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.