What happens when hotel investors mix great property fundamentals, double-digit returns and an abundance of capital in a cocktail shaker of limited supply? The hospitality industry becomes the life of one big investment party. That's what has been taking place over the past few years in the lodging industry, and it doesn't appear to be letting up any time soon.

In this euphoric climate, expert advice to investors isn't complicated — buy and build. “Now's the time to build or develop new hotels,” urges Steve Rushmore, president and founder of HVS Hospitality Consulting, based in New York. “Buy as many as you can and build as many as you can. Then look to get out somewhere in 2009 or 2010.”

In practice, investors seem to be heeding that advice. U.S. full-service hotel sales will total in excess of $30 billion this year, up from $21 billion in 2005, according to Jones Lang LaSalle Hotels. Occupancy has been bubbly with 3.2% growth in the first quarter, while revenue per available room (RevPAR) increased 12.8% over the same period. The hotel doors are wide open and investors are packing in.

“What we have seen is that as profits and property values have grown, we're closer than we've been in five or six years to that important point where market values equal replacement costs,” says Mark Woodward, senior vice president of PKF Consulting, an Atlanta-based hotel consultant. “But we're still not quite there yet.”

Dissecting the sector

So far, supply has grown at a snail's pace. From 2003 through the end of 2005, the supply of available rooms grew by a total of only 1.9% (see chart, p.32). Woodward predicts the supply of available rooms will only grow by 0.7% in 2006 and not return to the long-term average of 2.3% until 2009.

In fact, it is exactly that finite amount of supply — and strong returns — that have proven to be honey to the institutional investment crowd. Traditionally wary of the hotel sector, institutional investors have set aside their reservations because of changing industry standards that allow owners more say in day-to-day operations. “You have stricter performance clauses [for managers], and in many cases the right to terminate upon sale, which adds greater liquidity to the exit,” says Alan Tantleff, executive vice president for Jones Lang LaSalle Hotels.

“The perception is that there is a lot more room to move income in hotels than in other product types,” says Tantleff. “[Investors are] less concerned about the risk than they have been in the past.”

The closely watched index compiled by the National Council of Real Estate Investment Fiduciaries tells the story. As of the second quarter of this year, hotels outperformed all other sectors with annualized returns of 20.82% compared with office, 19.46%, or apartments, 18.84% (see chart, top right).

In spite of the almost ebullient attitudes of investors, most developers are loudly bemoaning rising building costs. Builders are also keeping a nervous eye on the 10-year Treasury yield. Despite falling to 4.8% in late August, the 10-year Treasury remains 40 basis points higher than last year at this time. Earlier this year, in fact, the yield breached the 5% mark.

Against a backdrop of rising construction costs and the prospect of higher rates, developers and owners are combatting rising costs by employing creative tactics, such as stockpiling materials and building full-service product with the help of tax incentives or residential components.

High-class problems

The same factors that have contributed to making the sector so frothy have also had the effect of putting a ceiling on yields. It appears that as long as the planets remain aligned, however, investors won't be skittish about the lower returns.

“I think most developers today are looking at 10% to 11% yields on stabilized properties [assets that have been open for three years]. Two or three years ago, I would say that yield was 12% to 13%,” says Joe Green, president and CFO of Raleigh, N.C.-based Winston Hotels.

Woodward concurs, pointing out that technically, the lodging industry has become a victim of its own success. “Over the last 25 to 30 years, it was very common to see hotel investors requiring leveraged returns in the 18% to 25% range, and they had that requirement because of risk,” adds Woodward. Lower risks have made yields of 10% to 11% more palatable.

Red flags

It may prove to be a delicate balance for investors to reconcile healthy returns with rising costs. For instance, while revenue is projected to grow by 7.2% this year, operating costs are also expected to balloon by another 5%, atop a 6.5% increase last year, according to PKF.

Construction costs are at best draconian — up nearly 35% over last year, according to Green of Winton Hotels — but that hasn't brought building to a complete standstill. “The development costs and the land costs have increased substantially in the last one to two years,” says Green.

