today's market are to public companies, which is in sharp contrast to the 1980s when financing was done at a much lower volume on a project basis," says Brand. "In the 1980s, lenders were more focused on loan-to-value rather than cashflow orientation which drives corporate lenders, corporate bond investors and equity investors."

When publicly traded companies are on the acquiring end of transactions, raising equity or debt (primarily debt!) has become straightforward as the public markets treated hotel companies favorably in 1996-1997. This year, the pattern continues, except the perception of the hotel industry is a slight bit cloudier. The market, says Hotel Partners' Burba, still holds hotel companies in good regard, but maybe not as favorably as last year. "There are still a lot of deals coming together, largely driven by the health of the stock market, but it's starting to settle down. Last year was red hot, this year is a notch below that."

On a basic level, the public hotel market is made up of REITs, which own properties, and C-Corporations, which manage hotels (and sometimes own) and never the twain shall meet except in paired-share REITs and the mimic financial structure called a "paper clip" REIT. With all of the publicity that REITs get, the fact of the matter is there are about three times the amount of hotel C-Corps than hotel REITs. However, the REITs' ability to grow appears to be outpacing C-Corps.

"The REIT structure seems to have a competitive advantage over the traditional C-Corp structures," says Robert Mullikin, a managing director with Horwath Landauer in New York. "The REITs have tremendous access to capital and their ability to grow and gain marketshare gets Wall Street very excited. The more REITs acquire, the more money they get. It is almost a never-ending cycle."

Individual property deals, especially with REITs, move fast and dealers aren't waiting for the lender to be lined up. "If you are going to put 60 to 70% financing on the new acquisition, that will be done at some point in the future," says Burba. "If you are a REIT, you might be issuing REIT shares or cash."

Mergers follow a similar pattern of cash, stock or both. In Meditrust REIT's $2.1 billion acquisition of La Quinta Inns, a Bass brothers affiliate that holds a 28% stake in La Quinta will get an 8.5% piece of Meditrust. The Bass group was originally expected to take cash in the transaction. Patriot American's acquisition of Summerfield Hotel Corp. cost $170 million in cash plus 4.59 million operating partnership units and paired shares for a total value of $283.9 million. In the FelCor-Bristol deal, FelCor is buying Bristol's real estate holdings in return for 317 million shares of newly issued FelCor stock. That transaction is valued at $1.9 billion, including the assumption of $700 million in debt.

A more complicated transaction has Servico REIT buying Impac Hotel Group for $111.8 million in stock and the assumption of $406 million in debt. The new company will be called Lodgian and Servico plans to issue 6 million shares of Lodgian to Impac shareholders and then swap its own shares for Lodgian on a one-for-one basis. In addition, Impac's shareholders will receive another 1.4 million shares when six hotels under construction are completed next year.

A perceived REIT advantage in deal-making may be one reason why some C-Corps are making the shift to the REIT structure. Host Marriott is consolidating six limited partnerships into a new real estate investment trust to be called CRF Lodging, which upon completion of an initial public offering will own 221 limited service and extended stay hotels located in 35 states and operate under three Marriott brand names - Courtyard by Marriott, Residence Inn and Fairfield Inn. The value of the IPO should be around $800 million.

"We intend to grow that company," says Robert Parsons, executive vice president and chief financial officer. "I'm not sure bigger is necessarily better, but there are a number of profitable investment opportunities for that company to make."

In addition, Host Marriot has decided to become a REIT itself. "A REIT definitely has an advantage in that it doesn't pay taxes at a corporate level," says Parsons. "So from that standpoint it would certainly have a competitive advantage in terms of acquiring properties."

The requirement for growth by public companies will increase in the near future and that growth will come from accretive acquisitions and internal property profits. Over the past couple of years, profitability has come easily to the hotel industry. The average daily room rate (ADR) in 1997 was up 6.1% while the consumer price index rose just 1.9%. Meanwhile, national occupancies have been above the 64.5% mark since 1994. A comparison of the state of the hotel industry in 1997 versus 1990 by Smith Travel Research shows ADRs of $58.07 in 1990 vs. ADRs of $75.60 in 1997, and RevPAR of $36.93 in 1990 vs. RevPAR of $48.50 in 1997.

The ability to do accretive acquisitions will get tougher and tougher. According to Stephen Rushmore, president and founder of HVS International in Mineola, N.Y., last year there were 243 hotel transactions of $10 million or more (in 1993 there were just 53), and the average price per room has risen as well, moving from $93,000 per room in 1993 to $128,000 in 1997. This year, Rushmore predicts a major jump forward to an estimated average price per room of $150,000 because of the demand for larger hotels.

"Values are going up because occupancies have gone up significantly," says Rushmore. "And capitalization rates have come down, particularly with the public hotel companies." Put another way, the low cost of capital is one factor that can enhance value. Since capitalization rates are tied directly to the price of capital, the lower the cap rate then conversely the higher the value. The cost of hotel debt capital averaged 10.5% in 1990 and today similar financing is 8.5% to 9.5%.

Asked if companies can still make money on their acquisitions, Rushmore responded: "Hotel companies are still making money on what they are buying, but they are making less money than if they bought property back in 1994. In 1994, if you bought hotels you were making a lot of money. Companies are still making a reasonable rate of return."

A reasonable rate of return is certainly keeping hotel companies interested in the game, but as noted, expansion by acquisition has been accelerating because some public formats such as REITs need to keep growing, the cost of capital is low, and the availability of capital with so many more lenders has kept the market liquid. Hotel brokerage companies are having trouble keeping up with all of the business.