Green points to a recent Winston development of a Homewood Suites in Princeton, N.J. While the building was framed in lumber instead of concrete, the cost per room when the company broke ground last fall was $138,000. “If that project had been built two years ago, it probably would have been $120,000 per key,” he says. “And two years ago, it could have been built out of concrete.”

Another example is a Hilton Garden Inn in Akron, Ohio that's currently being built by Winston at $105,000 per key. Again, two years ago, Green believes the costs would have been $85,000 to $90,000 per key.

Necessity is the mother of invention. Atlanta-based Noble Investment Group is fighting high construction costs by stockpiling materials. “We've started committing to subcontractors and direct deals,” says Mit Shah, the firm's president and CEO. He also notes that the Katrina-torn Gulf Coast will pose major competition for materials, as will ongoing global growth and consequent construction.

The upper crust

With the high price of existing product and the steep cost of development, many developers and investors are either attempting to squeeze every last drop of profit out of their existing properties, or are moving toward redevelopment.

Of the $500 million in assets Noble acquired in 2005, for example, 25% underwent a major redevelopment, according to Shah. In an August transaction, Noble purchased the 28-story, 467-room Sheraton Colony Square in Midtown Atlanta from Starwood for $48.5 million in a joint venture with AEW Capital Management LP. The hotel is slated to open in late 2007 following a $50 million renovation and conversion to a W Hotel.

In May, the group purchased the Wyndham Metairie Hotel in New Orleans from Metairie Hotel Investors for $23 million. The hotel received a $2 million upgrade and was converted to a Sheraton. The upgrade includes revamping the exterior and adding a new business center and a Sheraton Club lounge. For just $25 million, the investors ended up with a full-service, 7-story hotel strategically located halfway between downtown and the New Orleans International Airport.

In fact, of the $350 million Noble currently has in development, $150 million will be spent on redevelopment. Slicing the pie another way, $150 million will also be devoted to select-service, although Noble's biggest focus will remain first-class, full-service product in top metropolitan cities. Over the next 18 to 24 months, the investment should translate into 2,500 new rooms on the market.

How does Noble make full-service hotels financially feasible? Shah says his firm makes those projects work by either developing with a public-private partnership or building projects with a residential component. In the latter scenario, “We'll stack condos on top of the hotels, sell the condos off, and then effectively lower the aggregate cost of the project,” explains Shah.

As far as public-private partnerships, Noble is working with the City of Raleigh, N.C., where it is building a 400-room Marriott hotel attached to the convention center, which is slated to open in 2008. The developer is receiving $20 million in incentives from the city to make the $70 million project viable.

Big fish

HEI Hospitality, a private ownership/investment firm based in Norwalk, Conn., is also still bullish about its core portfolio: first-class, full-service, brand name assets such as Marriott, Sheraton, Westin and Hilton located primarily in urban markets where there is little room for new development to compete. The company currently owns 26 hotels.

To date, HEI has raised two discretionary equity funds made up of capital investors, largely from university endowments: HEI Hospitality Fund I, at $275 million, closed in early 2004 and HEI Hospitality Fund II, at $425 million, was raised earlier this year. While the focus will be full-service acquisitions, a portion of Fund II may be invested in hotel development opportunities and vacation or leisure-oriented residential product.

“The best part of the cycle and the best buying opportunity is behind us, but compelling returns still exist,” says Clark Hanrattie, senior vice president and chief investment officer for HEI. “Supply will be very, very limited in full-service product in major markets.”

The firm's strategy is to buy into markets where the fundamentals work over a longer period of time — on average five to 10 years.

Troubled waters?

With all of the excitement in hotels, a number of investors from other industry sectors are crashing the hotel party. Many seasoned hotel investors caution: Hotels aren't just pretty faces, they're daily operations that require management and marketing skills, not to mention constant upkeep and maintenance.

“[Investors] go into the industry because they've perhaps been successful in other industries,” notes Morris Lasky, president and CEO of Lodging Unlimited, a Chicago-based hotel management firm. “It doesn't take them long in most cases to run these hotels down, even though their neighbors are doing extremely well.”

For instance, part of a reservations system in one hotel was shut down for an entire year. Potential guests were unable to book rooms. The fix was easy, says Lasky, but the problem was the result of a lack of management experience on the part of the owner.

The solution? According to Lasky, investors should work with management companies to execute daily operations. Lasky's firm takes unprofitable hotel properties and turns them around through branding, marketing and daily operations. The average turnaround time to make a property profitable is 16 months, he says. “If you can turn a hotel around in 16 months, it shouldn't have gone under in the first place.”

In spite of the influx of relative amateurs into lodging, delinquency and default rates remain extremely low, according to Bruce Lowrey, senior vice president of commercial mortgage lender CapMark, formerly known as GMAC Commercial Mortgage. Senior debt leverage is typically in the 70% to 75% range, although Lowrey notes that it's not uncommon to see mezzanine debt pushing lodging deals up to 80% or 85% of asset value.

Lowrey says that CapMark looks for borrowers who know hotels are daily operations and who realize the cyclical nature of the industry. Though he admits, “We have certainly seen very sophisticated investors who don't have much hospitality experience getting into this sector — on both the debt and the equity side.”

Removing the punch bowl

Barring any unforeseen terrorist event, severe economic downturn or supply glut, the lights will slowly dim on the current hotel party, possibly with an unforeseen surprise or two in the favor bag.

Rushmore of HVS predicts that the middle classes in both India and China will start traveling in the next five to 10 years. In the U.S., they'll hit gateway cities and destination markets. He says it's too early to calculate absolute numbers, but the outlook is bright. “When these people start traveling and spending money in the United States, it's going to be an amazing impact.”

So when is the critical moment, when investors should go home before they turn into pumpkins? According to Lowrey, while lenders have traditionally financed a fair amount of construction over the past 10 years, there isn't much going on right now. “To borrow on Alan Greenspan's phrase,” he says, “it is the lenders who are supposed to take the punch bowl away before too many people get drunk at the party.”

Sibley Fleming is the managing editor of NREI.

Developers narrow sights on select-service

With rising land prices and construction costs, many developers are opting to build or buy in the select-service segment, also referred to as limited service. Some $3 billion in property sales will occur in 2006, compared with $2.6 billion in 2005 and $2 billion in 2004, according to Jones Lang LaSalle.

Select-service hotels should see a 2.9% rise in occupancy in 2006, while full-service hotels are expected to remain flat for the remainder of the year, according to PKF Consulting. The segment is also forecast to see greater gains in average daily rate (7.5%) than its full-service cousin (6.4%).

Today's prices are too much for some investors to swallow. “Last year we acquired assets that are valued at $80 million, and this year we haven't bought any properties,” says Joe Green, president of Raleigh, N.C.-based Winston Hotels.

A preferred developer of Starwood's “aloft” product, Winston will develop 10 properties, at an average of $95,000 per key, excluding land costs. “The aloft is expected to compete directly with Hilton Garden Inn and Marriott Courtyard,” says Green.

In the select-service sector, Steve Rushmore, president of HVS Hospitality Consulting in New York, likes the “new concept” hotels such as aloft. “They're catering to the younger market that hasn't been singled out, but that is increasingly wealthy and will be traveling.”

Industry giant Hilton Hotels is betting on select-service in a big way. Of the 730 Hilton-branded hotels around the world, 85% are select-service. That number goes up in the U.S. market, where 90% of Hilton's projects in the pipeline are select-service. The brands are Hilton Inns, Hilton Inn & Suites, Homewood Suites and Hilton Garden Inns.

“In that focused service segment, it's really a great opportunity to build,” says Bill Fortier, senior vice president of franchise development for Hilton. Added costs are recouped in operations, he says.

With so many flocking to the select-service sector, is Fortier worried about a supply glut? “There are occasions now when we're saying no to a development because we just don't think the market is strong enough.”
— Sibley Fleming