Last year was a record year with 30 transactions for The Mumford Co. of Newport News, Va., and this year transactions should do even better as early business puts the company on a 40-plus pacing. "More today than before, it is institutional business in terms of ownership, more publicly owned larger companies than in previous years when hotel ownership was widely fragmented," says Paul Mumford, president of the company. "We are seeing a lot of smaller owners selling to larger owners. With the increased values in the hotel industry, the small owners can sell at fairly high numbers and they can either take their money and go home or reinvest it in turn-around situations (which can be fixed up and sold to institutional investors)."

The most profound change sweeping the hotel industry is the dramatic shift from private to public ownership, reports ERE Yarmouth and Real Estate Research Corp.'s Emerging Trends in Real Estate 1998.

"REIT juggernauts - Starwood, Patriot American, Prime and CapStar - have joined Marriott and Hilton to dominate lodging markets. Marriott and the REITs, in particular, have been on a buying tear - first properties, then portfolios and more recently owner-operators."

The hotel industry used to be very much a cottage industry, meaning if you took the 100-largest owners of hotels in the United States they probably accounted for only 4-5% of the rooms in the country, observes Dana Ciraldo, senior vice president of Atlanta-based property broker Hodges Ward Elliott. "What is going on is a huge consolidation similar to what happened to the steel and rubber industries before World War II. The trend over the next 20 years is for the big companies to double, triple and quadruple in size."

In the early-1990s, consolidation in the hotel industry was hampered by a lack of capital. "This situation has corrected itself very quickly," adds Ciraldo. Indeed, sources of capital in 1998are expected to be more interested in lending money than they were in 1997 and the lending community is finding the hotel industry a safe place to make mortgages.

The volume of finance for the hotel industry today is far in excess of what it used to be as banks, insurance companies, finance companies and everyone on Wall Street is in the game, says Greg Spevok, director of national marketing for the commercial debt finance group of Bear Stearns. Last year, Bear Stearns did $750 million in volume. Through the first four months of this year, the company is averaging $130 million a month. All of the loans eventually will become part of Bear Stearns' conduit program.

Unfortunately, with so much competition, lenders have to do even more volume to stay even as margins have slimmed considerably. "The ability to make money has declined as the business has matured, but that is the characteristic of any new business," says Spevok.

The Specialty Real Estate Finance division of Phoenix-based Finova Capital Corp. does two basic things - credit sale-leaseback transactions and hospitality lending. Of its $700 million portfolio, about $300 million is comprised of hotel and resort loans.

The market for lenders is crazy right now, says Randy Heller, vice president for Finova's Specialty Real Estate division. "Two years ago, spreads were 400 basis points over Treasury and we were making loans. Today, spreads are 150 to 180 basis points over Treasury. The market is 200 points below where it was two years ago and 100 points below where it was last year. We are not down there because we can't make money down there," says Heller. "There is too much money and not enough good product out there."

For the past two years "good product" has meant full-service hotel properties. During the mid-1990s, the industry focused on adding limited-service hotels through rebranding and even new construction, and the full-service segment remained relatively stable. Now there is a strong demand for full-service, especially in major cities - New York, San Francisco, Boston - where there are strong barriers to entry.

The big news last year was the consolidation among full-service chains. Starwood acquired Westin and ITT Sheraton, Marriott grabbed Renaissance Hotels & Resorts, while Patriot American helped itself to Wyndham Hotels and Carnival Hotels & Resorts. "Expansion through acquisition continues to make the most economic sense so long as companies can acquire them cheaper than building them - and we expect that this will be the case into the next century," reports the 1998 National Lodging Report published by E&Y Kenneth Leventhal Real Estate Group.

There is a run on the full-service and luxury hotel segment right now and prices are being driven up, says Horwath Landauer's Mullikin. "There is a perception that limited-service may go through a bit of a slump in the next few years so REITs feel as though they need to get more inventory in the full-service sectors. That is why you see a Starwood picking up Westin and Sheraton hotels. There is a perception that this is where you want to be in the marketplace."

Besides, full-service hotels just make a lot of economic sense at the moment. In the late-1980s, lenders stopped financing large, full-service properties because of a high rate of loan defaults. Even today, refinance and construction loans are readily available for budget, economy and mid-priced hotels, while first-class and luxury hotels remain difficult to finance.

Since there have not been many full-service hotels built in this decade, they are now in the enviable position of being able to push room rates sky high without compromising improving occupancies. In cities like New York and Chicago, occupancies for full-service and luxury hotels are in the high-80% range.

"Everybody wants these hotels because there hasn't been a lot of building in this segment, so there is still a lot of upside on room rates as a lot of these hotels are peaking in occupancy," says Frank Nardozza, national director of hospitality services at KPMG Peat Marwick LLP in Miami. "In some major markets, rates are increasing at a 10% clip."

The value cycle of economy and mid-priced hotels probably has already peaked as more new supply comes on-line. Occupancies will begin to decline and room rates won't improve significantly as they have over the past few years. There will be pressure on earnings. "Upper end categories still haven't peaked yet," adds Nardozza. "When you look at resort markets and you look at major city-center markets, values are still trending upwards. In some cities such as New York, property values for full-service luxury hotels have been popping up as much as 12 to 15% a year."

The caution is, prices for full-service hotels are getting closer to replacement costs, especially on larger, high-profile deals. "Whether the deals still make economic sense has a lot to do with what the buyer is expecting to do with the property," says Hotel Partners' Burba. "But, the prices are getting pretty high, especially at the luxury end."